Understanding earnings quality - MIT Sloan School of Management

differences, which investors rationally interpret as a "red flag" for decreasing persistence (Hanlon,
2005).
The mispricing even exists at the time of an IPO or SEO (Rangan, 1998; Teoh et al., 1998;
DuCharme, Malatesta, and Sefcik, 2004). These results contradict the notion that investors
anticipate earnings management in cases when it is likely. More consistent with investor
anticipation, Shivakumar (2000) finds evidence of abnormal accruals prior to SEOs but not
mispricing. DuCharme et al. (2004) find that the likelihood of litigation is positively associated with
abnormal accruals around equity offerings, which begs the question whether issuers anticipate the
litigation risk.
6.1.2 Market valuation
Discretionary loss reserves are associated with lower market valuations in the P&C insurance
industry (Petroni, Ryan, and Wahlen, 2000; Beaver and McNichols, 1998) and in the banking
industry (Beaver and Engel, 1996). Firms that consistently meet or beat prior period earnings have
higher price-earnings ratios or market-multiples than matched samples (Barth, Elliott, and Finn,
1999; Myers, Myers, and Skinner, 2007) even if there is evidence of earnings management to
achieve the results (Myers, Myers, and Skinner, 2007). Kasznik and McNichols (2002) document
that firms that meet analyst expectations do not get rewarded with higher relative valuations unless
they meet them consistently. When firms eventually miss a target, they are likely to immediately
lose the extra valuation (e.g., Skinner and Sloan, 2000; Myers, Myers, and Skinner, 2007).
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