The Effect of Voluntary Disclosure and Preemptive Preannouncements on Earnings Response Coefficients (ERC) When Firms Manage Earnings

Abstract

We study analytically the effect of preliminary voluntary disclosure and preemptive preannouncement on the slope of the regression of returns on earnings surprise—the earnings response coefficient (ERC). When firms do not manage earnings, additional disclosure has no effect, and the ERC is proportional to price/permanent earnings ratio. If they manage earnings by attempting to inflate them, the response to (100% credible) negative earnings surprise is stronger than the response to (less than 100% credible) positive surprise. To avert litigation, firms that manage earnings adopt a partial voluntary disclosure strategy—either public revelation of good news and withholding bad news, or public revelation of bad news and withholding good news. Voluntary disclosure affects ERC on positive earnings surprise only, depending on what the firm reveals: the good- news revealing ERC (GRC) is higher than the bad-news revealing ERC (BRC), because good news enhances the credibility of the positive earnings surprise, even though the market discounts good news. Furthermore, preemptive pre-announcements improve ERC accuracy by narrowing the scope of earnings management.