Really Dirty Surplus and Expectations Bias Hypothesis

• In Event: Surprise…Financial Reporting

Abstract

In this paper, we investigate whether the magnitude of really dirty surplus (RDS) is associated with sell-side analysts’ over-optimism in earnings forecasts and stock recommendations. RDS is defined as the contingent equity claims settled at prices other than the fair market value. Using a large sample of U.S. public firms from 1994 to 2012, we find that analysts’ earnings forecasts are more optimistic for firms with large negative RDS than firms with small negative RDS. We also find that analysts’ expectations bias related to RDS extends to their stock recommendations. Overall, our evidence supports the mispricing argument over the unidentified risk factor as an explanation for the profitable future stock returns following RDS-related equity transactions in the literature because we find that RDS is related to biased investor expectations.

Authors

• Thomas D Dowdell, North Dakota State University

• Sangwan Kim, University of Massachusetts-Boston

• Steve C Lim, Texas Christian University