I review empirical research on the relation between capital markets and financial statements.The principal sources of demand for capital markets research in accounting are fundamental analysis and valuation, tests of market efficiency, and the role of accounting numbers in contracts and the political process.The capital markets research topics of current interest to researchers include tests of market efficiency with respect to accounting information, fundamental analysis, and value relevance of financial reporting.Evidence from research on these topics is likely to be helpful in capital market investment decisions, accounting standard setting, and corporate financial

It is well established that the realized returns of ‘growth ’ stocks have been low relative to other stocks. We show that this phenomenon is explained by a large and asymmetric response to negative earnings surprises for growth stocks. After controlling for this effect, there is no longer evidence of a stock return differential between growth stocks and other stocks. Our evidence is consistent with investors having naively optimistic expectations about the prospects of growth stocks (e.g., Lakonishok, Shleifer, and

Recent articles in the popular press suggest that managers are placing greater emphasis on meeting or exceeding analysts ’ expectations. 1 Consistent with this, empirical research provides evidence that firms manage both earnings and earnings forecasts in order to report earnings that meet or exceed analysts ’ expectations (Burgstahler and Dichev, 1997; Brown, 1998; Burgstahler and Eames 1998;

We test predictions relating to the role of financial analysts in aiding investors ’ assessment of the different valuation implications of the cash flow and accrual components of earnings. First, we examine whether analysts revise their forecasts of future earnings in anticipation of predictable accrual reversals. Then, we examine whether share prices reflect predictable accrual reversals differently depending on analyst activity. Our findings suggest that analysts act as sophisticated information intermediaries in that some analysts are able to identify firms with less persistent accruals. However, share prices do not reflect the information conveyed by analyst forecast revisions. Rather, investors appear to expect the same persistence in earnings, regardless of its cash flow and accrual components and regardless of analyst activity, until the accruals reverse. Thus, incorporating information from analyst activity substantially improves short-tem returns to an accrual-based trading strategy.

We investigate whether the direction and magnitude of earnings management by firms is affected by the sensitivity of their stock prices to earnings news. We argue that firms with high price sensitivity to relatively small earnings surprises are more likely to direct their earnings management toward meeting or beating analysts' earnings forecasts than firms whose price sensitivity to earnings news is low. As a consequence, these firms are more likely to engage in either income-increasing or income-decreasing earnings management that leaves reported earnings equal to or above analysts' forecasts and are less likely to engage in extreme, incomedecreasing earnings management than other firms. In contrast, firms with low price sensitivity to earnings news are more likely to engage in reserve-creating earnings management, leading to negative (i.e., bad news) forecast errors than other firms. The level of analysts' outstanding stock recommendations is used as proxy for contemporaneous stock price and, hence, firms' sensitivity to earnings news. Consistent with our predictions, after being rated a Buy (Sell) firms are more (less) likely to engage in earnings management that leaves reported earnings equal to or slightly above analysts' forecasts. In contrast, after being rated a Sell (Buy) firms are more (less) likely to engage in extreme, income-decreasing earnings management that leads to extremely negative forecast errors. Our empirical results provide direct evidence of purported but, heretofore, weakly documented equity market incentives for firms to manage earnings. They are also consistent with a growing body of literature that finds analysts either cannot anticipate or are not motivated to anticipate perfectly in their forecasts firms' efforts to manage earnings. 1.

This paper investigates the extent to which investors are rational with respect to two well-known empirical properties of analyst consensus forecasts: optimism and autocorrelated revisions. Consistent with previous research, I find that investors are aware of the optimistic bias in analyst forecasts, but do not adjust for it completely. Using Mishkin’s test, I find that the market’s expectation adjusts for approximately 70 % of the optimistic bias in analyst forecasts. The market is fully rational about the auto-correlation in two-year-ahead and three-year-ahead forecast revisions, but not so for one-year-ahead revisions: it recognizes 82 % of the auto-correlation in one-year-ahead forecast revisions. I further examine whether the degree of investor rationality is positively correlated with commonly used proxies for sophistication of marginal investors: size, analyst following and institutional ownership. I fail to find evidence that those proxies are positively correlated with the degree of investor rationality. Finally, I examine time-series variation in investor rationality, and find that investors seem to be more rational in recent years.

Although recent studies provide convincing evidence that firms manage earnings to achieve certain reporting objectives, there is still little evidence on what steps firms take to manage their earnings. This paper presents evidence as to which components firms use in order to manage bottom-line, reported earnings. Specifically, we identify a set of firms believed to be managing earnings upward; plot the empirical distributions of analysts ' forecast errors for sales, gross margin, operating expenses, non-operating expenses, and depreciation expense; and then examine these distributions for discontinuities around zero. Results suggest that these firms managed earnings upward by managing sales upward and by managing operating expenses downward. There is no evidence to suggest that these firms managed non-operating expenses or depreciation expense to affect earnings. We also use a firm's stock recommendation to make predictions about its incentives to manage earnings. Evidence suggests that firms rated buy (rated sell) manage earnings upward (downward) by managing sales, operating, and non-operating expenses in predictable directions. 2 Evidence on the Management of Earnings Components 1.

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