This article was downloaded by: [UNBC Univ of Northern British Columbia] On: 30 March 2013, At: 17:30 Publisher: Routledge Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer House, 37-41 Mortimer Street, London W1T 3JH, UK Applied Economics Letters Publication details, including instructions for authors and subscription information: http://www.tandfonline.com/loi/rael20 Profit warnings: will openness be rewarded? Matthew Church a & Han Donker a a School of Business, University of Northern British Columbia, Prince George, British Columbia, V2N 4Z9, Canada Version of record first published: 30 Mar 2009. To cite this article: Matthew Church & Han Donker (2010): Profit warnings: will openness be rewarded?, Applied Economics Letters, 17:7, 633-637 To link to this article: http://dx.doi.org/10.1080/17446540802298043 PLEASE SCROLL DOWN FOR ARTICLE Full terms and conditions of use: http://www.tandfonline.com/page/terms-and-conditions This article may be used for research, teaching, and private study purposes. Any substantial or systematic reproduction, redistribution, reselling, loan, sub-licensing, systematic supply, or distribution in any form to anyone is expressly forbidden. The publisher does not give any warranty express or implied or make any representation that the contents will be complete or accurate or up to date. The accuracy of any instructions, formulae, and drug doses should be independently verified with primary sources. The publisher shall not be liable for any loss, actions, claims, proceedings, demand, or costs or damages whatsoever or howsoever caused arising directly or indirectly in connection with or arising out of the use of this material.
Applied Economics Letters, 2010, 17, 633 637 Profit warnings: will openness be rewarded? Matthew Church and Han Donker* School of Business, University of Northern British Columbia, Prince George, British Columbia, V2N 4Z9, Canada We investigate the information content of profit warnings released by firms on the abnormal returns for a sample of 149 firms listed on the Euronext Amsterdam in 2000 2002. We propose that firms can diminish the negative influence of profit warnings on shareholder s returns by releasing detailed information, thereby reducing the information asymmetry between shareholders and management. We find empirical evidence that a greater degree of disclosure has a significantly positive impact on the abnormal returns of firms with multiple successive profit warnings. We argue that negative abnormal returns will occur with firms which provide external reasons in their press releases indicating that the causes of the current situation are a market-wide phenomenon and beyond their scope. We report a negative but not significant impact of information regarding external reasons on the abnormal returns to shareholders of firms with profit warnings. Our research findings offer valuable insights into the practical implications of the information content of profit warnings. I. Introduction This article examines the information content of profit warnings issued by firms listed on the Euronext Amsterdam between November 2000 and December 2002. The Euronext Amsterdam regulations for listed firms oblige firms to publish price-sensitive information immediately (Article 28h of the Listing and Issuing Rules). Article 28h stipulates that firms must immediately release information regarding any facts or events which are expected to have a significant influence on the share price. This relates in particular to new facts and circumstances which are not public knowledge and includes such matters as important new developments affecting the firm, changes in the firm s financial position and performance, and changes in the firm s own expectations regarding these matters. Firms must immediately release a profit warning via the media when new forecasts substantially deviate from an earlier forecast regarding the development of the firm s performance and/or financial position. The press release can consist of a simple statement or a detailed description of problems, reasons and solutions for the firm. Corporate officers have the discretion to select either of these options. Grossman and Hart (1980) show that officers of firms have incentives (such as share-based compensation plans) to reveal all available information to obtain higher share prices because failure to release information would cause shareholders to assume the worst. Shareholders can rely on these disclosures when there are legal and contractual penalties, as well as consequences for managerial reputation in case of misreporting. Within this context, officers are less reluctant to release price-sensitive information. The decision to issue a profit warning ultimately rests with the firm s officers, who know that profit warnings and related announcements will most likely influence share prices negatively in the short term. Diamond and Verrecchia (1991) and Botosan (1997) have found that a greater degree of disclosure generally decreases the cost of equity capital thus increasing firm profitability. *Corresponding author. E-mail: donker@unbc.ca Applied Economics Letters ISSN 1350 4851 print/issn 1466 4291 online Ó 2010 Taylor & Francis http://www.informaworld.com DOI: 10.1080/17446540802298043 633
634 M. Church and H. Donker Our article examines the influence of profit warnings on shareholder s returns and investigates what information content will maximize shareholder value. We hypothesize that a greater degree of disclosure will be rewarded by the market, and thus, the abnormal returns will be lower in those companies that release only a simple statement to warn of falling profits, compared with companies releasing a detailed warning. Our research is unique, as much of the previous academic research in the field has only concentrated on the market performance implications of profit warnings. The remainder of the article is organized as follows. Section II reviews the existing literature on profit warnings. Section III describes the data and methodology in this study. Section IV presents the results of the event study and the cross-sectional analysis. Section V summarizes our findings. II. Literature Review Previous research on profit warnings has focused on the impact of profit warnings on share price. Studies from Jackson and Madura (2003 and 2004) show a trend of strong negative abnormal returns both after and, to a lesser extent, before the issuance of the warning. On a broader level, profit warnings are related to earnings announcement containing surprises, a topic examined by Rendleman et al. (1982) and Bartov (1992), among others. Unlike earnings announcements, which have a predetermined and recurring release date, profit warnings are not announced in advance; thus, the element of surprise is greater, as are the accompanying negative abnormal returns. Bulkley and Herrerias (2005) also observed this same trend of negative abnormal returns after profit warnings and differentiated these into two groups: those that only warn of lower-than-expected profits and those that add a revised forecast in addition. Negative market performance was greater where the warning did not include a new forecast. Kearns and Whitley (2002) concluded that profit warnings are preceded by a consistent decline in profit margins, a decline larger than in firms also experiencing negative earnings surprises but not issuing profit warnings. The act of issuing a profit warning does not cause the decline in profit margins; rather, management only chooses to issue warnings in the most dire of circumstances. This same study also found that the extent of leverage increases and dividends fall to a greater extent in profit warning-issuing companies than in those that have a drop in profits without issuing a warning. Our research incorporates leverage (LEV ) as a variable in the analysis of abnormal returns, taking the Kearns and Whitley study one step further. Mikhail et al. (2004) found that companies with repeated earnings surprises differing from analysts forecasts (mainly negative surprises, but also positive surprises to a lesser extent) experience a higher cost of equity capital. The authors also found that the number of analysts covering a company decreases with repeated earnings surprises, but this was not substantiated as the sole cause of the increased cost of capital. Our study incorporates these factors as descriptors of abnormal returns with the multiple warning (MUL) and discrepancy in analyst forecasts (FOR) variables. The study of the market s reaction to profit warnings is as much a study of psychology as finance. Libby and Tan (1999) experimentally determined that the sequential processing of a profit warning followed by the actual (negative) earnings announcement leads analysts to issue much lower future earnings guidance, compared to disappointing earnings announcements on their own. These results conflict with those of Easterwood and Nutt (1999), which found that analysts tend to underreact to profit warnings and other negative earnings surprises. In addition to analysts earnings forecasts, the decision to issue profit warnings is another behavioural aspect that has been considered. Kasznik and Lev (1995) and Helbok and Walker (2003) both found that the management of a firm is more likely to issue a warning when the financial problems are of a permanent nature. If there is a one-time drop in earnings, then management is much more likely to forego a warning and save the news until the actual earnings announcement. Collett (2004) additionally found that management may withhold profit warnings where they desire to conceal increased default risk from creditors and where directors hold share interests in the corporation. III. Data and Methodology The sample of profit warnings used in our study is collected from listed firms on the Euronext Amsterdam. The total sample contains 149 profit warnings from November 2002 to December 2002. The information regarding profit warnings is obtained from the Dutch Financial Times (Het Financieele Dagblad). The daily share prices and the accounting data for the sample are gained from Datastream. Data on managerial shareholdings are collected from the filings of the financial securities authorities (Authorities Financial Markets, AFM). We used an event study to measure the abnormal returns around the announcements of profit warnings.
Profit warnings: will openness be rewarded? 635 Daily stock returns are used to estimate the abnormal returns associated with the profit warning (Brown and Warner, 1985). For each security in our sample, we measure the market model returns. For each security i, we estimate the abnormal returns AR i,t as follows: Market model: AR i;t ¼ R i;t _ i þ _ ir m;t where _ i and _ i are ordinary least squares (OLS) values from the estimation period prior to the event window. In our cross-sectional analysis, we use a multiple regression model of the following form: CAR i; ½t n;tþnš ¼þ 1 MAN i þ 2 SIZE i þ 3 ROA i þ 4 LEV i þ 5 EXT i þ 6 DIS i Where: CAR i,[t n,t+n] MAN i SIZE i ROA i LEV i EXT i DIS i IV. Results Cumulative abnormal returns over the t - n to t + n event window for firm i; Total percentage of shares held by management; Log of the firm s market value before the announcement of the profit warning; Return on assets reported at the end of the year prior to the profit warning; Total debt divided by the book value of total assets reported at the end of the year prior to the profit warning; Dummy variable that equals 1, if the firm holds external reasons responsible for the deviation from the market expectations; Dummy variable that equals 1, if the firm discloses quantitative and qualitative information in the press release of the profit warning. Table 1 summarizes the results for the cumulative average abnormal returns (CAARs) based on the market model. The daily average abnormal return (AAR) on the announcement day (t = 0) is negative (-6.12%) and statistically significant at the 1% level. The CAAR ðþ ðþ Table 1. Cumulative average abnormal returns (CAARs) of profit warnings Event window (days) CAAR Statistics [-20,20] -7.96%*** ( p = 0.00) [-1,1] -8.38%*** ( p = 0.00) AAR(0) -6.12%*** ( p = 0.00) [-20,-1] -1.89%* ( p = 0.09) [1,20] 0.06% ( p = 0.51) Notes: ***, ** and * indicate significance at the 1, 5 and 10% levels, respectively (two-tailed tested). based on a 20-day window interval around profit warnings shows a significantly negative CAAR (-7.96%) as well. The CAAR from day -20 to day -1 (-1.89%) is significant at the 10% level (p-value = 0.09). The CAAR (0.06%) from day 1 to day 20 is not significant. Nearly all information is absorbed in the market price around the announcement of the profit warning [-1,1]. Figure 1 shows the market response during the time span around the announcement of profit warnings. As shown in Figure 1, the abnormal returns plumbed down around the press release. The disparity between firms with single announcements (SINGLE) and firms with multiple announcements (MULTI) widens in the post-announcement period. A possible explanation for the deviation is that the market has already absorbed some previous (negative) news for firms with multiple announcements. Overall, the empirical evidence is consistent with previous studies in the view that the stock market responds negative to profit warnings. Table 2 presents the results of our OLS regressions analyses for profit warnings. We estimate the cumulative abnormal returns of profit warnings using different regressions for firms with single announcements (Equation 2) and multiple announcements (Equation 3). Equation 1 shows the results of the total sample. The OLS-estimate for managerial shareholdings (MAN)is positive and significant at the 5% level. Jensen and Meckling (1976) argued that alignment between the interest of management and shareholders will reduce agency costs. Shareholders will have more faith in the future prospects of the firm when management has a stake in the company (convergence-of-interest hypothesis). We have included the variables SIZE, ROA and LEV in the regressions as controls for some firm-specific characteristics. Prior literature has shown that larger firms often have greater institutional monitoring, more media coverage and greater reporting responsibilities. Therefore, firm size seems to be an important determinant of the quality of the firm s information environment. The ability of analysts to forecast earnings could be related to SIZE.
636 M. Church and H. Donker 2 0 CAAR 2 4 6 8 MULTI TOTAL 10 12 SINGLE Table 2. Regressions on profit warnings Dependent variable: CAR[-20,20] Independent variables 14 20 18 16 14 12 10 8 6 4 2 0 2 4 6 8 10 12 14 16 18 20 Days Fig. 1. Event study Equation 1 total sample The estimated coefficient of SIZE is significantly different from zero and positive across all models. Regarding the control variable ROA (return on assets), we find a negative relationship (across all equations) between ROA and the cumulative abnormal returns to shareholders. The estimates are significant for Equations 1 and 3. A possible explanation could be that shareholders are more surprised (and react accordingly) when ROA is high in the year prior to the profit warning. We next examine the information content of profit warnings on shareholder value. We predict that the coefficient estimates on disclosure (DIS) will be positive. The estimated coefficient of DIS is positive and statistically significant for firms with Equation 2 single announcement Equation 3 multi-announcements Intercept -52.758*** (0.00) -50.561** (0.03) -67.213** (0.04) MAN 5.473** (0.05) 4.587 (0.16) 9.869 (0.14) SIZE 7.778*** (0.01) 6.682* (0.08) 11.579** (0.02) ROA -0.558** (0.04) -0.419 (0.31) -0.747** (0.04) LEV 5.799 (0.69) 26.048 (0.16) -31.942 (0.15) EXT -4.310 (0.42) -7.649 (0.29) -1.845 (0.82) DIS 4.651 (0.45) -10.929 (0.18) 30.289*** (0.01) Number of observations 145 81 64 R 2 8.0% 12.5% 24.9% F-statistics 2.00* 1.76 3.15*** Notes: ***, ** and * indicate significance at the 1, 5 and 10% levels, respectively (two-tailed tested); p-values in parentheses. multiple profit warnings (Equation 3). The positive coefficient estimate associated with DIS is consistent with our predictions that shareholders will reward openness with respect to the information content of profit warnings. We find no similar empirical evidence for firms with single profit warnings (Equation 2). If firms refer to external reasons EXT in their press releases indicating that reasons for the current situation are a market-wide phenomenon and solutions are beyond the firm s scope, we suggest a negative impact on the returns to shareholders. We find a negative but not significant relationship between the variable EXT and the cumulative abnormal returns to shareholders across all equations.
Profit warnings: will openness be rewarded? 637 V. Summary and Conclusions In this article, we examined whether corporate officers should release detailed quantitative and qualitative information in order to dampen a fall in the share price during the announcement of a profit warning. Our results show that the AARs on the announcement day (t = 0) of the profit warnings for the total sample are significantly negative, at 6.12%. Our findings are consistent with the findings of prior studies. In our regression analysis, we found empirical evidence that a greater degree of disclosure has a significantly positive impact on the abnormal returns in firms with multiple successive profit warnings ( p = 0.01). Furthermore, we found a significant positive relation between the market s reaction to a profit warning announcement and managerial shareholdings. Our research findings provide an interesting contribution to the empirical implications of the information content of profit warnings. Our empirical research showed that openness in multiple successive profit warnings will be rewarded with a significantly dampened market reaction on the share price compared with less descriptive profit warnings. For the single profit warnings announcements, we did not find conclusive evidence. References Bartov, E. (1992) Patterns in unexpected earnings as an explanation for post-announcement drift, The Accounting Review, 67, 610 22. Botosan, C. (1997) Disclosure level and the cost of equity capital, The Accounting Review, 72, 323 49. Brown, S. J. and Warner, J. B. (1985) Using daily stock returns: the case of event studies, Journal of Financial Economics, 14, 3 31. Bulkley, G. and Herrerias, R. (2005) Does the precision of news affect market underreaction? Evidence from returns following two classes of profit warnings, European Financial Management, 11, 603 24. Collett, N. (2004) Reactions of the London Stock Exchange to company trading statement announcements, Journal of Business Finance and Accounting, 31, 3 35. Diamond, D. and Verrecchia, R. (1991) Disclosure, liquidity, and the cost of capital, The Journal of Finance, 46, 1325 9. Easterwood, J. and Nutt, J. (1999) Inefficiency in analysts earnings forecasts: systematic misreaction or systematic optimism?, Journal of Finance, 54, 1777 97. Grossman, S. and Hart, O. (1980) Disclosure laws and takeover bids, Journal of Finance, 35, 323 34. Helbok, G. and Walker, M. (2003) On the willingness of UK companies to issue profit warnings: regulatory, earnings surprise permanence, and agency cost effects, Working Paper, University of Manchester. Jackson, D. and Madura, J. (2003) Profit warnings and timing, The Financial Review, 38, 497 513. Jackson, D. and Madura, J. (2004) Bank profit warnings and signaling, Managerial Finance, 30, 20 31. Jensen, M. C. and Meckling, W. H. (1976) Theory of the firm: managerial behaviour, agency costs and ownership structure, Journal of Financial Economics, 3, 305 60. Kasznik, R. and Lev, B. (1995) To warn or not to warn: management disclosures in the face of an earnings surprise, The Accounting Review, 70, 113 34. Kearns, A. and Whitley, J. (2002) The balance sheet information content of UK company profit warnings, Bank of England. Quarterly Bulletin, 42, 292 8. Libby, R. and Tan, H. (1999) Analysts reactions to warnings of negative earnings surprises, Journal of Accounting Research, 37, 415 35. Mikhail, M., Walther, B. and Willis, R. (2004) Earnings surprises and the cost of equity capital, Journal of Accounting, Auditing and Finance, 19, 491 513. Rendleman, R., Jones, C. and Latane, H. (1982) Empirical anomalies based on unexpected earnings and the importance of risk adjustments, Journal of Financial Economics, 10, 269 88.