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Does Disclosure Reputation Explain Earnings Warnings ?

This study empirically examines whether maintaining a strong disclosure reputation motivates firms to issue a warning when they anticipate an earnings shortfall. My main test examines the positive association between the likelihood of a warning and a firm’s existing disclosure reputation after controlling for the litigation motivation and other crosssectional firm differences. I use three reputation proxies: “Analyst Following”, “Forecast Dispersion” (with a negative sign) and “Management Horizon”. All three proxies are positively associated with the likelihood of a warning, indicating that maintaining a good reputation explains earnings warnings above and beyond the litigation argument. My second set of tests re-examines market reaction to warnings in light of the disclosure reputation argument. Even after controlling for earnings decline permanency, I still find that around the event quarter, the market reacts more negatively to the warning firms than to those that anticipate negative earnings news but do not warn, suggesting market overreaction. To confirm this market overreaction, I examine post-event returns and find positive buy-and-hold abnormal returns for the warning firms. The return test results are consistent with the disclosure reputation explanation for earnings warnings: reputable firms focus on the long-term and are willing to wait out the short-term market overreaction.