114  The Stock Market Is Smarter Than You Think companies that give full information about their options schemes—even when the option values are not explicitly expensed in the companies’ income state- ments.18 In fact, companies that voluntarily expensed their employee options before doing so became mandatory experienced no decrease in share price, despite the negative implications for reported earnings.19 We came to a similar conclusion after examining 120 U.S. companies that began expensing their stock options between July 2002 and May 2004. Furthermore, we found no relationship between the size of the earnings de- crease due to option expensing and any abnormal returns during the days surrounding the new policy’s announcement. The market already had the relevant information on the option plans and was not confused by a change in reporting policy. Different Accounting Standards Share price data for companies that report different accounting results in dif- ferent stock markets provide additional evidence that stock markets do not take reported earnings at face value. Prior to 2008, non-U.S. companies that had securities listed in the United States and did not report under U.S. Gener- ally Accepted Accounting Principles (GAAP) or International Financial Re- porting Standards (IFRS), for example, were required to report equity and net profit under U.S. GAAP.20 These could have provided results that differed significantly from the equity and net profit reported under their domestic ac- counting standards. We analyzed a sample of 50 European companies that began reporting reconciliations of equity and profit to U.S. GAAP after obtain- ing U.S. listings between 1997 and 2004. The differences between net income and equity under U.S. and local accounting standards were often quite large; in more than half the cases, the gap exceeded 30 percent. Many executives probably worried that lower earnings under U.S. GAAP would translate directly into a lower share price. But this was not the case. Even though two-thirds of the companies in our sample reported lower earn- ings following U.S. disclosure, the stock market reaction to their disclosure was positive, as shown in Exhibit 7.12. At that time, following U.S. GAAP standards also generally meant disclosing more information than required by local standards. Evidently, improved disclosure outweighed any artificial ac- counting effects. 20 Since March 2008, non-U.S. companies reporting under IFRS are no longer required to reconcile fi- nancial statements to U.S. GAAP in their Securities and Exchange Commission (SEC) filings. 18 D. Aboody, M. Barth, and R. Kasznik, “SFAS No. 123 Stock-Based Compensation Expense and Equity Market Values,” Accounting Review 79, no. 2 (2004): 251–275. 19 D. Aboody, M. Barth, and R. Kasznik, “Firms’ Voluntary Recognition of Stock-Based Compensation Expense,” Journal of Accounting Research 42, no. 2 (December 2004): 251–275. Myths about Earnings Management  115 Myths about Earnings Management On July 17, 2019, Internet entertainment service company Netflix reported second-quarter earnings of $0.56 per share, just four cents short of the $0.60 analyst consensus expectations. In addition, it had generated $4.92 billion in revenues, 25 percent higher than for the same quarter the year before, but missed analyst revenue targets by $10 million. On the same day, its share price dropped by more than 10 percent. The trigger for the price decline was not the company’s missing its earnings or revenue targets. Rather, investors were concerned about the company’s long-term outlook because of a decline in U.S. subscribers when an increase was expected, as well as significantly lower growth in international subscribers. Still, events such as this have led many managers to believe that stock markets are increasingly sensitive to short-term earnings that undershoot analysts’ expectations or to volatility in earnings generally. As we’ll show, events like these are not driven by the earnings an- nouncement itself, but by other information that accompanies the earnings, such as the underlying subscriber base growth in the case of Netflix. Further- more, investors are not much concerned by earnings volatility and offer no rewards for predictable earnings or earnings guidance. Earnings Volatility Some managers believe investors will pay a premium for steady earnings growth. Indeed, executives regularly cite stabilizing earnings growth as a rea- son for strategic actions. For example, the CEO of Conoco once justified a EXHIBIT 7.12  No Clear Impact of U.S. GAAP Reconciliation Average cumulative abnormal return (CAR) index Day relative to announcement Announcement return –1/+1 days Positive earnings CAR –0.5% impact (n = 16) t-statistic –1.54 Negative earnings CAR 1.7% impact (n = 34) t-statistic 14.63 –30 –25 –20 –10 –15 15 –5 0 5 10 20 25 30 106 108 110 104 98 100 102 94 96 92 90 Source: SEC filings, Datastream, Bloomberg.