Earnings surprise

An earnings surprise, or unexpected earnings, in accounting, is the difference between the reported earnings and the expected earnings of an entity.^[1] Measures of a firm's expected earnings, in turn, include analysts' forecasts of the firm's profit^[2][3] and mathematical models of expected earnings based on the earnings of previous accounting periods.^[4][5]

Effect of earnings surprises

Stock markets tend to react in the same direction as earnings surprises—positively to positive earnings surprises and negatively to negative earnings surprises—although a significant proportion of earnings surprises result in stock markets reacting in the opposite direction, which may be a reaction to other relevant information released with the earnings announcement or inaccurate measurement of the earnings surprise.^[6]

The market, however, may not correctly estimate the implications of earnings surprises when it revises its expectations of future earnings, which will decrease the change in stock prices associated with the change in earnings. In fact, many studies in accounting research have documented that the market takes up to a year to adjust to earnings announcements, a phenomenon known as the post-earnings announcement drift.^[7]

Large negative earnings surprises may have legal and reputational costs to managers. Firstly, managers can be held personally liable if shareholders sue the firm for failing to disclose negative earnings news promptly. Secondly, money managers may choose not to hold, and analysts may choose not to follow, the stocks of firms whose managers have reputations for withholding bad news. This may contribute to managers' voluntary disclosure of information related to negative earnings surprises: quarterly earnings announcements containing large negative earnings surprises are preempted by voluntary disclosures more frequently than are other earnings announcements.^[8]

Measurement

Earnings surprises can be measured using historical earnings or analysts' forecasts.^[9]

In accounting research, a measure that uses historical earnings is standardized unexpected earnings (SUE). SUE is the standardized difference between reported earnings and expected earnings, where expected earnings is modelled based on the assumption that earnings follows a seasonal random walk with a trend. In other words, in the case of quarterly earnings the SUE for quarter t is

${\displaystyle SUE_{t}={\frac {Q_{t}-E(Q_{t})}{\sigma (Q_{t}-E(Q_{t}))}}}$

where σ(X) is the standard deviation of X, and the expected earnings, E(Q_t), is calculated using prior reported earnings:

${\displaystyle E(Q_{t})=\delta +Q_{t-4}}$

where Q_t-4 is the reported earnings for quarter t-4 and δ is the average trend.^[4]

An alternative measure of SUE that uses analysts' forecasts is

${\displaystyle SUE={\frac {EPS-Forecast}{\sigma (EPS-Forecast)}}}$

where EPS is a firm's earnings per share, and Forecast is analysts' consensus forecast of its earnings per share.^[9]

See also

• Profit warning

References

1. Pinto, Jerald E.; Elaine Henry; Thomas R. Robinson; John D. Stowe (2010). Equity Asset Valuation (2nd ed.). John Wiley & Sons. ISBN 047057965X. Retrieved 18 January 2014.
2. "Earnings Surprise Definition". Investopedia. 2013. Retrieved 12 January 2014.
3. Defond, Mark L., and Chul W. Park. 2001. “The Reversal of Abnormal Accruals and the Market Valuation of Earnings Surprises.” The Accounting Review 76 (3): 375–404.
4. Bernard, Victor L.; Jacob K. Thomas (1990). "Evidence that Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings". Journal of Accounting and Economics. 13: 305–340. doi:10.1016/0165-4101(90)90008-r. Retrieved 18 January 2014.
5. Soffer, Leonard C.; Thomas Lys (1999). "Post-Earnings Announcement Drift and the Dissemination of Predictable Information". The Accounting Review. 16 (2): 305–331. doi:10.1111/j.1911-3846.1999.tb00583.x. Retrieved 18 January 2014.
6. Zhou, Ping. "Option Strategies for Earnings Announcements: Opportunities and Risks". FT Press. Pearson Education. Retrieved 13 January 2014.
7. Kothari, S. P. (2001). "Capital markets research in accounting" (PDF). Journal of Accounting and Economics. 31: 105–231. doi:10.1016/s0165-4101(01)00030-1. Retrieved 18 January 2014.
8. Skinner, Douglas J. (1994). "Why Firms Voluntarily Disclose Bad News" (PDF). Journal of Accounting Research. 32 (1): 38–60. doi:10.2307/2491386.
9. Anson, Mark J. P.; Donald R. Chambers; Keith H. Black; Hossein Kazemi (2012). CAIA Level I: An Introduction to Core Topics in Alternative Investments (2nd ed.). John Wiley & Sons. ISBN 1118285654.