Earnings Warnings: Market Reaction and Management Motivation by Somchai Supattarakul, B.B.A., M.B.A., M.P.A. Dissertation Presented to the Faculty of the Graduate School of The University of Texas at Austin in Partial Fulfillment of the Requirements for the Degree of Doctoral of Philosophy The University of Texas at Austin May, 2003 UMI Number: 3116199 ________________________________________________________ UMI Microform 3116199 Copyright 2004 by ProQuest Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ____________________________________________________________ ProQuest Information and Learning Company 300 North Zeeb Road PO Box 1346 Ann Arbor, MI 48106-1346 Dedication To my parents Acknowledgements I would like to express my most sincere gratitude to my committee members: Rowland Atiase (Chair), Robert Freeman, Tom Shively, Laura Starks, and Senyo Tse. Rowland has been an invaluable mentor to me, and has been generous with his time and advice throughout my doctoral studies. In addition, I wish to acknowledge with sincere thanks to many helpful suggestions of Peggy Weber. Also, I would like to thank First Call Corporation, and Steve Sommers in particular, for the corporate earnings guidance data. I appreciate the financial support of Ministry of University Affairs (Thailand) and Faculty of Commerce and Accountancy, Thammasat University (Thailand). I would like to thank my colleagues and friends at Thammasat University (Thailand) for their support and encouragement. Finally, my deepest thanks go to my parents, my sister and brothers, for their unconditional love and support. They have always been my source of strength. Without them this would have not been possible. v Earnings Warnings: Market Reaction and Management Motivation Publication No._____________ Somchai Supattarakul, Ph.D. The University of Texas at Austin, 2003 Supervisor: Rowland K. Atiase This dissertation provides empirical evidence on the market reaction to earnings warnings as well as management’s motivation to issue earnings warnings. Specifically, this study first investigates whether self-selection bias exists in a firm’s warning choice and if so, whether the warning effect (i.e., a differential market reaction associated with earnings news between warning and no-warning scenarios) is positive (negative) for good (bad) news warnings after controlling for potential self-selection bias. I find that self-selection does exist in a firm’s warning choice and it creates a downward bias in the warning effect. I also find that the warning effect after controlling for self-section bias, on average, is positive (negative) for good (bad) news warnings suggesting that empirical evidence in Kasznik and Lev [1995] and Atiase, Supattarakul, Tse [2003] is robust after controlling for self-selection bias. More importantly, this study vi investigates whether and how the warning effect affects a firm’s warning choice (i.e., to warn or not to warn). I find that a firm’s tendency to warn is positively associated with the warning effect after controlling for other management motives to issue earnings warnings, i.e., litigation concerns, reputation concerns, and information asymmetry consequence concerns, suggesting that the warning effect itself provides management with an economic motivation to issue earnings warnings. vii Table of Contents List of Tables x List of Figure xii Chapter 1: Introduction 1 Chapter 2: Prior Studies and Hypotheses 10 2.1 Differential market reaction (The warning effect) 10 2.2 Self-selection in a firm’s warning choice 12 2.3 Management motives to issue earnings warnings 15 Chapter 3: Model Specification and Estimation Procedures 20 3.1 Model specification 20 3.2 Limited dependent variable or self-selectivity problem 22 3.3 Lee [1978]’s approach 23 3.4 Methodological problems in Shu [2001] 27 Chapter 4: Sample Design and Variable Definitions 30 4.1 Sample selection criteria 30 4.2 Sample Description 31 4.3 Variable Definitions 32 4.3.1 Market reaction associated with earnings news (MRW and MRN) 32 4.3.2 Determinants of market reaction associated with earnings news (Z * ) 33 4.3.3 Warning choice (WARN) 37 4.3.4 Management motives to issue earnings warnings (S * ) 37 4.4. Sample descriptive statistics 41 Chapter 5: Empirical Tests and Results 43 5.1 Self-selection and its impacts on the warning effect 43 viii 5.2 A firm’s tendency to warn and the warning effect 57 Chapter 6: Summary and Conclusions 62 6.1 Summary 62 6.2 Contributions and future research 63 Figure and Tables 66 References 97 Vita… 101 ix List of Tables Table 1 – Reconciliation of Sample Data 68 Table 2 – Distribution of Earnings Warnings by Year and Quarter 69 Table 3 – Sample Descriptive Statistics 70 Table 4 – Correlations of Market Reaction Associated with Earnings News (MR), Unexpected Earnings (UE) and Analyst Forecast Revisions (AFR) 72 Table 5 – Results of Probit Maximum Likelihood Estimation of Warning Choice Model to Obtain Parameters to Calculate “Inverse Mills Ratio” 73 Table 6 – Results of OLS Estimation of Market Reaction Model under Warning Scenario – Controlling for Self-selection Bias 76 Table 7 – Results of OLS Estimation of Market Reaction Model under No-Warning Scenario – Controlling for Self-selection Bias 79 Table 8 – Distribution of the Warning Effect after Controlling for Self-selection Bias ( R M ˆ ∆ ) 82 Table 9 – Results of OLS Estimation of Market Reaction Model under Warning Scenario – without Controlling for Self-selection Bias 84 Table 10 – Results of OLS Estimation of Market Reaction Model under No-Warning Scenario – without Controlling for Self-selection Bias 87 Table 11 – Distribution of the Warning Effect without Controlling for Self-selection Bias ( R M ˆ ′ ∆ ) 90 x Table 12 – Distribution of Self-selection Bias ( S ) in the Warning Effect 92 BS ˆ Table 13 – Results of Probit Maximum Likelihood Estimation of Warning Choice Model 94 xi [...]... Eqs (1) and (2), MRWi and MRNi denote firm i’s market reactions associated with earnings news under warning and no-warning scenarios, 20 respectively, and Z * denotes a vector of firm i’s firm-specific characteristics that i determine firm i’s market reaction to earnings news ε iW and ε iN denote firm i’s random residuals under warning and no-warning scenarios and are assumed to be N(0, σ 2 ) and N(0,... choice and the association between a firm’s tendency to warn and the warning effect 2.1 DIFFERENTIAL MARKET REACTION (THE WARNING EFFECT) Kasznik and Lev [1995; hereafter KL] examine whether there is a differential market reaction associated with earnings news between firms that warn and firms that do not warn (i.e., a differential market reaction induced by earnings warnings or “the warning effect”) Market. .. This dissertation provides empirical evidence on the market reaction to earnings warnings and management s motivation to issue earnings warnings Earnings warnings are any earnings- related management voluntary disclosures made prior to the earnings announcement date.1 Firms use earnings warnings to provide timely information to their shareholders and investors as well as financial analysts regarding... interchangeably for both good and bad news Earnings warnings are also referred to as earnings preannouncements (Soffer, Thiagarajan, and Walther [2000]) 2 Market reaction to earnings news under a warning scenario is the reaction to the news in both the earnings warnings and earnings announcements combined while market reaction to earnings news under a no-warning scenario is measured as the returns over a comparable... proxy for management motives to issue earnings warnings As a result, her model is misspecified Furthermore, according to Maddala [1983; 1991], among others, selfselectivity variables should only be used to obtain unbiased OLS estimates (in the market reaction models), and never be used to estimate dependent variables (i.e., market reactions associated with earnings news); and differential market reactions... reaction induced by earnings warnings or “the warning effect”) Market reaction to earnings news for warning firms is the reaction to the news in both the earnings warnings and the earnings announcements (i.e., a combination of cumulative abnormal returns around the warning date and the earnings announcement date) Market reaction to earnings news for no-warning firms is measured as the cumulative abnormal... prior to the earnings announcement date (Ip [1997], McLean [2001] and Stone [2002]) Kasznik and Lev [1995; hereafter KL] and Atiase, Supattarakul, and Tse [2003; hereafter AST] find a differential market reaction to earnings news between warning and nowarning scenarios (i.e., “the warning effect”).2 Specifically, AST document that the warning effect is positive for good news warnings while KL and AST find... effect, self-selection bias in a firm’s warning choice, and management motives to issue earnings warnings Chapter 2 also develops hypotheses regarding the existence of self-selection bias in a firm’s warning choice and the association between a firm’s tendency to warn and the warning effect Chapter 3 specifies the market reaction and warning choice models, and describes estimation procedures that address... reviews the contribution of the study, proposes possible avenues for future research and concludes the dissertation 9 Chapter 2: Prior Studies and Hypotheses This chapter discusses prior studies on differential market reactions induced by earnings warnings (i.e., the warning effect), management motives for issuing earnings warnings and issues related to self-selection bias It also develops hypotheses regarding... self-selection bias and to explicitly examine the associations between a firm’s tendency to warn and the warning effect after controlling for three other management motives 19 Chapter 3: Model Specification and Estimation Procedures This chapter describes the models and estimation procedures used in the study I specify market reaction models for warning and no-warning scenarios and a warning choice . on the market reaction to earnings warnings and management s motivation to issue earnings warnings. Earnings warnings are any earnings- related management. Without them this would have not been possible. v Earnings Warnings: Market Reaction and Management Motivation Publication No._____________ Somchai