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Reconciling the market’s overreaction to (abnormal) accruals and underreaction to earnings
Henock Louis, Penn State University
Amy Sun, Penn. State University
ABSTRACT. Prior studies find that investors underreact to earnings surprises and overreact to (abnormal) accruals. We provide a plausible explanation for the apparent contradiction. We suggest that the post-earnings-announcement drift and the accrual anomaly are likely to have a common factor: investors’ failure to completely unravel managerial discretionary reporting behavior. We show that, after removing those cases where investors are likely to be mistaken about managers’ financial reporting incentives, there is little profit to be made from a strategy based on earnings surprises. In contrast, a trading strategy that focuses on instances where investors are most likely to be mistaken about managers’ financial reporting incentives yields an average abnormal return of 23.2% over the two quarters after the earnings announcement. Not only is the strategy substantially profitable, it is also relatively safe, yielding positive hedge-portfolio abnormal returns in every quarter in our sample period.
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