Earnings Surprises, Growth Expectations, and Stock Returns:

plausible, since it implies that the risk premium to value investors is only realized in
those states of the world where negative earnings surprises are announced.
Our evidence also has implications for managers’ financial reporting and
disclosure strategies. If managers of growth firms are aware that their firms’ stock prices
suffer large downward adjustments when they report earnings disappointments, they have
incentives to manage reported earnings and/or manage analysts’ expectations of reported
earnings to avoid negative earnings surprises. For example, managers may decide to
‘smooth’ earnings over a long period of time to make their earning more easily
predictable for analysts and avoid the likelihood of future earnings shortfalls. 16 A
number of recent studies document evidence of earnings and expectations management
for capital market reasons. Rangan (1998) and Teoh, Welch, and Wong (1998) find that
firms manage earnings upward around the time that they issue new equity. Brown
(1998), Burgstahler and Eames (1998), and Degeorge, Patel, and Zeckhauser (1999) all
report evidence consistent with the idea that managers manage both reported earnings and
analysts’ expectations of earnings to avoid negative surprises, and Brown finds that this
result is especially pronounced for growth stocks. Myers and Skinner (1999) find that
there are many more firms with long strings of consecutive increases in quarterly
earnings than would be expected by chance and report some evidence that managers of
these firms practice income smoothing to help achieve this result. Finally, Matsumoto
investors observe a series of consistently good earnings reports, but then “fall to earth” when those stocks
report earnings disappointments and investors realize their expectations were overly optimistic.
16 Of course, this begs the question of what costs or frictions are in place that allow these strategies to
“work” in an efficient capital markets setting.
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