The Reliability of Preliminary Earnings Releases

The following post comes to us from Scott N. Bronson of the School of Business at the University of Kansas; Chris E. Hogan of the Department of Accounting & Information Systems at Michigan State University; Marilyn F. Johnson of the Department of Accounting & Information Systems at Michigan State University; and K. Ramesh of the Jones Graduate School of Business at Rice University.

In the paper, The Unintended Consequences of PCAOB Auditing Standards Nos. 2 and 3 on the Reliability of Preliminary Earnings Releases, forthcoming in the Journal of Accounting and Economics, we examine the trade-off that companies face in providing value relevant information on a timely basis through preliminary earnings announcements (PEAs) versus the potential loss of reliability from releasing information prior to the audit report date. Historically, the vast majority of publicly-traded companies wait until after the audit report date (i.e., after the completion of audit fieldwork) to release preliminary earnings information. However, the implementation of Public Company Accounting Oversight Board Auditing Standards No. 2 (“AS2”) on internal control and No. 3 (“AS3”) on audit documentation resulted in delaying completion of the audit for a large number of public companies.

Using a large sample of annual earnings releases over the period 2000-2005, we find a dramatic increase in the length of time between the fiscal year-end and the audit report date (“audit report lag”) that is concurrent with the implementation of PCAOB AS2 and AS3. Audit report lags in the 2000-2003 period, which preceded the regulatory changes, average 46 – 50 days. In contrast, following the regulatory changes, 2004 and 2005 audit report lags increased to 62 and 65 days, respectively. However, due to market demand for timely disclosures, most firms maintain the same preliminary earnings release date even though the audit may not be complete as of that date. Consequently, the incidence of firms announcing earnings after the audit report date declined from close to 70% in the 2000-2001 period to around 20% in 2005. This change is due predominantly to accelerated filers that had to comply with both AS2 and AS3.

To the extent the new regulations increase the proportion of firms announcing earnings prior to the audit report date, we expect a commensurate decrease in the reliability of preliminary earnings information in the marketplace. To test this prediction, we examine preliminary earnings announcement (PEA) revisions, which we define as cases in which earnings as reported in the preliminary annual earnings announcement differs from the number subsequently reported in the audited 10-K filing. Consistent with the increase in the proportion of firms whose preliminary releases contain pre-audit report date numbers, we show that the number of PEA revisions in our sample has increased over time from 12 in 2000 to 186 in 2005. After controlling for characteristics of firms with PEA revisions, we find that this unintended regulatory effect is economically significant in that PEA revisions would have been 35% lower during 2005 if the historical frequency of issuing earnings releases after the audit report date had not changed due to the new regulations.

We provide additional evidence on the economic significance of the PEA revisions by examining the market reaction to their disclosure. Consistent with prior evidence of a negative market reaction to announcements that previously-filed earnings numbers will be restated, we find a significantly negative market reaction to the announcement of a forthcoming PEA revision for 35% of PEA revision firms that announce the revision in a press release and/or 8-K. However, we find no significant market reaction when the initial disclosure of a PEA revision is the 10-K filing containing the revised numbers (which occurs in 46% of our sample revisions). This result is consistent with our finding that revisions disclosed in 10-K filings are generally smaller in absolute magnitude than revisions disclosed in press releases and/or 8-K filings. In addition, for firms that foreshadow impending PEA revisions in the earnings press release (19% of our sample), we find that the market reaction around the release of preliminary earnings reflects the market’s reliability concerns, as evidenced by the fact that the market reaction to unexpected earnings is less (more) pronounced for good (bad) news.

Taken together, the study’s findings are of interest to investors, regulators, and academics. While audits are designed to provide reasonable assurance that financial statements are free from material misstatements, few archival studies have directly examined the value of the audit process to public companies. Evidence of a lower incidence of revisions when firms release preliminary earnings subsequent to the audit report date is consistent with auditing increasing the reliability of information in the preliminary releases.

A working version of the paper is available here.

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