Does Lower Timely Loss Recognition Reflect Managers' Favorable Private Information?

A manager may choose not to record the full extent of bad economic news reflected in negative stock returns (i.e. a manager may exercise low timely loss recognition) if she believes she has private information that justifies a more favorable outlook than the stock market’s pessimistic outlook. Researchers often interpret the resulting deviations between earnings and stock returns as distortions in earnings. However, if managers' more favorable view is correct, earnings will more closely reflect the changes in fundamental value even as they become less aligned with stock returns. In other words, greater deviations between earnings and returns may actually be consistent with more rather than less transparent earnings. We test this possibility using a sample of firm years with negative annual returns. Using future returns as the proxy for the public revelation of managers’ favorable private information, we find that future returns offset current negative returns to a greater extent when managers exercise lower levels of timely loss recognition. Equivalently, we document a negative association between future returns and the portion of implied losses in current negative returns that managers do not recognize. This negative association is stronger when it is more likely that managers have private information. The association is also stronger when managers face higher disclosure costs that prevent full disclosure of their favorable private information. We also find that only a relatively small portion of unrecognized implied losses is recognized in earnings during the subsequent three years. These findings indicate that the traditional explanation for misalignments between earnings and negative stock returns as being due to delayed recognition of economic losses is only partial. Such misalignments are also due to managers’ use of appropriate discretion to include favorable private information in earnings