IR Papers: Serve bad news fast

May 11, 2011
<p>A roundup of academic research from the world of IR studies</p>

The sooner a company announces bad earnings news, the less likely unhappy shareholders are to sue it.

In fact, the temporal effect is so significant that US researchers find companies that wait until the last few weeks of a quarter to publicize their likelihood to miss analysts’ expectations are 45 times more likely to face shareholder lawsuits than firms announcing in the quarter’s first few weeks.

‘While we can’t observe when the company got the bad news, we have pretty strong evidence that [timely disclosure] reduces litigation risk,’ says Dain Donelson, assistant professor of business at the University of Texas at Austin.

‘The channel [press release, conference call, meeting] matters, but our results show timeliness matters more,’ adds working paper co-author John McGinnis, also an assistant professor at the University of Texas at Austin.

Along with reputational damage, dodging earnings-related shareholder lawsuits has big financial implications. During 1996-2005, US companies shelled out more than $15 bn in settlements for securities-related class action lawsuits, and billions more fighting lawsuits that never made it to settlement.

Mythic thresholds
Think managing earnings to show an unexpected increase in earnings or profits will have a market effect? Think again.

After examining observations made about more than 100,000 separate business quarters, US and Canadian researchers came to the conclusion that there is little evidence of incremental threshold effects beyond simply meeting analysts’ forecasts.

‘Managers may perceive market rewards or penalties for meeting or missing these thresholds but we find little evidence that these actions are market-based,’ says study co-author Wayne Thomas, professor of accounting at the University of Oklahoma. ‘The most important hurdle – the only hurdle, in fact – is meeting analyst consensus forecasts.’

Thomas’ research also casts doubt on the so-called ‘torpedo effect’, where barely missing an earnings threshold detonates a disproportionate penalty. ‘Missing forecasts by a penny is bad news but missing by two pennies is worse,’ he maintains.

Style & content
Studies show that more readable disclosures lead to stronger reactions from retail investors. Recent research, however, suggests this isn’t necessarily because better readability lets investors gather more information.

Rather, it would appear that easy-to-process information may also simply boost investors’ confidence in its reliability.

‘Because individuals assume that feelings experienced while thinking about a target bear on the target itself, positive feelings of processing fluency are treated as a cue that the disclosure is dependable,’ explains Kristina Rennekamp, a PhD candidate at Cornell University.

Curiously, Rennekamp’s experimental study finds no direct link between a press release’s readability and investor judgments about management credibility.

‘My guess is that investors don’t consider the fact that managers had some choice in the level of readability,’ says Rennekamp. ‘It’s only when that is made apparent that they begin to make inferences about management.’

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