An Evaluation of Alternative Proxies For The Market S Assessment of Unexpected Earnings

Journal of Accounting and Economics 9 (1987) 159-193.
North-Holland
AN EVALUATION OF ALTERNATIVE PROXIES FOR THE

MARKETS ASSESSMENT OF UNEXPECTED EARNINGS *
Lawrence D. BROWN and Robert L. HAGERMAN

State Universq of New York, Buffalo, NY 14260, USA
Paul A. GRIFFIN
Unwersity of California, Davis, CA 95616, USA
Mark E. ZMIJEWSKI
Unwersiry of Chicago, Chicago, IL 60637, USA
Received October 1985, final version received April 1987
This study examines the association between abnormal returns and five alternative proxies for the
markets assessment of unexpected quarterly earnings. We examine the role that measurement
error potentially has in multiple regression tests of abnormal returns (occurring around the time of
earnings announcements) on an unexpected earnings proxy and other non-earnings variables. The
results indicate a potential measurement error interpretation of such multiple regression tests. We
examine three procedures which reduce, to an unknown degree, the measurement error problem.
Our procedures appear to be more (less) effective at reducing measurement error for small (large)
firms and recent (non-recent) forecasts.
1. Introduction
Numerous studies have shown that stock market prices respond to the sign
and magnitude of earnings that are unexpected by the market. These studies
use a proxy for the markets assessment of unexpected earnings (market
unexpected earnings) that is conditioned on a particular earnings forecast. If
the unexpected earnings proxy measures the markets assessment with error,
*The authors acknowledge comments on earlier versions from workshop participants at the
University of California at Berkeley, University of Chicago, Columbia University, Duke Univer-
sity, University of Iowa, University of Michigan, New York University, University of North
Carolina at Chapel Hill, Northwestern University, Purdue University, University of Rochester,
State University of New York at Buffalo, and the University of Southern California. We extend
special thanks to R. Castanias II, A. Christie, R. Holthausen, W. Landsman, R. Leftwich, T. Lys,
P. OBrien, R. Watts, and an anonymous reviewer for advice on various topics.
See Foster (1986, ch. ll), Watts and Zimmerman (1986, ch. 3) or Brown (1987, ch. 2) for a
review of this literature.
0165-4101/87/$3.5001987, Elsevier Science Publishers B.V. (North-Holland)

160 L.D. Brown et al., Alternativeproxies for unexpected earnings
the results can, in certain experimental designs, lead to incorrect inferences.

This issue is potentially important when the researcher attempts to hold
constant the effects of unexpected earnings while testing hypotheses for other
financial variables (e.g., accounting changes, non-earnings information). In
tests of this type, any correlation between the measurement error in the
unexpected earnings proxy and the other financial variables results in biased
statistics2
This study examines the association between abnormal (stock) returns and
alternative proxies for market unexpected earnings and the significance of the
measurement error in those unexpected earnings proxies. Three procedures are
used to detect and reduce the measurement error effects. Daily security
returns, assumed to impound the markets knowledge of earnings, are used to
investigate unexpected earnings from five one-quarter-ahead expectation mod-
els. Four of the expectation models are based on the time series of quarterly
earnings numbers; the fifth consists of quarterly earnings forecasts made by
security analysts.3
The empirical analysis proceeds in five stages. First, we examine five
alternative measures of unexpected earnings individually (i.e., five alternative
unexpected earnings proxies). This allows us to link our findings with those of
prior studies using a single proxy. Second, we assess the incremental explana-
tory power of a single unexpected earnings proxy vis-a-vis a combination of
proxies that includes the single proxy; the emphasis is on combining altema-
tive unexpected earnings proxies to detect and reduce measurement error.
Third, we examine factors that might explain differences in measurement error
across firms. Fourth, we examine the effects of using the stock return prior to
the abnormal return holding period to control for measurement error. Finally,
we examine the effects of using instrumental variable procedures to reduce
measurement error.
The results indicate that no single proxy consistently dominates in the
simple association (e.g., regression) tests across the various abnormal return
holding periods we examine. However, unexpected earnings that are based on
financial analysts earnings forecasts, in general, explain abnormal returns
better than other proxies. Further, the results indicate a significant amount of
measurement error in all earnings proxies and that our procedures may be
useful for reducing (to an unknown degree) measurement error, especially for
small firms and recent forecasts. Nevertheless, while our procedures do appear
to mitigate the measurement error problem, we are unable to determine
whether they produce reliable parameter estimates in a multiple regression
The effects of measurement error are of less concern in studies of the relation between stock
price changes and unexpected earnings when the null hypothesis of no relation is rejected, see
Beaver et al. (1987) and Collins et al. (1987).
The proxy variables are conditioned on a seasonal random walk model, three Box and Jenkins
(1976) models, and forecasts from The Value Line Investment Survqy.
L.. D. Brown et al., Alternative proxies for unexpected earnings 161
research design (i.e., regressing abnormal returns on unexpected earnings and

one or more additional non-earnings explanatory variables).
Overall, our results indicate that measurement error is a significant problem
for the researcher using this multiple regression research design. Researchers
must interpret the coefficients for the additional explanatory variables condi-
tional on an assumed correlation between the additional variables and the
measurement error in the unexpected earnings proxy variable. A non-zero
correlation potentially results in a measurement error interpretation of the
coefficients for the additional explanatory variables.
The paper is organized as follows. Section 2 describes the underlying
empirical model and discusses the research design incorporating the potential
effects of measurement error. The data, the forecasting models, and the
variables for stock price adjustment and unexpected earnings are described
and defined in section 3. Section 4 presents and discusses the results. Section 5
contains a summary and conclusions.
2. The underlying model, measurement error, and empirical tests
2.1. The model
The model below. is used to show the effects of measurement error in a

specific context. Although the model that underlies the empirical tests is
consistent with models underlying many tests of association between stock
price changes and unexpected earnings (as well as multiple regression models
incorporating other financial variables), it is not the only specification. For
alternative specifications, see Christie (1985) Miller and Rock (1985) and
Watts and Zimmerman (1986). The model states
where
R,, = stock return resulting from the earnings announcement of firm i at

time t,
S,, = the market unexpected earnings associated with the earnings armounce-
ment of firm i at time t,
11,1 = a random error term for firm i at time t with properties pit - N(0, u *( p ;,))
and a(~~~, pi, t+k) = 0 for all k and i #j.
The parameters OLand fl are assumed to be identical across firms and
stationary over time.4 This assumption would be valid, for example, if S,,
equals the change in the expectations of the appropriately discounted future
For evidence on the cross-sectional variation in p, see Easton and ZmiJewski (1987)
162 L. D. Brown et al., Alternative proxies for unexpected earnings
cash flows available to equity holders when the conditioning signal for the
change in expectations is the earnings announcement. In this case, LY= 0 and
/? = 1. However, due to alternative specifications of eq. (1) including alterna-
tives regarding the stochastic processes underlying S,,, we are unable to form
definitive expectations on the magnitude of /3, except that it is expected to be
positive.
2.2. Measurement error
Since S,, is unobservable, a proxy variable, Pilx, must be used in the

empirical tests. Let
P;rx = S,, + Crrh for X = 1,. . . , P models (proxies), (4
where elrX is a random error term for firm i at time t with properties
for all i #j,
for all i, j, k,
for all i, j, k,
for all i, j, k.
Substituting PIIh for S,, in eq. (1) yields
R,, = a + ,LlPIlh+ p;,. (3)
It is well known that CXand p are biased and inefficient estimates of (Yand
p [Madalla (1977)]. In particular, the slope coefficient, /3, is biased towards
zero and the error variance is biased upwards. The direction of the bias in (Y
depends on the signs of p and the mean of S,,. If p and the mean of S,, have
identical signs, then the bias in (Yis positive; if they have opposite signs, the
bias is negative; and if either is equal to zero, there is no bias in (Y.Researchers
often assume that the measurement error in the proxy is small and can be
ignored, especially in simple association tests, since the tests are biased against
rejecting the null hypothesis of no association. Additionally, if it can be
assumed that the dependent variable Ri, is measured without error, a reverse
regression can be conducted [see Beaver et al. (1987) for an example of this
technique], resulting in unbiased estimates of (Yand /?.
The impact of measurement error in the earnings proxy is less clear and
more troublesome when using a multiple regression research design, i.e., using
L. D. Brown et al., Alternative proxies for unexpected earnings 163
explanatory variables in addition to market unexpected earnings to explain

Ri,. To demonstrate this point, we add another independent variable to eq. (l),
Z,,. We assume initially that this variable is uncorrelated with R,,, Sit, and pir.
Let
Ri,= a + PS;, + 6Z;, + pit, (4)

where, in addition to the above assumptions,
4zit2R,.t+A= 0 forall i,j,k,
4.L SJ,r+k)
=0 forall i, j, k,
(J(zIt?
P,,t+J= 0 forall i,j,k.
In this special case of eq. (4), that is, in the case where Z;, is uncorrelated with
R,,, S,,, and P,~, 8 = 0, and the estimates of CY
and p are unbiased and efficient
[Madalla (1977)].
Now, suppose eq. (4) can be estimated only by using proxies for S,,, namely,
P,rx, and assume that Zi, is perfectly correlated with the measurement error in
Pirx. In this extreme situation we have
Ri,= a + PPirx + 6Z,, + p;;,
where
In this case, the estimates of LXand 8 are biased estimates of OLand 6,

respectively, and estimates of 0 and a(~;;) are unbiased estimates of fi and
u(pL,,). The sign of the bias in 8 (and the sign of a, since 6 = 0) depends on
the sign of /3 and the sign of the correlation between Z,, and crtX, p(Z,,, eltX);
6 > 0 if j3 and p( Zll, c,,,,) have opposite signs; and 6 -C0 if ,8 and
p( Zjl, cirX) have identical signs. However, Z,, does not have to be perfectly
correlated with the measurement error in P,th to result in biased estimates of
6. Bias in 6, i.e., S f 0, results whenever Zi, has a non-zero correlation with the
measurement error in PitA.
Additionally, the estimates of p and a(~;;) are unbiased estimates of j3
and u(p,,) in this special case because Z;, is perfectly correlated with the
measurement error in PitA. Since Zi, is not, most likely, perfectly correlated
with the measurement error in Pirx [i.e., 0 -Cp(Zi,, eirX) -C 11, estimates of p
and u(p;;) are biased estimates of /3 and a(~,,). However, this bias decreases
with increases in Ip(Z,,, ci,,,)(.
164 L. D. Brown et al., Alternativeproxiesfor unexpected earnings
If significant measurement error exists in the unexpected earnings proxies,

studies using a multiple regression approach similar to eq. (5) may report
estimates for the coefficients for the additional explanatory variables (e.g., 8)
that are significantly different from zero, not because there exists a relation
between the additional explanatory variable (Z,,) and the dependent variable
(R,,), conditional on market unexpected earnings (Sjf), but because these
coefficients may be picking up the measurement error in the unexpected
earnings proxy variable. 5 The measurement error in an unexpected earnings
proxy may be mitigated if another explanatory variable is added to eq. (3) that
is highly correlated with the measurement error in Pjtx, yet uncorrelated with
R Io & and pit. We use the above result in an attempt to reduce the
measurement error in estimating eq. (3).6
2.3. Approaches to assessing measurement error
(i) Using two or more proxy variables: Based on the preceding model, our
first approach to document the existence of significant measurement error in
alternative earnings proxies is to use jointly two or more proxies to estimate
eq. (1). Consider a two proxy model of the form
R,, = Yo+ YlP,,, + Y2<,2 + Vrt, (6)
where P,,, and Pit2 are alternative unexpected earnings proxies as defined in
eq. (2).
The sum of the coefficients of the unexpected earnings proxy variables (i.e.,
yi + yz) is an estimate of the coefficient for unexpected earnings. If the sum of
the proxy variable coefficients increases as the number of proxy variables in
the regression increases, this suggests the existence of measurement error in
the unexpected earnings proxy variables and a reduction in the bias of the
estimates of p and u(pil) in eq. (1). That is, for PiI1 and Pit2 less than
perfectly correlated,
and
4%) - 44 < 40 - 41,)
For the above specification of eq. (6) significant coefficients for both y1 and
y2 indicate significant measurement error in both proxy variables P,,l and
An alternative explanation for observing that 8 # 0 is that the additional independent

variable(s) pick up misspecification of the basic model (e.g., cross-sectional variation in p). We
assume throughout the paper that eq. (1) is the true model (i.e., we do not have an omitted
variables problem) and that R,, is measured without error.
6See also Lys and Sivaramakrishnan (1986).
L.D. Brown et al., Alternative proxies for unexpected earnings 165
Pif2. In order to examine the extent to which the use of multiple proxy
variables may reduce measurement error, we examine the incremental explana-
tory power (i.e., the partial F-statistic) of adding an additional proxy variable
to the (ex post) best proxy variable among the alternative single proxy
variable regressions, of adding an additional proxy variable to the best set of
two proxy variables among the alternative two proxy variable regressions, of
adding an additional proxy variable to the best set of three proxy variables
among the alternative three proxy variable regressions, and of adding an
additional proxy variable to the best set of four proxy variables among the
alternative four proxy variable regressions.*
(ii) Using variables that are ex ante correlated with measurement error: As a
second approach for assessing measurement error, we incorporate potentially
relevant stock return data as an additional explanatory variable in an attempt
to control for the measurement error in the unexpected earnings proxies. We
add the stock return from 100 trading days before the earnings announcement
through the trading day before the dependent variable (abnormal return) is
measured as an additional explanatory variable to eq. (3). Since the forecasts
that are used to condition unexpected earnings are typically made prior to the
period over which the abnormal return is calculated (in other words we use
dated forecasts to condition unexpected earnings), we assume that the mea-
surement error in the proxy for market unexpected earnings is positively
correlated with this stock return.
We assume that j3 > 0, and hence, estimates of j3 are biased downward.
Thus, an indication of the degree to which measurement error is reduced is
given by the increase in the coefficient for unexpected earnings from estimat-
ing eq. (5) rather than eq. (3). Additionally, since we assume j3 > 0 and a
positive correlation between the additional explanatory variable and the
measurement error in the unexpected earnings proxy variable, the coefficient
for the additional explanatory variable should be negative [see the discussion
of eq. (5)].
(iii) Using instrumental variables procedures: Finally, as a third approach for

assessing measurement error, we apply an instrumental variables technique.
We follow the standard procedure [see Judge et ai. (1984)]; namely, we (1)
regress the earnings proxy, P,tx, on K instruments, Irkr, k = 1,. . . , K, calculat-
ing a predicted value of the proxy, and (2) regress the original dependent
Non-zero coefficients may also indicate misspecification of the underlying model of the form of
the measurement error in the proxies. See section 2.1 for the required assumptions of the
underlying model.
Best is determined on the basis of adjusted R-squares. The model with the highest adjusted
R-square is deemed the best of a particular set of proxy variable alternatives. It is most likely
(but not necessary) that the best N + 1 variable model includes all the variables in the best N
variable model
variable, R,,, on the predicted proxy from the first regression. This two-stage
procedure assumes that the instrument, Irk,, is correlated with the true
independent variable, Sir, and uncorrelated with (a) residuals from the stage 1
regression, (b) the eq. (I) residuals, CL,,,and (c) the measurement error in the
proxy, eilx. Unfortunately, we have no guidance as to the choice of instrumen-
tal variables and it is unlikely that the required assumptions hold literally for
any set of instrumental variables we could choose.
For this reason, we examine four alternative sets of instrumental variables in
an attempt to gain some insights on the usefulness of this approach. For a
given proxy, the four sets of instrumental variables are (a) the four unexpected
earnings proxy variables that are not the dependent variable in the stage 1
regression, (b) the signs of the five unexpected earnings proxy variables, (c) a
stock return variable and the instrumental variables in (a), and (d) a stock
return variable and the instrumental variables in (b). The stock return instru-
mental variable is the stock return from 100 days before the earnings an-
nouncement (day - 100) through the day before R, is measured (day d - 1).9
However, the stock return variable most likely violates the assumption (c)
above.
3. Sample and variable definitions

3. I. Sample
Two samples are obtained for this study. The first sample includes forecasts
for the five-year period 197551979. The second sample is a subset of firms
included in the first sample, with appropriate forecasts for the year 1980. All
firms included in the first (second) sample satisfy three criteria:
(1) 1960-1979 (1960-1980) quarterly earnings per share available in Moodys

Hardbook of Common Stocks,
(2) the same fiscal year end between 1960 and 1979 (1960 and 1980)
(3) covered by The Value Line Investment Survey between 1975 through 1979
(1975 through 1980).
The number of firms satisfying these criteria is 233 for the first (197551979)
sample and 212 for the second (1980) sample. We require additional data for
the empirical tests and thus impose two more sample selection criteria:
(4) Sufficient data on the CRSP Daily Master file to deflate unexpected
earnings by price and on the CRSP Daily Return file to calculate
abnormal returns,
(5) Wall Street Journal Index availability of the quarterly earnings announce-
ment date.
Given the instrumental variables we examine, this approach is similar to estimating a

cross-sectional ex post composite forecast from alternative forecasting models.
L.D. Brown et al., Alternariveproxies for unexpected earnings 167
The first criterion provides a source of quarterly earnings data that is used
to generate time series forecasts based on the Box and Jenkins (1976) proce-
dure. The second ensures that a firms quarterly earnings reflects the same
degree of seasonality each year. The third criterion is imposed because a
source of analysts forecasts of quarterly earnings is needed.O Criteria (4) and
(5) are required for calculating the earnings proxy and stock return variables.
Overall, there are at most 5,508 firm/year/quarter observations, but due to
data requirements, the samples for various analyses range in size from 1,611
observations (for the longest abnormal return holding period) to 4,177 ob-
servations (for the shortest abnormal return holding period). These criteria
bias the sample toward larger firms. * Thus the extent to which our results are
generalizable to all firms is unknown. Nevertheless. our criteria are similar to
the assumptions that have been made in previous research, so our results
should be comparable to those of other studies.
3.2. Variable definitions
We specify the proxy for market unexpected earnings for firm i in quarter t,
conditional on forecasting model A, as
where
E,, = earnings for firm i in quarter t,

qrx = earnings forecast for firm i in quarter r by forecasting model A,
D;, = stock price of firm i the day before the abnormal return holding period
begins (i.e., the deflator for quarter t).13
We use five alternative forecasting models to generate efx. The first is the
seasonal random walk (SRW) model, defined as the most recently reported
earnings number for the quarter whose earnings are being forecast. For
The Value Line Investment Survey is the only publicly available source of quarterly analysts
forecasts for the period under study.
The maximum number of firm/year/quarter observations of 5,508 is calculated as (233
firms X 5 years X 4 quarters) + (212 firms X 4 quarters).
t2An examination of the percentage of sample firms contained in each size decile of all
American and New York Stock &change firms (based on market value of common equity)
revealed that over half the firms are in the largest size decile, and over 85 percent of the firms are
in the largest four size deciles in every year under study.
t3 While a common stock price deflator for earnings forecast errors has not been widely used in
the literature, Christie (1985). Easton and Zmijewski (1987). and others have argued that such a
deflator is appropriate. We use the stock price the day before the period over which the abnormal
return is measured (day d + 1). An earlier version of this paper reported results using three
alternative deflators: actual earnings, forecasted earnings, and the mean and standard deviation of
earnings. Those results are similar to the results presented here, except that the use of actual
earnings as a deflator appears to increase measurement error.
example, the earnings forecast for the first quarter of 1979 conditional upon
knowledge of the first, second, third, or fourth quarter of 1978 equals the
earnings number reported for the first quarter of 1978. The second to fourth
models, TSl, TS2, and TS3, respectively, are the forecasting models intro-
duced by Brown and Rozeff (1979) Foster (1977) and Watts (1975) - Griffin
(1977), respectively. The fifth model (VL) is the forecast reported in The V&e
Line Investment Suruey after the quarter t - 1 earnings announcement, but
before the quarter t earnings announcement. These models have commonly
been used in the forecasting literature and performed well relative to other
naive benchmarks over short horizons [Hopwood et al. (1982)]. The SRW and
TS models use information up to and including the latest earnings number,
and hence, assume approximately a ninety-day forecast horizon. Brown et al.
(1987a) report that Value Line forecasts are made approximately thirty-nine
calendar days before the earnings announcement.
We use four alternative holding periods to generate abnormal returns (CR):
a short, two-day holding period, representing the day before and the day of
the earnings announcement (- 1,O); a long, forty-one-day holding period,
representing a return cumulated from forty days before the earnings an-
nouncement through the day of the earnings announcement ( - 40,O); and two
intermediate holding periods, ( - 10,O) and (- 20,O). While the holding peri-
ods are admittedly ad hoc, they include those commonly used by researchers
and they enable us to examine the sensitivity of the validity of our techniques
to alternative holding periods.
Eq. (8) defines firm is excess stock return for the holding period, trading
day d through day 0, as
= t (ri,-a^,-a^,r,,),
CR;,(d,O) (8)
t=d
where
CR,,( d, 0) = abnormal return for firm i, cumulated from day d (d =
- 1, - 10, - 20, - 40) prior to the earnings announcement (i.e.,
day 0) through day 0,
r;Z = continuously compounded return on firms is common stock on
trading day t,
rmr = continuously compounded return on the CRSP value weighted
market index on trading day t,
*I n
a,* a1 = ordinary least squares regression parameters.14
I4 For all holding periods (the period from day d through day 0), the regression parameters are
estimated using returns from day -361 to day -61, where day 0 is the earnings announcement
date. We require a minimum of 100 daily returns over the estimation period and all returns over
the holding period for an observation to be included in a particular test.
Table I
Comparison of individual proxy variables for unexpected earnings based on weighted portfolio
excess stock returns and correlations with excess stock returns.
Number Unexpected earnings (IYE,,~)

Cumulative
residuaLsa of obs.b SRW TSl TS2 TS3 VL
Panel A. Weighted portfolio percentage abnormal returned

CR(-1,O) 4,177 1.174 1.470 1.422 1.478 1.666
CR(-10.0) 3,431 1.392 1.947 1.964 2.058 2.202
CR(-20.0) 2,931 1.334 1.669 2.027 2.122 2.006
CR(-40.0) 1,611 1.137 1.542 1.726 2.137 2.346
Panel B. Pearson correlations between CR,,( d, 0) and L/E,,,
CR(-1.0) 4,177 0.210 0.252 0.234 0.243 0.272
CR(-10.0) 3,431 0.136 0.180 0.177 0.182 0.198
CR(-20,O) 2,931 0.101 0.123 0.139 0.144 0.136
CR(-40,O) 1.611 0.076 0.093 0.093 0.110 0.117
Panel C. Rank correlations between CR,,(d,O) and UE,,A
CR(-1.0) 4,177 0.210 0.286 0.302 0.281 0.317
CR(-10.0) 3,431 0.144 0.202 0.234 0.207 0.227
CR(-20.0) 2,931 0.177 0.154 0.176 0.180 0.175
CR(-40,O) 1,611 0.097 0.124 0.155 0.149 0.137
Cumulative residual, CR( d,O), is the cumulated market model residual, cumulated from d
da? before the earnings announcement date through the earnings announcement date (day 0).
Number of observations available for the test. The number of observations decreases as the
cumulation period increases because an observation is constrained so that each observations
Value Line report date occurs before the first day of the cumulation period, d.
Unexpected earnings for firm i, in quarter f, conditional on forecasting model X is denoted as
&,A. There are five unexpected earnings proxy variables. SRW denotes the seasonal random
walk forecasting model, TSl the Brown and Rozeff (1979) model, TS2 the Foster (1977) model,
TS3 the Watts (1975) - Griffin (1977) model, and VL the forecast in The Value Line Investment
SUiV~.
d Weighted portfolio abnormal returns in percentages, conditional on forecasting model A, are

calculated as
where CR,,( d,O) is the cumulative residual for firm I in quarter t, N the number of observations,
and 1.1the absolute value operator.
4, Results
4.1. Comparison of individual proxies

Table 1 presents individual analyses of the five unexpected earnings proxies,
SRW, TSl, TS2, TS3, and VL. For each CR(d,O) calculation, the sample is
constrained so that each companys Value Line report date occurs before the
170 L. D. Brown et al., Alternaliveproxiesfor unexpected earnings
first day of the cumulation (day d) period. Thus, the longer the cumulation
period, the fewer the number of observations in the sample. This constraint
achieves a consistency between the holding period and the markets presumed
knowledge of the Value Line forecast, and it enables researchers requiring
measures of earnings expectations to ensure that the proxy variables they
utilize are available to the market as of the start of the presumed holding
period.
Panel A reports the weighted average excess (portfolio) returns (stated in
percentages) from an investment strategy of (1) buying long (selling short) on
the first day of the holding period (day d) common stock with positive
(negative) unexpected earnings, UEjlx, and (2) holding the portfolio of firms
through the end of the earnings announcement date (day 0). The weighted
abnormal returns (for a sample of N observations) are calculated as follows:
where 1. ) is the absolute value operator.

The results in panel A indicate that SRW has the lowest abnormal return in
every holding period. VL has the highest abnormal return for the (- LO),
( - 10, 0), and (- 40,O) holding periods. However, TS2 and TS3 have slightly
higher abnormal returns than VL for the (- 20,O) holding period. Panels B
and C, respectively, present pairwise Pearson and rank correlation coefficients
between CR,, and lJEi,,,. Consistent with panel A, VL has the highest
correlation for the (- LO) holding period.
In sum, proxies for unexpected earnings based on analysts forecasts (VL)
have the highest association with abnormal returns for one of the four holding
periods. One of the time series models (SRW) is the worst proxy in that it
consistently exhibits the poorest measure of association. Although not re-
ported, weighted return measures which are based on the rank of the
unexpected earnings measures are qualitatively identical. Also, tests based on
unweighted abnormal returns display a similar pattern.15
4.2. Multiple earnings proxies
Table 2 summarizes the results of using multiple unexpected earnings

proxies in explaining abnormal returns for various holding periods. More
Aciditional results indicate: (1) The five UE ,rX proxy variables have identical signs in
approximately 48 percent of the cases, (2) four of the five UE,,,, variables have identical signs for
approximately 78 percent of the cases, and (3) when the proxies disagree in the sign of fJElrh, the
magnitudes of the UElrhs are closer to zero than they are when the proxies agree in sign. The
latter finding suggests that grouping on the basis of consistency of sign of 1/E,,, is positively
correlated with grouping on the basis of magnitude of UE,,,,.
specifically, it reports an adjusted R-square and the sum of cross-sectional

regression coefficients (sum of y,,) for the regression of abnormal returns on F
(P = 1,. . .) 5) unexpected earnings proxy variable(s):
P
CR,,( d,O) = y. + c yJJEItx + error. (9)
X=1
Because we estimate regression eq. (9) for all combinations of proxies, the
results are presented in five panels. Panel A reports the regressions with one
proxy variable in eq. (9) (five regressions for each of the four holding periods),
panel B with two proxy variables (ten regressions for each of four holding
periods), panel C with three proxy variables (ten regressions for each of the
four holding periods), panel D with four proxy variables (five regressions for
each of four holding periods), and panel E with five proxy variables (one
regression for each of four holding periods). The principal findings from these
analyses follow.
First, the yx coefficient values for the single proxy variable forms of eq. (9)
that is, the twenty regressions in panel A, are all highly significant with
t-statistics significant at less than the 0.001 probability level. These results
essentially confirm the results in table 1 and in the extant literature.
Second, the sum of coefficients tends to increase and the adjusted R-squares
always decrease as the holding period for the regressions increases. These
results are consistent with the measurement error discussion in section 2. The
earnings forecasts we use are dated in that the forecast is made before
the first day of the holding period and, as such, are not conditioned on the
earnings related information that is released between the forecast date and the
day before the holding period begins (d + 1). Increasing the holding period
reduces the datedness of the earnings forecast which should result in an
increase in the estimate of R. Decreases in the adjusted R-squares over longer
holding periods are consistent with the hypothesis that abnormal returns with
longer holding periods contain more variation due to factors unrelated to the
firms earnings.16
Third, table 2 shows that the sum of yx coefficients generally increases when
additional proxies are added to regression eq. (9). While the increase in the
sum of coefficients with respect to holding period is seldom monotonic, an
examination of the table reveals that the sum of coefficients for the three
longer holding periods ( - lO,O), (- 20,0), and ( - 40,O) is always greater than
it is for the shortest holding period (- l,O).
The actual timing of the analysts forecast is also critical here. We would expect, for instance,
that if all analysts forecasts are made just before earnings announcements. the coefficient for the
(- 1.0) holding period would be higher. Unfortunately, we cannot examine this issue with our
analyst data, as the average forecast in our sample is made approximately 39 days prior to the
earnings announcement date (our day 0).
Table 2
Summary of cross-sectional regressions between cumulative residuals and one or more unexpected earnings proxy variable(s).
P
Regression: CR,,(J.O) = y. + c yAUE,,, + error.

X=1
Dependent variable: Cumulative residual (CR,,( d, 0))
CR,,(-I,O) CR,,(- 10.0) CR,, ( - 20,O) CR,,(-4090)

Regression 4,177 observationsb 3,431 observations 2,931 observations 1,611 observations
Independent Adjusted Sum of Adjusted Sum of Adjusted Sum of Adjusted Sum of
No. variable(s) R-square coeff.d R-square coeff. R-square coeff. R-square coeff.
Panel A. ( P = 1)
Regressions with one earnings pr-0~~~
1. SRW 0.0437 0.3170 0.0182 0.3822 0.0099 0.3911 0.0044 0.3507
2. TSl 0.0631 0.4740 0.0321 0.6299 0.0149 0.6140 0.0081 0.6230
3. TS2 0.0547 0.3859 0.0311 0.5577 0.0189 0.6027 0.0080 0.5473
4. TS3 0.0590 0.4220 0.0329 0.5866 0.0205 0.6523 0.0115 0.6613
5. VL 0.0738 0.6985 0.0388 0.9335 0.0183 0.8927 0.0131 1.0096
Panel B. Regressions with two earnings proxies ( P = 2)
6. TSl, TS2 0.0660 0.4871 0.0346 0.6565 0.0189 0.6505 0.0083 0.6444
7. TSl, TS3 0.0649 0.4809 0.0340 0.6372 0.0203 0.6219 0.0109 0.6433
8. TSl, SRW 0.0674 0.5029 0.0328 0.6555 0.0157 0.6531 0.0082 0.6715
9. TSI, VL 0.0886 0.7680 0.0445 0.9990 0.0208 0.9671 0.0133 1.0670
10. TS2, TS3 0.0644 0.4588 0.0360 0.6473 0.0223 0.7178 0.0112 0.7010
11. TS2, SRW 0.0675 0.4826 0.0341 0.6408 0.0203 0.6891 0.0089 0.6630
12. TS2, VL 0.0905 0.7769 0.0472 1.0239 0.0252 1.0185 0.0147 1.1259
13. TS3, SRW 0.0648 0.4662 0.0336 0.6200 0.0206 0.6828 0.0112 0.7067
14. TS3,VL 0.0891 0.7639 0.0463 0.9989 0.0251 0.9955 0.0156 1.1015
15. VL, SRW 0.0826 0.7335 0.0409 0.9666 0.0199 0.9383 0.0128 1.0294
Panel C. Regressions wirh three earnings proxies ( P = 3)
16. TSl, TS2, TS3 0.0669 0.4906 0.0359 0.6599 0.0233 0.6585 0.0109 0.6615
17. TSl, TS2, SRW 0.0709 0.5193 0.0354 0.6845 0.0199 0.6928 0.0085 0.7OQo
18. TSl, TS2, VL 0.0918 0.7837 0.0470 1.0260 0.0251 1.0119 0.0142 1.1251
19. TSl, TS3, SRW 0.0684 0.5058 0.0343 0.6568 0.0205 0.6535 0.0107 0.6809
20. TSl,TS3,VL 0.0899 0.7715 0.0460 1.0005 0.0259 0.9722 0.0158 1.0718
21. TSl , VL, SRW 0.0898 0.7718 0.0444 1.0032 0.0210 0.9770 0.0128 1.0713
22. TS2, TS3, SRW 0.0702 0.5038 0.0366 0.6776 0.0223 0.7441 0.0109 0.7442
23. TS2, TS3, VL 0.0924 0.7834 0.0480 1.0272 0.0262 1.0294 0.0152 1.1271
24. TS2,VL,SRW 0.0933 0.7868 0.0472 1.0309 0.0252 1.0289 0.0142 1.1305
25. TS3, VL, SRW 0.0903 0.7687 0.0461 1.0018 0.0248 0.9988 0.0150 1.1018
Panel D. Regressions withfour earnings proxies ( P = 4)
26. TSl , TS2, TS3, SRW 0.0711 0.5198 0.0363 0.6827 0.0236 0.6884 0.0109 0.7055
27. TSl,TSZ,TS3,VL 0.0923 0.7845 0.0480 1.0246 0.0291 1.0111 0.0164 1.1243
28. TSI, TS2, VL, SRW 0.0934 0.7888 0.0470 1.0311 0.0253 1.0232 0.0138 1.1316
29. TSl,SRW,TS3,VL 0.0908 0.7743 0.0458 1.0027 0.0257 0.9772 0.0152 1.0737
30. TS2, SRW, TS.3, VL 0.0938 0.7889 0.0478 1.0299 0.0259 1.0321 0.0146 1.1274
Panel E. Regressions withfive earnings proxies (TSl, TS2, TS3, SRW, VL) ( P = 5)
31. All models 0.0936 0.7890 0.0478 1.0281 0.0290 1.0178 0.0158 1.1280
YR,,(d,O) is the cumulative residual for firm i in quarter 1. It is calculated as the cumulated market model residual, cumulated from d days before
the earnings announcement date through the earnings announcement date (day 0). UE,,A is the unexpected earnings proxy for firm i, in quarter 1,
conditional on forecasting model h (see note c). ya is the estimated regression intercept coefficient. P is the number of proxy variables for unexpected
earnings in the regression, P = 1,. (5. yi is the estimated regression coefficient for LIE,,,,.
bNumber of observations available for the test. The number of observations decreases as the cumulation period increases because an observation is
constrained so that each observations Value Line report date occurs before the first day of the cumulation period, d.
The independent variable(s) in the regressions are proxy variables for unexpected earnings, There are five unexpected earnings proxy variables.
SRW indicates that the unexpected earnings proxy is calculated conditional on the seasonal random walk forecasting model, TSl the Brown and
Rozeff (1979) model, TS2 the Foster (1977) model, TS3 the Watts (1975) - Griffin (1977) model, and VL the forecast in The Value Line Inuestment
Survey.
dSum of coeff. is the sum of the coefficients for the proxy variables in the regression, i.e., the sum of yx. Since all independent variables are proxy
variables for unexpected earnings, the sum of the coefficients represents the estimated coehicient for unexpected earnings. For the single proxy variable
regressions (regressions 1 through 5), the sum of coefficients is the coefficient for the single proxy variable.
174 L..D. Brown et al., Alternativeproxies for unexpected earnings
The following results pertain to the (- LO) holding period. The highest
sums of coefficients in panels A through E are 0.6985 (panel A, #5, VL),
0.7769 (panel B, # 12, TS2, VL), 0.7868 (panel C, #24, TS2, VL, SRW),
0.7889 (panel D, #30, TS2, SRW, TS3, VL), and 0.7890 (panel E, #31, all
five models), respectively; the lowest sum of coefficients in panels A through E
are 0.3170 (panel A, #l, SRW), 0.4588 (panel B, #lO, TS2, TS3), 0.4906
(panel C, #16, TSl, TS2, TS3), 0.5198 (panel D, #26, TSl, TS2, TS3, SRW),
and 0.7890 (panel E, #31, all five models), respectively.
As discussed in section 2.3, a finding that the sum of yx coefficients
increases when additional proxies are included in regression eq. (9) suggests
that the proxy variables contain measurement error and the regressions with
two or more proxy variables reduce (to an unknown degree) the measurement
error. To examine the extent to which the use of multiple proxy variables
reduces (ex post) measurement error, we examine the incremental explanatory
power (i.e., the partial F-statistic) of adding an additional proxy variable to
the (ex post) best proxy variable among the alternative single proxy variable
regressions, of adding an additional proxy variable to the best set of two
proxy variable regressions, and so on. Assuming that eq. (1) is the true model
for Ri,, a significant partial F-statistic suggests the existence of measurement
error and that our procedure of combining earnings proxies reduces (to an
unknown degree) measurement error.
Fig. 1 presents a bar graph of the maximum adjusted R-squares from table
2 for a given number of proxy variables for each of the four holding periods.
For example, for the (- LO) holding period, the proxy variables represented
by the bar graph are regressions #5 (VL), # 12 (TS2, VL), #24 (TS2, VL,
SRW), # 30 (TS2, SRW, TS3, VL), and #31 (all five models) for the
regressions with one through five proxy variables, respectively. We first ex-
amine the t-statistic of TS2 in regression #12 to ascertain whether addition of
a second proxy variable significantly reduces measurement error. Finding a
significant t-statistic, we conclude that a two proxy variable equation reduces
measurement error in this case. Similarly, we examine the t-statistic of SRW in
regression #24, of TS3 in regression #30, and of TSl in regression #31,
respectively, to ascertain whether addition of a third, fourth, and fifth explana-
tory variable to a set of two, three, and four explanatory variables significantly
reduces measurement error. The incremental f-statistics of SRW and TS3 in
regressions #24 and #30 were significant, but the t-statistic of TSl in
equation #31 was not significant.
The bar graph in fig. 1 representing the four proxy variable equation for the
( - 1,0) holding period is designated by an asterisk to indicate that the four
variable set appears to be (ex post) best for this holding period. Similar
analyses are conducted for the longest holding period (- 40,O) and the two
intermediate holding periods (- 10,O) and (- 20,O). The best set of proxy
12%
I
10%r .......................................................................+ .........._.............................
Number of Proxy Variables in Regression

m cR(-1.0) fEm cR(-10.0) ez4 CR(-20,O) El cR(40.0)
Fig. 1. Maximum adjusted R-squares across number of proxy variables - table 2 regressions
variable equations for these holding periods is also represented by an asterisk

in fig. 1. Comparing the longest holding period (-40,O) with the shortest
holding period (- LO), it is evident that our procedure is more successful for
reducing measurement error for the shortest holding period. More specifically,
the best set of proxy variable equations for the shortest holding period is
represented by four proxy variables, while it is represented by two proxy
variables for the longest holding period.
In summary, the results presented in table 2 and fig. 1 suggest that our
procedures are more effective for reducing measurement error for shorter
abnormal return holding periods than they are for reducing measurement error
for the longest (- 40,O) holding period. We cannot distinguish between the
explanations that our procedure is not sufficiently powerful for detecting
measurement error over the longest ( - 40,O) holding period and that measure-
ment error is not a signiticant problem in our sample for the longest holding
period. However, for shorter holding periods, our results indicate that mea-
surement error is a significant problem for the researcher using a multiple
regression research design.
While we have demonstrated an increase in the explanatory power of the
relation between CR,, and UEitx by using multiple proxies for unexpected
earnings - which we attribute in part to the reduction of the error in measur-
ing the markets expectation of unexpected earnings - we realize that we do
not purge all the error, and thus, the coefficient values that are estimated do
Table 3
Summary of cross-sectional regressions between cumulative residuals and one or more unexpected earnings proxy variable(s), comparison of large and
small firms.
P
Regression: CR,,( d. 0) = y,) + c y,bE,,, + error.
h=l
Dependent variable: Cumulative residual (CR,,( d.0))

CR,,(-LO) CR,,(-4030)
Regression 1,044 small firmsb 1,044 large firms 403 small firms 403 large firms
Panel A. Regressions with one earnings pro,y ( P = 1)

1. SRW 0.0560 0.3220 0.0035 0.1393 0.0108 0.4464 - 0.0025 - 0.0449
2. TSl 0.0810 0.4659 0.0146 0.3192 0.0108 0.6015 0.0054 1.1356
3. TS2 0.0632 0.3583 0.0116 0.2521 0.0071 0.4325 0.0176 1.6575
4. TS3 0.0880 0.4451 0.0146 0.3142 0.0218 0.7682 0.0049 1.0106
5. VL 0.0945 0.6416 0.0383 0.7824 0.0252 1.0711 ~ 0.0010 0.5796
Panel B. Regressions with fwo earrtingsprowies
(P = 2)
6. TSl, TS2 0.0828 0.4789 0.0138 0.3205 0.0084 0.6052 0.0164 1.4482
I. TSl, TS3 0.0904 0.4834 0.0144 0.3302 0.0215 0.6832 0.0031 1.1428
8. TSl, SRW 0.0873 0.5055 0.0150 0.3079 0.0138 0.7411 0.0121 1.1704
9. TS1,VL 0.1158 0.7391 0.0383 0.8036 0.0234 1.1166 0.0030 1.0511
10. TS2, TS3 0.0894 0.4674 0.0139 0.3177 0.0194 0.7532 0.0156 1.5445
11. TS2, SRW 0.0843 0.4840 0.0107 0.2568 0.0137 0.7127 0.0207 1.3563
12. TS2, VL 0.1162 0.7468 0.0384 0.8043 0.0246 1.1711 0.0153 0.5051
13. TS3, SRW 0.0938 0.4939 0.0151 0.3017 0.0230 0.8971 0.0093 0.9098
14. TS3,VL 0.1239 0.7445 0.0389 0.8147 0.0290 1.2070 0.0024 0.9517
15. VL, SRW 0.1071 0.6996 0.0376 0.7749 0.0258 1.1532 -0.0028 0.5279
Panel C. Regressions with three earnings proxies ( P = 3)
16. TSl, TS.2, TS3 0.0903 0.4897 0.0134 0.3303 0.0195 0.6936 0.0140 1.4522
17. TSl. TS2. SRW 0.0901 0.5239 0.0141 0.3087 0.0119 0.7594 0.0186 1.4242
18. TSI; TS2; VL 0.1187 0.7589 0.0376 0.8060 0.0224 1.1703 0.0140 1.4651
19. TSl,TS3, SIZW 0.0944 0.5148 0.0153 0.3208 0.0238 0.8114 0.0101 1.1835
20. TSl,TS3,VL 0.1232 0.7475 0.0381 0.8157 0.0317 1.1512 0.0007 1.0446
21. TSI, VL, SRW 0.1175 0.7495 0.0396 0.7986 0.0235 1.1698 0.0097 1.2494
22. TS2, TS3, SRW 0.0955 0.5186 0.0142 0.3042 0.0206 0.8853 0.0188 1.4271
1.4961 E
23. TS2, TS3, VL 0.1248 0.7612 0.0380 0.8147 0.0266 1.1952 0.0132
24. TS2, VL, SRW 0.1210 0.7698 0.0387 0.7957 0.0247 1.2341 0.0185 1.5271 .&
a
25. TS3,VL, SRW 0.1246 0.7543 0.0411 0.8159 0.0280 1.2504 0.0070 1.0313 f
Panel D. Regressions with four earnings proxies (P = 4) z
Q
26. TSl, TS2, TS3, SRW 0.0950 0.5260 0.0144 0.3203 0.0226 0.8406 0.0163 1.4311 ?
27. TSl, TS2, TS3, VL 0.1240 0.7602 0.0372 0.8161 0.0316 1.2195 0.0115 1.4597 5
28. TSI, TS2, VL, SRW 0.1210 0.7725 0.0387 0.7996 0.0232 1.2428 0.0162 1.5486 2
29. TSl,SRW,TS3,VL 0.1238 0.7550 0.0402 0.8159 0.0316 1.2011 0.0077 1.2426 g,
30. TSZ,SRW,TS3,VL 0.1256 0.7722 0.0402 0.8158 0.0256 1.2408 0.0165 1.5405 P
b
Panel E. Regressions with five earnings proxies (TSl, TS2, TS3, SRW, VL) (P = 5) 0
5.
31. All models 0.1251 0.7707 0.0393 0.8154 0.0322 1.2898 0.0140 1.5407 Q
>
CR,,(d,O) is the cumulative residual for firm i in quarter t. It is calculated as the cumulated market model residual cumulated from d days before i
the earnings announcement date through the earnings announcement date (day 0). riElrh is the unexpected earnings proxy for firm i, in quarter t,
conditional on forecasting model X (see note c). v,, is the estimated regression intercept coefficient, P is the number of proxy variables for unexpected $
earnings in the regression, P = 1,. ,5. yx is the estimated regression coefficient for UE,,,. r?
bNumber of observations available for the test. The number of observations decreases as the cumulation period increases because an observation is B
constrained so that each observations V&e Line report date occurs before the first day of the cumulation period, d. The total number of observations 6
for a particular cumulation period is partitioned into quartiles on the basis of size, then the upper quartile (large firms) is compared to the lower $
quartile (small firms) in the columns of the table. For CR,,( - 1,O). small firms have equity with a market value of less than $274 million and large %
firms have equity with a market value of more than $1,269 million: for CR,,( -40,O) small firms have equity with a market value of less than $328
million and large firms have equity with a market value of more than $1,356 million.
The independent variable(s) in the regressions are proxy variables for unexpected earnings. There are five unexpected earnings proxy variables.
Rozeff (1979) model, TS2 the Foster (1977) model, TS3 the Watts (1975) - Griffin (1977) model, and VL the forecast in The Value Line Investment
Survey.
dSum of coeff. is the sum of the coefficients for the proxy variables in the regression, i.e., the sum of yh. Since all independent variables are proxy 2
variables for unexpected earnings, the sum of the coefficients represents the estimated coefficient for unexpected earnings. For the single proxy variable
regressions (regressions 1 through 5) the sum of coefficients is the coefficient for the single proxy variable.
not reveal the magnitude of the true /3 implicit in eq. (1). Also, recall that the
coefficients are based on a cross-sectional estimation procedure, a technique
that makes the simplifying assumption that the /3 coefficient is cross-section-
ally invariant.
4.3. Eflects of $rm size

Measurement error in unexpected earnings may differ on the basis of firm
characteristics. Larger firms are subject to closer scrutiny by equity analysts
[e.g., Advisory Committee on Corporate Disclosure (1977)] and earnings
information of large firms generally is available earlier to the market. For large
firms, the market obtains information from primary and secondary sources on
a relatively continuous basis. On the other hand, for small firms, new informa-
tion tends to be released less frequently, for example, at the time of earnings
announcements.
In order to examine whether or not the results differ on the basis of firm size
(i.e., the market value of equity measured two days before the earnings
announcement), we segment our sample into four quartiles conditional on firm
size, and present, in table 3, the results for the smallest and the largest
quartiles for the shortest ( - LO) and longest ( - 40,O) holding periods. For the
short holding period, (- LO), small firms have equity with a market value of
less than $274 million and large firms have equity with a market value of more
than $1,269 million; for the long holding period, (- 40,0), small firms have
equity with a market value of less than $328 million and large firms have
equity with a market value of more than $1,356 million. Consistent with the
format of table 2, panel A of table 3 summarizes regressions with one proxy,
panel B with two proxies, etc. In a manner similar to fig. 1, fig. 2 presents a bar
graph of the maximum adjusted R-squares from table 3 for a given number of
proxy variables (one to five) for the (- 1,O) and (-40,O) holding period for
the small and large firms. The principal results follow.
First, the yi coefficient values for the single variable forms of eq. (9) are
highly significant for the small firms for both the shortest and longest holding
periods. However, they are not always significant for the large firms. The
adjusted R-squares are actually negative in two instances for the large firms
for the longest holding period. Second, the sum of the yx coefficients always
increases and the adjusted R-squares always decrease as the holding period
increases for the small firms. Such is not the case, however, for the large firms.
Third, the partitioning of the sample on firm size appears to have opposite
effects for Value Line and the Box-Jenkins time series conditioned proxies.
For the shortest (longest) holding period, the Box-Jenkins time series models
yi (see regressions # 2 through #4) are larger (smaller) for small firms than
_,-
1 Proxy 2 Proxies 3 proIfes 4 ProXkm 6 Prorlw
EB CR(-1.0) Efz!JlCR(-1.0) lz3 CR(-4&O) El cRf-40,0)

SIMU L=w smrll
Fig. 2. Maximum adjusted R-squares from table 3 - comparing large firms to small firms.
for large firms, while the opposite is observed for VL (see regression #5).
Fourth, the sum of the yx coefficients generally increases when additional
proxy variables are added to eq. (9), regardless of firm size or length of holding
period.
Similar to fig. 1, the asterisks for fig. 2 designate the N proxy variable set
that is (ex post) best for the particular firm size/holding period. Fig. 2
reveals that our procedures appear to be more effective at reducing measure-
ment error for small than for large firms and for short than for long holding
periods. More specifically, for the (- LO) holding period, a four variable set
appears to be best for small firms, while a three variable set appears to be
best for large firms. For the (- 40,O) holding period, a three variable set
appears to be best for small firms, while a two variable set appears to be ex
post best for large firms.
In sum, the results presented in table 3 and fig. 2 again suggest the existence
of measurement error in unexpected earnings proxies, that our procedures are
more effective at reducing measurement error for the short holding period than
they are for the long holding period, and that these results hold for both small
and large firms. However, the results also suggest that the relation between
abnormal returns and unexpected earnings is better specified for small than
for large firms, and that our procedures are more effective at ameliorating
measurement error for the small firms.,
Table 4
Summary of cross-sectional regressions between cumulative residuals and one or more unexpected earnings proxy variable(s), comparison of recent and
non-recent forecasts.
P
Regression: CR,,(d,O) = y0 + c y,,UE,,, + error.=

X=1
Dependent variable: Cumulative residual (CR,,(d,O))

CR,,(- LO) CR,,(-40,O)
Regression 1,056 recentb 1,095 non-recent 429 recent 409 non-recent
Panel A. Regressions with one earnings proxy ( P = 1)

1. SRW 0.0640 0.3536 0.0173 0.1852 0.0005 0.2795 0.0057 0.4041
2. TSl 0.0746 0.4458 0.0359 0.3684 0.0169 0.8631 0.0013 0.4197
3. TS2 0.0672 0.3762 0.0226 0.2561 0.0358 1.0467 - 0.0001 0.3139
4. TS3 0.0676 0.4032 0.0387 0.3711 0.0197 0.7269 0.0036 0.5185
5. VL 0.0860 0.7544 0.0526 0.5572 0.0118 1.1926 0.0037 0.6183
Panel B. Regressions with two earnings proxies ( P = 2)
6. TSl , TS2 0.0784 0.4619 0.0350 0.3681 0.0356 0.9039 - 0.0010 0.4091
7. TSl,TS3 0.0756 0.4562 0.0386 0.3871 0.0180 0.8230 0.0024 0.4596
8. TSl , SRW 0.0820 0.4795 0.0370 0.3892 0.0147 0.8324 0.0038 0.5277
9. TSl,VL 0.1096 0.8318 0.0565 0.6005 0.0169 1.2389 0.0014 0.6317
10. TS2, TS3 0.0746 0.4360 0.0383 0.3825 0.0337 1.0325 0.0021 0.4704
11. TS2, SRW 0.0889 0.4972 0.0289 0.3257 0.0338 0.9845 0.0035 0.4834
12. TS2, VL 0.1134 0.8513 0.0560 0.6073 0.0344 1.2993 0.0013 0.6241
13. TS3, SRW 0.0788 0.4581 0.0394 0.3914 0.0176 0.6775 0.0050 0.6199
14. TS3, VL 0.1088 0.8358 0.0588 0.6096 0.0204 1.1990 0.0024 0.6846
15. VL, SRW 0.1037 0.7890 0.0524 0.5628 0.0096 1.2044 0.0047 0.6492
Panel C. Regressions with three earnings proxies ( P = 3)
16. TSl, TS2, TS3 0.0781 0.4662 0.0378 0.3887 0.0334 0.8950 0.0001 0.4500
17. TSl,TSZ,SRW 0.0887 0.5069 0.0361 0.3898 0.0333 0.8940 0.0014 0.5195
18. TSl, TS2, VL 0.1144 0.8547 0.0560 0.6093 0.0358 1.2984 - 0.0010 0.6259
19. TSl,TS3,SRW 0.0819 0.4851 0.0391 0.4030 0.0161 0.7701 0.0043 0.5573
20. TSl,TS3,VL 0.1103 0.8399 0.0579 0.6087 0.0181 1.2035 0.0022 0.6639
21. TSl, VL, SRW 0.1115 0.8288 0.0557 0.6007 0.0150 1.2113 0.0022 0.6498
22. TS2, TS3, SRW 0.0882 0.5009 0.0390 0.4019 0.0317 0.9851 0.0035 0.5716
23. TS2,TS3,VL 0.1142 0.8572 0.0582 0.6181 0.0326 1.3132 0.0011 0.6446
24. TS2, VL, SRW 0.1189 0.8548 0.0553 0.6080 0.0328 1.2630 0.0022 0.6406
25. TS3,VL,SRW 0.1113 0.8321 0.0579 0.6095 0.0188 1.1571 0.0028 0.6949
Panel D. Regresstons with four earnings proxies ( P = 4)
26. TSl,TSZ,TS3,SRW 0.0878 0.5069 0.0383 0.4054 0.0312 0.8797 0.0019 0.5500
27. TSl, TS2, TS3, VL 0.1138 0.8569 0.0577 0.6204 0.0337 1.2897 - 0.0002 0.6542
28. TSl,TSZ,VL,SRW 0.1180 0.8548 0.0552 0.6095 0.0337 1.2810 - 0.0002 0.6412
29. TSl,SRW,TS3,VL 0.1116 0.8358 0.0571 0.6087 0.0165 1.1625 0.0026 0.6741
30. TS2, SRW, TS3, VL 0.1181 0.8551 0.0574 0.6181 0.0308 1.2784 0.0014 0.6564
Panel E. Regrewons withfive earnrngs proxies (TSI, TS2, TS3, SRW, VL) (P = 5)
31. All models 0.1172 0.8552 0.0568 0.6204 0.0316 1.2677 0.0002 0.6666
TR,,( d.0) is the cumulative residual for firm i in quarter t. It is calculated as the cumulated market model residual, cumulated from d days before
the earnings announcement date through the earnings announcement date (day 0). UE,,* is the unexpected earnings proxy for firm i, in quarter t,
conditional on forecasting model A (see note c). y. is the estimated regression intercept coefficient. P is the number of proxy variables for unexpected
earnings in the regression, P = 1,. ,5. yh is the estimated regression coefficient for UE,,,.
constrained so that each observations Value Line report date occurs before the first day of the cumulation period, d. The total number of observations
for the particular cumulation period is partitioned into quartiles on the basis of the age of the forecast, then the upper quartile (non-recent forecasts) is
compared to the lower quartile (recent forecasts) in the columns of the table. For CR,,( - l,O), the recent forecasts are less than 21 days old and the
non-recent forecasts are more than 67 days old; for CR,,( -40.0) the recent forecasts are less than 62 days old and the non-recent forecasts are more
than 75 days old.
The independent variable(s) in the regressions are proxy variables for unexpected earnings. There are five unexpected earnings proxy variables.
Rozeff (1979) model, TS2 the Foster (1977) model, TS3 the Watts (1975) - Griffin (1977) model, and VL the forecast in The Value Line Investment
Survey.
dSum of coeff. is the sum of the coefficients for the proxy variables in the regression, i.e., the sum of yh. Since all independent variables are proxy
variables for unexpected earnings, the sum of the coefficients represents the estimated coefficient for unexpected earnings. For the single proxy variable
regressions (regressions 1 through 5), the sum of coefficients is the coefficient for the single proxy variable.
182 L. D. Brown et al., Aliernative proxies for unexpected earnings
1
2Prox&m 3 Proxiaa 4 ProhJll 6 Proxha
m cR(-1.0) iSI cR(-1.0) ED cw-4oxJ) = W-WJ)

hoant Non-ha& lfeoent Non-Reoent
Fig. 3. Maximum adjusted R-squares from table 4 - comparing recent to non-recent forecasts.
4.4. Eflects of forecast timing

Another characteristic of our data is that all forecasts are not equally
timely; some forecasts are more recent than others relative to the earnings
announcement date. Time series model forecasts have approximately a 90 day
forecast horizon. However, security analysts make their forecasts with varying
horizons [median forecast horizon (age) of 39 days]. It is possible that the
older the forecast, the greater the measurement error, and hence the lower the
estimated /I coefficient. Table 4 examines this issue by presenting the adjusted
R-squares and sum of yx coefficients for recent and non-recent forecasts in a
format similar to tables 2 and 3.
Firms with recent (non-recent) forecasts are partitioned into the lowest
(highest) quartile of days between the Value Line report date and the earnings
announcement date for the entire sample. As a result, recent and non-recent
forecasts for the (- 1,0) holding period are less than 21 days old and more
than 67 days old, respectively, where days old is defined as the number of
days the VL forecast precedes the earnings announcement day (day 0). Recent
and non-recent forecasts for the ( - 40,O)l holding period are less than 62 days
old and more than 75 days old, respectively. Fig. 3 presents a bar graph of the
maximum adjusted R-squares from table 4 for a given number of proxy
variables for each of the two holding periods for both recent and non-recent
forecasts similar to figs. 1 and 2. The principal results follow.
First, the yi coefficient values for the single firm variable forms of eq. (9) are
highly significan? for the recent forecasts for both the shortest and longest
holding periods. However, they are not always significant for the non-recent
forecasts. The adjusted R-square for TS2 in panel A is actually negative for
the non-recent forecasts for the longest holding period. Second, with one
exception (i.e., SRW in panel A), the sum of the yx coefficients always
increases and the adjusted R-squares always decrease as the holding period
increases for the recent forecasts. Similarly, the sum of the yx coefficients
always increases and the adjusted R-squares always decrease for the non-
recent forecasts. Third, for the short holding period, the sum of the yx
coefficients and the adjusted R-squares are always higher for the recent than
for the non-recent forecasts. Similarly, for the long holding period, with the
sole exception of SRW in panel A, the sum of the yh coefficients and the
adjusted R-squares for the recent forecasts are larger than those of firms with
non-recent forecasts. These results are consistent with the conjecture that
unexpected earnings proxies that are conditioned on non-recent forecasts
contain more measurement error than proxies that are conditioned on more
recent forecasts. Fourth, the sum of the y,, coeffic ents generally increases
when additional proxy variables are added to eq. (91, regardless of recency of
forecast or length of holding period.
Similar to figs. 1 and 2, the asterisks in fig. 3 designate the N proxy variable
set that is (ex post) best for the particular recency of forecast/holding
period. Fig. 3 reveals that our procedures appear to be more effective at
reducing measurement error for recent than non-recent forecasts, and for short
rather than long holding periods. More specifically, for the (- 1,O) holding
period, a three variable set appears to be best for the recent forecasts, while a
two proxy variable set appears to be best for non-recent forecasts. For the
( - 40,O) holding period, the multiple proxy variable procedure is ineffectual in
the sense that the goodness of fit of the best two proxy variable equation is
not significantly better than the goodness of fit of the best single variable
equation, regardless of the recency of the forecast.
In sum, the results in table 4 and fig. 3 again suggest the existence of
measurement error in unexpected earnings proxies and that our procedures are
more effective at reducing measurement error for the short abnormal return
holding period than they are for the long holding period. However, the results
suggest that the relation between abnormal returns and unexpected earnings is
better specified for recent forecasts than for non-recent forecasts, and that our
procedures are more effective at reducing measurement error for the recent
forecasts.
Table 5
Summary of cross-sectional regressions between cumulative residuals and one or more unexpected earnings proxy variable(s) using stock return to
control for measurement error in unexpected earnings.
P
Regression: CR,,( d, 0) = ya + 1 yAIJE,,, + w R;, + error.=

X=1
Dependent variable: Cumulative residual (CR,, (d, 0))
C&,(-LO) C&,(-10,0) C&,(-20,0) CR,, ( - 4090)

4,177 observationsb 3,431 observations 2,931 observations 1,611 observations
Independent Sum of Table 2 Sum of Table 2 Sum of Table 2 Sum of Table 2
No. variable(s)c 0Xff.d change coeff. change coeff. change coeff. change
Panel A. Regressions with one earnings proxy ( P = 1)

1. SRW 0.3182 0.36% 0.3829 0.20% 0.3882 - 0.73% 0.3630 3.50%
2. TSl 0.4788 1.01% 0.6434 2.15% 0.6198 0.95% 0.6550 5.15%
3. TS2 0.3910 1.33% 0.5790 3.83% 0.6180 1.35% 0.5814 6.23%
4. TS3 0.4273 1.26% 0.6048 3.10% 0.6587 0.99% 0.6887 4.15%
5. VL 0.7163 2.54% 0.9728 4.21% 0.9198 3.03% 1.1341 12.33%
Panel B. Regressions with hvo earnings proxies (P = 2)
6. TSl , TS2 0.4927 l,.14% 0.6736 2.61% 0.6575 1.07% 0.6790 5.38%
7. TSI , TS3 0.4861 1.10% 0.6520 2.32% 0.6340 0.98% 0.6757 5.04%
8. TSl, SRW 0.5073 0.88% 0.6667 1.71% 0.6566 0.54% 0.7038 4.80%
9. TSl,VL 0.7860 2.35% 1.0375 3.85% 0.9917 2.54% 1.1827 10.84%
10. TS2, TS3 0.4652 1.39% 0.6700 3.51% 0.7260 1.16% 0.7364 5.05%
11. TS2, SRW 0.4875 1.01% 0.6567 2.48% 0.6928 0.54% 0.6984 5.34%
12. TS2, VL 0.7975 2.65% 1.0688 4.38% 1.0461 2.71% 1.2507 11.08%
13. TS3. SRW 0.4708 1.00% 0.6338 2.22% 0.6859 0.46% 0.7350 4.00%
14. TS3, VL 0.7834 2.55% 1.0405 4.17% 1.0212 2.58% 1.2194 10.70%
15. VL, SRW 0.7498 2.22% 1.0023 3.69% 0.9607 2.38% 1.1487 11.58%
Punel C. Regressions with three earnings proxies ( P = 3)
16. TSl, TS2, TS3 0.4965 1.20% 0.6779 2.72% 0.6657 1.09% 0.6964 5.27%
17. TSl,TS2,SRW 0.5246 1.01% 0.6993 2.16% 0.6973 0.65% 0.7354 5.06%
18. TSl, TS.2, VL 0.8035 2.53% 1.0697 4.26% 1.0398 2.67% 1.2502 11.13%
19. TSl, TS3, SRW 0.5105 0.94% 0.6686 1.80% 0.6572 0.56% 0.7134 4.77%
20. TSl, TS3, VL 0.7903 2.43% 1.0403 3.98% 0.9975 2.60% 1.1876 10.80%
21. TSl,VL, SRW 0.7892 2.25% 1.0402 3.68% 0.9998 2.32% 1.1853 10.64%
22. TS2, TS3, SRW 0.5095 1.12% 0.6956 2.66% 0.7491 0.67% 0.7802 4.84%
23. TS2, TS3, VL 0.8040 2.63% 1.0719 4.35% 1.0562 2.60% 1.2509 10.98%
24. TS2, VL, SRW 0.8062 2.46% 1.0732 4.10% 1.0538 2.43% 1.2526 10.80%
25. TS3, VL, SRW 0.7873 2.41% 1.0413 3.94% 1.0226 2.38% 1.2177 10.51%
Panel D. Regressions with four earnings proxies (P = 4)
26. TSl,TS2,TS3,SRW 0.5252 1.04% 0.6977 2.20% 0.6929 0.67% 0.7410 5.03%
27. TSl,TS2,TS3,VL 0.8047 2.57% 1.0690 4.34% 1.0386 2.71% 1.2494 11.13%
28. TSl , TS2, VL, SRW 0.8079 2.42% 1.0732 4.08% 1.0481 2.44% 1.2549 10.90%
29. TSl, SRW, TS3, VL 0.7924 2.34% 1.0410 3.81% 1.0008 2.42% 1.1879 10.64%
30. TS2,SRW,TS3,VL 0.8085 2.48% 1.0724 4.12% 1.0572 2.43% 1.2491 10.80%
Panel E. Regressions with five earnings proxies (TSl, TS2, TS3, SRW, VL) (P = 5)
31. All models 0.8084 2.46% 1.0707 4.15% 1.0433 2.51% 1.2513 10.94%
YR,,(d, 0) is the cumulative residual for firm i in quarter t. It is calculated as the cumulative market model residual, cumulated from d days before
the earnings announcement date through the earnings announcement day (day 0). UE,,A is the unexpected earnings proxy for firm i, in quarter t,
conditional on the forecasting model h (see note c). y0 is the estimated regression intercept coefficient. P is the number of proxy variables for
unexpected earnings in the regression, P = 1,. ,5. yx is the estimated regression coefficient for UE,,,. w is the coefficient for RJ, which is firm is
stock return from day - 100 through the day before the cumulation period begins (day d - 1).
constrained so that each observations V&e Line report date occurs before the first day of the cumulation period, d.
There are five unexpected earnings proxy variables. SRW indicates that the unexpected earnings proxy is calculated conditional on the seasonal
random walk forecasting model, TSl the Brown and Rozeff (1979) model, TS2 the Foster (1977) model, TS3 the Watts (1975) - Griffin (1977) model,
and VL the forecast in The Value Line Investment Survey.
dSum of coetT. is the sum of the coefficients for the proxy variables in the regression, i.e., the sum of yx, estimated via eq. (10). Table 2 change is the
percentage change in the sum of the coefficients from table 2 [estimated via eq. (9)] to table 5 [estimated via eq. (lo)]. Since all independent variables
are proxy variables for unexpected earnings, the sum of the coefficients represents the estimated coefficient for the unexpected earnings. For the single
proxy variable regressions (regressions 1 through 5), the sum of coefficients is the coefficient for the single proxy variable. To the extent R(I, is
correlated with the measurement error in the proxy variable, the sum of the coefficients should increase.
186 L.D. Brown et al., Alternativeproxies for unexpected earnings
4.5. Using stock returns to control for measurement error

Given the model and underlying assumptions in section 2, we show that
including another independent variable in eq. (3) reduces the bias in estimat-
ing B in eq. (1) when the additional independent variable, Zil, is correlated
with the measurement error in the proxy, cirX, and uncorrelated with the
dependent variable, Ri,, the independent variable, S,,, and the eq. (1) residu-
als, pit. For present purposes, we use as Z,, the firms stock return from 100
days before the earnings announcement (day - 100) through the day before
the cumulation period begins (day d - 1) and re-estimate eq. (9) with this
additional variable. More formally, the model we estimate is
P
CR,,(d,O) = y. + c YAUEirh+ oRJt + error, (10)
A=1
where Rjt is our proxy for Z,,.

If earnings revisions and stock returns are positively correlated, then this
additional stock return variable would be positively correlated with the
measurement error in the (dated) unexpected earnings proxy variables. We
assume that the stock return variable is positively correlated with the measure-
ment error in the unexpected earnings proxy variables and uncorrelated with
the dependent variable, the independent variable, and the residuals from the
eq. (1) regression model. Since the additional return variable is assumed to be
positively correlated with the measurement error in the unexpected earnings
proxy variable, and /I is assumed to be positive, we expect R;, to have a
negative coefficient (i.e., w < 0).
Each of the regressions in table 2 [see eq. (9)] is re-estimated with inclusion
of this additional stock return variable [see eq. (lo)]. The percentage increase
in the sum of the yx coefficients resulting from the addition of this additional
variable is reported in table 5 for each of the 124 regressions in table 2. The
coefficients for w (not reported in the table) are, as expected, negative and
have t-statistics which reject the null hypothesis that o is greater than or equal
to 0 at less than the 0.01 probability level for every proxy variable combina-
tion and for every holding period (i.e., for all 124 regressions).
Further, with the sole exception of regression #1 (SRW) for the (- 20,O)
holding period, the percentage change in the sum of the yx coefficients is
positive; that is, the sum of the yx coefficients increases with the addition of
the return variable for 123 of the 124 regressions. However, the percentage
increases are small, the 124 regressions are not independent tests, and we do
not conduct statistical tests for the significance of the increases. For the
(- 1,0) holding period, the percentage increases range from 0.36 percent to
2.65 percent. The amount of the increase does not generally appear to be
affected by the number of proxy variables in the regression. The increase in the
L.D. Brown et al., Alfernativeproxies for unexpected earnings 187
percentage change increases as the holding period increases from ( - IO) to

( - 10,O) and from ( - 10,O) to ( - 40,O). The percentage increase is greatest for
the (- 40,O) holding period, ranging from 3.50 to 12.33 percent.
In sum, the results from the addition of the stock return variable to the
multiple proxy variable regression [eq. (9)] are consistent with the discussion
of the measurement error problem above. These results indicate the existence
of measurement error for long as well as short abnormal return holding
periods. Further, the use of a multiple proxy variable research design does not
appear to be a substitute for the addition of the stock return variable in that
the addition of the stock return variable to a multiple proxy regression
research design appears to reduce additional measurement error.
4.6. Instrumental variables
As discussed in section 2.2, an instrumental variables procedure regresses a

proxy variable on a set of instrumental variables; the predictions from this
regression are then used in a second regression of CR(d,O) on the predicted
variable. More specifically, the following two regressions are estimated:
K
UEith = 8, + c 6,I,,, + error,, 01)
k=l
where
a,, PO = regression intercept coefficients for eqs. (11) and (12) respectively,
I rkt = instrumental variable k for firm i, in quarter t; k is the number of
instrumental variables that are used in eq. (a) in table 6, k = 4, 5, or 6,
k = regression coefficient for l,k,,
Pi = slope coefficient in eq. (12).
Since it is unlikely that any variable exists that precisely meets the instru-
mental variable requirements discussed in section 2.2, we examine four alter-
native sets of instrumental variables which are based on earnings and stock
returns. The four sets of instrumental variables are: (i) the four unexpected
earnings proxy va,riables that are not the dependent variable in eq. (11) (ii) the
signs of the five unexpected earnings proxy variables, (iii) a stock return
variable and the instrumental variables in (i), and (iv) a stock return variable
and the instrumental variables in (ii). The stock return instrumental variable is
the stock return from 100 trading days before the earnings announcement
through the day before the abnormal return holding period.
Table 6
Summary of cross-sectional regressions between cumulative residuals and instrumental variables for unexpected earnings.
K
Regressions: (a) UE,,, = S, + c 6, I,k, + error,, (b) CR,,(d,O) = /3,, + & [ b0 + k=,
f 8 k I ,k,] +error2.
k=l
Dependent variable: Cumulative residual (CR,,( d, 0))

C&,(-LO) CR,,(-l&O) C&,(-20,0) C&,(-40,0)
Eq. (b) regression 4,177 observationsb 3,431 observations 2,931 observations 1,611 observations
Initial Adjusted P, Adjusted B, Adjusted P1 Adjusted P1
No. proxy R-square coeff. R-square coeff. R-square coeff. R-square coeff.
Panel A. Instrumental variables are the four unexpected earnings proxies not med as the initial unexpected earnings proxy variable ( K = 4)
1. TSl 0.0753 0.5663 0.0402 0.7600 0.0246 0.8500 0.0135 0.8618
2. TS2 0.0618 0.5049 0.0331 0.7005 0.0160 0.6833 0.0072 0.6317
3. TS3 0.0686 0.5096 0.0342 0.6612 0.0165 0.6552 0.0088 0.6652
4. SRW 0.0750 0.6307 0.0393 0.8686 0.0207 0.9035 0.0131 1.0450
5. VI. 0.0675 1.1734 0.0333 1.4175 0.0157 1.3759 0.0082 1.2856
Panel B. Insirumentul variables are the signs of the five unexpected earnings proxy variables ( K = 5)
6. TSl 0.0838 0.8590 0.0396 1.1239 0.0346 1.4667 0.0307 1.9088
7. TS2 0.0844 0.9504 0.0329 1.1243 0.0255 1.3849 0.0235 1.8538
8. TS3 0.0818 0.9982 0.0343 1.2280 0.0329 1.6828 0.0286 2.1560
9. SRW 0.0818 0.9982 0.0343 1.2280 0.0329 1.6828 0.0286 2.1560
10. VI_ 0.0743 1.7908 0.0290 2.0073 0.0247 2.5671 0.0230 3.4194
_-..
Panel C Instrumental variables are the four unexpected earnings proxies not used as the initial unexpected earnings proxy variable and
the stock return variable ( K = 5)
11. TSl 0.0757 0.5619 0.0411 0.7681 0.0241 0.8531 0.0140 0.8752
12. TS2 0.0611 0.5017 0.0317 0.6848 0.0157 0.6172 0.0066 0.6064
13. TS3 0.0681 0.5077 0.0334 0.6529 0.0164 0.6525 0.0088 0.6648
14. SRW 0.0762 0.6349 0.0414 0.8904 0.0217 0.9229 0.0141 1.0834
15. VL 0.0627 1.1149 0.0296 1.3280 0.0141 1.2993 0.0051 1.0301
Panel D. Instrumental variables are the signs of the five unexpected earnings proxy variables and the stock return variable ( K = 6)
16. TSl 0.0871 0.9990 0.0395 1.2701 0.0368 1.7160 0.0342 2.2544
17. TS2 0.075 1 0.9374 0.0267 1.0559 0.0258 1.4571 0.0215 1.8788
18. TS3 0.0817 0.9324 0.0305 1.0801 0.0253 1.3782 0.0234 1.8509
19. SRW 0.0822 1.0009 0.0365 1.2632 0.0348 1.7190 0.0305 2.2240
20. VL 0.0644 1.6118 0.0234 1.7749 0.0216 2.3701 0.0143 2.6530
aUE,,h is the unexpected earnings proxy for firm i, in quarter t, conditional on forecasting model h (see note c). 6, and &, are the regression
intercept coefficients for eqs. (a) and (b), respectively. Ilk, is instrumental variable k for firm i, in quarter t. K is the number of instrumental variables
that are used in eq. (a), k = 4,5,5,6. The instrumental variables are (i) the four unexpected earnings proxy variables that are not the dependent
variable in eq. (a), see note c, (ii) the signs of the five unexpected earnings proxy variables, (iii) a stock return variable and the instrumental variables in
(i), and (iv) a stock return variable and the instrumental variables in (ii). The stock return instrumental variable is the stock return from day - 100
through the day before the cumulation period (day d + 1). 6, is the regression coefficient for IZk,. CR,,(d,O) is the cumulative residual for firm i in
quarter t. It is calculated as the cumulated market model residual, cumulated from d days before the earnings announcement date through the earnings
announcement date (day 0). PI is the slope coefficient in eq. (b) and it is denoted as PI coeff. in the table.
constrained so that each observations Value Line report date occurs before the first day of the cumulation period, d.
The initial proxy variable in the regressions are proxy variables for unexpected earnings. There are five unexpected earnings proxy variables. SRW
indicates that the unexpected earnings proxy is calculated conditional on the seasonal random walk forecasting model, TSl the Brown and Rozeff
(1979) model, TS2 the Foster (1977) model, TS3 the Watts (1975) - Griffin (1977) model, and VL the forecast in The Value Line Investment Survey.
Panels A through D of table 6 summarize the tests examining four altema-

tive sets of instrumental variables for each of the five proxy variables. The
table 6 results suggest that the instrumental variables technique has the desired
effect of reducing measurement error. The p coefficient estimates are higher
than in any of the regression estimates (based on the sum of the yx coeffi-
cients) reported earlier in table 2. For example, the highest coefficient esti-
mates in table 2 are 0.7890, 1.0311, 1.0321, and 1.1316 for the (-l,O),
( - 10, 0),( - 20,0), and (- 40,O) holding periods, respectively. These estimates
are dominated by the highest coefficient estimates based on the instrumental
variables approach in table 6 for these same holding periods: 1.7908, 2.0073,
2.5671, and 3.4194, respectively.
These results reveal the importance of using analysts forecasts in conjunc-
tion with non-VL proxies as measures of unexpected earnings. The magnitudes
of the /3 coefficients are generally highest in regressions #5, #lo, #15, and
#20; that is, where the instrumental variable technique uses non-VL proxies
to purge error from the VL proxy. Moreover, relative to using the VL proxy
without attempting to purge error, the magnitude of the coefficient increases
considerably (more than 100 percent in some cases, e.g., compare regression
# 5, table 2, with regressions # 5, # 10, # 15, and #20, table 6, for the various
holding periods).17
In sum, relative to the multiple regression approach with and without the
inclusion of prior stock return data, and despite possible violations of the
underlying assumptions, the instrumental variables approach apparently im-
proves the estimation of the p coefficient. The effects of the instrumental
variable procedure are most evident when the technique is used to purge error
from an unexpected earnings proxy derived from Value Line analysts fore-
casts.
5. Summary and conclusions
This study compares and evaluates five alternative proxy variables for the
markets assessment of unexpected earnings for four alternative abnormal
return holding periods. Since such proxy variables measure the markets
assessment of unexpected earnings with error, we examine procedures to
We do not claim that the reported coefficient estimates are close to what they would be if all
variables are measured without error. Such predictions depend on a particular model of the
earnings change versus price change relation. These models make numerous simplifying assump-
tions about earnings behavior, the relation of earnings to cash flow, and the mapping of earnings
or cash flows into prices. The models, however, generally predict that the /3 coefficient should be
positive. Recent examples of models linking earnings to prices include Miller and Rock (1985) and
Watts and Zimmerman (1986).
L.D. Brown et al., Alternative proxies for unexpected earnings 191
detect and potentially reduce the measurement error in these proxy variables.
The procedures we examine are (i) the use of multiple unexpected earnings
proxy variables in a regression of abnormal returns on unexpected earnings
(multiple proxy procedure), (ii) the addition of an explanatory variable that is,
ex ante, uncorrelated with the abnormal return (dependent) variable and
correlated with the measurement error in the unexpected earnings proxies
(additional explanatory variable procedure), and (iii) the use of an instrumen-
tal variables procedure (instrumental variable procedure). Additionally, we
examine the relation of abnormal returns and unexpected earnings conditional
on the size of the firm and on the age of the financial analysts forecast. The
major results follow.
For short holding periods, the results consistently indicate significant mea-
surement error in all five unexpected earnings proxy variables and the reduc-
tion (to an unknown degree) in measurement error using any of the three
procedures we examine. For the longest holding period, the results are mixed.
The multiple proxy procedure is less effective for reducing measurement error
for the longest holding period than for the shorter holding periods. However,
the additional explanatory variable procedure and the instrumental variables
procedure detect and appear to reduce measurement error for all holding
periods.
The multiple proxy procedure is used to examine the sensitivity of our
results to firm size and forecast age. This procedure appears to be more
effective at detecting and/or reducing measurement error for the shortest
holding period than for the longest holding period, regardless of firm size or
forecast age. The relation between abnormal returns and unexpected earnings
appears to be better specified for small firms and firms with more recent
forecasts than for large firms and firms with non-recent forecasts. Moreover,
our procedures appear to be more effective at reducing measurement error for
small firms and firms with more recent forecasts than for large firms and firms
with non-recent forecasts.
The more critical caveat to this study concerns the unknown effects of
misspecifying the underlying relation between abnormal returns and unex-
pected earnings. For instance, our evidence suggests that earnings variables
explain only a small portion of the markets response at the time of an
earnings announcement (e.g., our largest adjusted R-square equals 0.1256).
Future research may consider additional variables in conjunction with eam-
ings surprise (e.g., extent of analyst coverage, stochastic nature of the process
generating cash flows or earnings, confounding events) for the purpose of
detecting measurement error and controlling for omitted variables. Also, we
may have misspecitied the properties of the error in measuring unexpected
earnings. The sensitivity of our results to the unbiasedness property of
earnings measurement error may be evaluated. In addition, we examine only
two factors that potentially explain measurement error - firm size and age of
forecast. Future research could consider other potential explanatory factors.*
Overall, our results indicate that measurement error is a significant problem
for the researcher using a multiple regression research design; that is, regress-
ing abnormal returns (capturing the information content of accounting eam-
ings) on an unexpected earnings proxy variable and additional non-earnings
explanatory variable(s). For expositional purposes, assume a researcher is
regressing abnormal returns on an unexpected earnings proxy variable and one
additional non-earnings explanatory variable. Our results indicate that the
researcher must interpret the coefficient for the additional non-earnings ex-
planatory variable conditional on an assumed correlation between the ad-
ditional variable and the measurement error in the unexpected earnings proxy
variable. A non-zero correlation potentially results in a measurement error
interpretation of the coefficient for the additional non-earnings explanatory
variable.
The procedures we examine to reduce measurement error, while reducing
the measurement error problem to some extent, do not eliminate the problem.
Our results indicate that it may be useful to use multiple unexpected earnings
proxy variables and a stock return variable (observed before the abnormal
return holding period) in a multiple regression research design. If inclusion of
multiple unexpected earnings proxy variables or the stock return variable
alters the estimates of the coefficient of the additional non-earnings explana-
tory variable, then a measurement error interpretation of this variable is likely.
Unfortunately, if inclusion of the additional unexpected earnings proxy vari-
ables and the stock return variable does not alter the estimate of the coefficient
of the additional non-earnings explanatory variable, our results do not imply
that a measurement error interpretation of the additional non-earnings ex-
planatory variable is invalid.
References
Advisory Committee on Corporate Disclosure, 1977, Report of the advisory committee on
corporate disclosures to the securities and exchange commission (U.S. Government Printing
Office, Washington, DC).
Beaver, W.H., R.A. Lambert and S Ryan, 1987, The information content of security prices: A
second look, Journal of Accounting and Economics 9, this issue.
Box, G.E. and G.M. Jenkins, 1976, Time series models: Forecasting and control (Holden Day, San
Francisco, CA).
One possibility would be to consider the firms information environment. Brown et al. (1987b)
show that analyst superiority in predicting firms earnings relative to time series model forecasts is
positively related to firm size and the extent of analyst agreement regarding their ex ante earnings
predictions. Our finding that it is easier to reduce measurement error for small firms than for large
firms is consistent with Brown et al. (1987b). Future research may examine whether it is easier to
reduce measurement error in earnings proxies for firms for which analyst have heterogeneous
rather than homogeneous ex ante earnings expectations.
L,D. Brown et al., Alternative proxies for unexpected earnings 193
Brown, L.D., 1987, The modem theory of financial reporting (Business Publications, Inc., Plano,
TX).
Brown, L.D., P.A. Griffin, R.L. Hagerman and M.E. Zmijewski, 1987a, Security analyst superior-
ity relative to univariate time-series models in forecasting quarterly earnings, Journal of
Accounting and Economics 9, 61-87.
Brown, L.D., G.D. Richardson and S.A. Schwager, 1987b, An information interpretation of
financial analyst superiority in forecasting earnings, Journal of Accounting Research 25,49-67.
Brown, L.D. and MS. Rozeff, 1979, Univariate time-series models of quarterly accounting
earnings per share: A proposed model, Journal of Accounting Research 17, 179-189.
Christie, A.A., 1985, On cross-sectional analysis in accounting research, Unpublished working
paper (University of Southern California, Los Angeles, CA).-
Collins. D.W.. S.P. Kothari and J.D. Ravbum. 1987. Firm size and the information content of
prices withrespect to earnings, Journd of Accounting and Economics 9, this issue.
Easton, P.E. and M.E. Zmijewski, 1987, Cross-sectional variation in the stock markets response to
corporate earnings, Unpublished paper (University of Chicago, Chicago, IL).
Foster, G., 1977, Quarterly accounting data: Time-series properties and predictive-ability results,
The Accounting Review 52,1-21.
Foster, G., 1986, Financial statement analysis (Prentice-Hall, Englewood Cliffs, NJ).
Griffin, P.A., 1977, The time-series behavior of quarterly earnings: Preliminary evidence, Journal
of Accounting Research 15, 71-83.
Hopwood, W.S., J.C. McKeown and P.A. Newbold, 1982, The additional information content of
quarterly earnings reports: Intertemporal disaggregation, Journal of Accounting Research 20,
343-349.
Judge, G., R. Hill, W. Griffiths, H. Lutkepohl and T. Lee, 1984, Introduction to the theory and
practice of econometrics (Wiley, New York).
Kross, W. and D. Shroeder, 1985, Firm prominence and the differential information content of
quarterly earnings announcements, Unpublished working paper (Purdue University, West
Lafayette, IN).
Lys, T. and S. Sivaramakrishnan, 1986, Earnings expectations and capital restructuring: The case
of equity-for-debt swaps, Unpublished paper (Northwestern University, Evanston, IL).
Madalla, G.S., 1977, Econometrics (McGraw Hill, New York).
Miller, M.H. and K. Rock, 1985, Dividend policy under asymmetric information, Journal of
Finance 40, 1031-1051.
Watts, R.L., 1975, The time series behavior of quarterly earnings, Unpublished paper (University
of Newcastle, Newcastle, New South Wales).
Watts, R.L. and J.L. Zimmerman, 1986, Positive accounting theory (Prentice-Hall, Englewood
Cliffs, NJ).

An Evaluation of Alternative Proxies For The Market S Assessment of Unexpected Earnings

Încărcat de

Informații document

Titlu original

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

An Evaluation of Alternative Proxies For The Market S Assessment of Unexpected Earnings

Încărcat de

Drepturi de autor:

Formate disponibile

Journal of Accounting and Economics 9 (1987) 159-193.

AN EVALUATION OF ALTERNATIVE PROXIES FOR THE

Lawrence D. BROWN and Robert L. HAGERMAN

Received October 1985, final version received April 1987

0165-4101/87/$3.5001987, Elsevier Science Publishers B.V. (North-Holland)

the results can, in certain experimental designs, lead to incorrect inferences.

research design (i.e., regressing abnormal returns on unexpected earnings and

2. The underlying model, measurement error, and empirical tests

2.1. The model

The model below. is used to show the effects of measurement error in a

R,, = stock return resulting from the earnings announcement of firm i at

2.2. Measurement error

Since S,, is unobservable, a proxy variable, Pilx, must be used in the

P;rx = S,, + Crrh for X = 1,. . . , P models (proxies), (4

for all i #j,

Substituting PIIh for S,, in eq. (1) yields

R,, = a + ,LlPIlh+ p;,. (3)

explanatory variables in addition to market unexpected earnings to explain

Ri,= a + PS;, + 6Z;, + pit, (4)

4zit2R,.t+A= 0 forall i,j,k,

Ri,= a + PPirx + 6Z,, + p;;,

In this case, the estimates of LXand 8 are biased estimates of OLand 6,

If significant measurement error exists in the unexpected earnings proxies,

2.3. Approaches to assessing measurement error

R,, = Yo+ YlP,,, + Y2<,2 + Vrt, (6)

4%) - 44 < 40 - 41,)

An alternative explanation for observing that 8 # 0 is that the additional independent

(iii) Using instrumental variables procedures: Finally, as a third approach for

3. Sample and variable definitions

(1) 1960-1979 (1960-1980) quarterly earnings per share available in Moodys

Given the instrumental variables we examine, this approach is similar to estimating a

3.2. Variable definitions

E,, = earnings for firm i in quarter t,

Number Unexpected earnings (IYE,,~)

Panel A. Weighted portfolio percentage abnormal returned

d Weighted portfolio abnormal returns in percentages, conditional on forecasting model A, are

4.1. Comparison of individual proxies

where 1. ) is the absolute value operator.

4.2. Multiple earnings proxies

Table 2 summarizes the results of using multiple unexpected earnings

specifically, it reports an adjusted R-square and the sum of cross-sectional

Regression: CR,,(J.O) = y. + c yAUE,,, + error.

Dependent variable: Cumulative residual (CR,,( d, 0))

CR,,(-I,O) CR,,(- 10.0) CR,, ( - 20,O) CR,,(-4090)

Panel D. Regressions withfour earnings proxies ( P = 4)

Number of Proxy Variables in Regression

variable equations for these holding periods is also represented by an asterisk

Dependent variable: Cumulative residual (CR,,( d.0))

Panel A. Regressions with one earnings pro,y ( P = 1)

4.3. Eflects of $rm size

Number of Proxy Variables in Regression

EB CR(-1.0) Efz!JlCR(-1.0) lz3 CR(-4&O) El cRf-40,0)

Regression: CR,,(d,O) = y0 + c y,,UE,,, + error.=

Dependent variable: Cumulative residual (CR,,(d,O))

Panel A. Regressions with one earnings proxy ( P = 1)

Number of Proxy Variables in Regression

m cR(-1.0) iSI cR(-1.0) ED cw-4oxJ) = W-WJ)

4.4. Eflects of forecast timing

Regression: CR,,( d, 0) = ya + 1 yAIJE,,, + w R;, + error.=

Dependent variable: Cumulative residual (CR,, (d, 0))

C&,(-LO) C&,(-10,0) C&,(-20,0) CR,, ( - 4090)

Panel A. Regressions with one earnings proxy ( P = 1)

4.5. Using stock returns to control for measurement error