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Accruals Quality, Shocks to Expected Volatility, and Investor Response to Earnings News

Thu, March 18, 2:45 to 4:15pm, Virtual, TBA

Abstract

Prior research shows that Bayesian investors rationally place less weight on the earnings signal when they judge it as a noisier predictor of future outcomes, such as when accruals quality is low. Consequently, the market response to unexpected earnings is weaker when a firm’s accruals quality is lower. We hypothesize that investors’ behavior will change in an asymmetric way when macroeconomic shocks to expected volatility occur before the earnings announcement. Drawing on the ambiguity aversion literature, we argue that investors will not update beliefs in standard Bayesian fashion when unexpected events shake investors’ confidence in how well they can judge the parameters of the distribution of future outcomes. Instead, investors will favor a `better safe than sorry’ attitude, which leads them to react strongly (weakly) to bad (good) news regardless of accruals quality. Consistently, we find that larger shocks to expected volatility in the days before the announcement cause i) a stronger reaction to bad news for low-quality firms, ii) a weaker reaction to good news for high-quality firms, and iii) the difference between low- and high-quality firms’ reactions to become insignificant whether the news is good or bad.

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