Cutting Through the Spin

Research by Michael Kimbrough

Each quarter brings a flurry of news releases coming from publicly traded companies announcing their earnings, often with an explanation for the good or bad numbers. The companies have a lot riding on the highly scrutinized earnings reports: Stock price changes can be significant as the market reassesses the future prospects of a firm. 

Some firms try to soften the impact of negative news by downplaying losses, but new research from Smith professor Michael Kimbrough shows that investors are smart enough to sift through the corporate spin and draw their own conclusions. Thus, managers have every incentive to lay out the details. 

Kimbrough, associate professor of accounting, and co-author Isabel Yanyan Wang of Michigan State University, looked at earnings announcements for 94 companies from 1999 through 2005. They coded the announcements and compared the explanation companies provided for their results to the stock prices in the three days surrounding the announcement. They found that companies have a tendency to attribute good earnings news to their own management efforts, and bad news to other forces. They also found that investors are savvy enough to be skeptical of corporate explanations of earnings dips and spikes. 

“Having information about what caused or contributed to earnings news should be useful information, but we also know that managers have a self-interest in trying to maximize the rewards for good news and minimize the penalties for bad new,” Kimbrough says. “That creates a challenge for investors in determining how much they are going to rely on the management explanations.” 

He said the explanations can provide useful information for interpreting earnings news, but they also just might be a reflection of managerial self-interest. “Our paper examines the factors might help the market better assess or determine an appropriate degree of reliance on managers’ explanations.” 

For example, after 9/11 many companies blamed missed earnings on the terrorist attacks even when they weren’t a factor in the decline. Another example: In the early 2000s, Krispy Kreme used the low-carb diet craze as a reason for why their market share was decreasing. 

“Just because you cite a cause, doesn’t mean that investors should actually believe that that’s the cause,” Kimbrough says. “Even though the facts you marshal may be true, your claim that those facts are relevant to interpreting your earnings news may not be. It’s not clear. Our study looks at the factors that investors consult.” 

This does not mean managers should not provide context for an earnings report. “The crux of our study is there is a role for managers to try to influence the market’s response,” Kimbrough says. “Investors do not just have to take the numbers as given without a context. Management can provide a context for investors to interpret the numbers. You could call it spin — and sometimes it can be spin — but it can also just be more information.” 

The researchers found that investors don’t just respond unfavorably to a company’s poor earnings reports if the company offers a reason for the numbers. They actually try to differentiate or calibrate their response to the attributions based on other information. 

“We find that investors look to cues like what has happened to other firms in the industry and whether they are experiencing the same difficulties,” Kimbrough says. “They also look at what kind of commonalties a firm has with the market or the industry over time. Both of those can be useful signals in ferreting out how plausible explanations are in an earnings report.” 

Kimbrough says effective corporate managers are mindful of the fact that investors are sophisticated and will provide the necessary details to help interpret the earnings numbers.  So for managers, the more verifiable details they can provide to back up earnings explanations, the better, he says. And for investors: View a company’s explanations as useful, but don’t just take the explanations at face value. Look at how persistent the good or bad news is in the industry, he says. 

“Are Seemingly Self-serving Attribution in Earnings Press Releases Plausible? Empirical Evidence,”was published in The Accounting Review in March 2014.