Finding ZERO: When no news is bad news

The greater frequency of positive relative to negative earnings surprise in the distribution of analysts' forecast-based earnings surprises is well known. If the market anticipates the propensity of managers to generate positive surprises by biasing earnings or forecasts, then some of the common assumptions made in the information content studies are violated. In this paper I provide a rational framework that predicts and empirical tests that document that zero earnings surprises produce significantly negative stock price reactions, on average, and increasingly negative a firm's ex ante probability of generating a positive earnings surprise. If the greater frequency of positive than negative earnings surprises in typical earnings surprise distributions is attributable to bias, then a rational market framework also predicts that the slope coefficient and the y-intercept in abnormal return-earnings surprise regressions will be negatively correlated; a result that I also confirm in my empirical tests. These results have important implications for studies that examine the stock price effect of earnings surprises that meet or fail to meet hypothesized "bright lines" when empirical tests involve comparing CARs or ERCs for observations to the left and right of the bright line. Specifically, if such tests do not take into account the ex ante probability of positive earnings surprise inferences can be confounded. I review a selection of studies that conclude that there are asymmetric market responses around hypothesized bright lines and demonstrate how inferences drawn from announcement abnormal returns and earnings response coefficients can be altered by controlling for the propensity for firms to generate positive surprises.