Does the Stock Market See a Zero or Small Positive Earnings Surprise as a Red Flag?

Manipulation of earnings or analyst earnings expectations is costly to firms. Manipulators of earnings and/or analyst earnings expectations therefore are likely to report earnings that precisely meet or narrowly beat analyst earnings forecasts, resulting in a zero or small positive earnings surprise. We predict that investors see such an earnings surprise as a red flag in their attempt to identify manipulators of earnings and/or analyst earnings expectations. Consistent with our prediction, we find the coefficient in the regression of abnormal stock returns on the earnings surprise (known in the literature as the earnings response coefficients or ERC) is significantly lower for zero and small positive earnings surprises than for earnings surprises in adjacent ranges. We find evidence that analysts see a zero or small positive earnings surprise as a red flag as well. The coefficient in the regression of analyst revisions of next-quarter earnings forecasts on the earnings surprise (the analyst ERC) is significantly lower for zero and small positive earnings surprises than for earnings surprises in adjacent ranges