Softening the Blow of Bad News
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Oct 9, 2007

Softening the Blow of Bad News

Some companies offset negative earnings surprises by strategically releasing news of new patents

Based on the research of

Benjamin Lansford

Chief financial officers and investors focus on earnings per share more than any other single financial figure. Researchers in accounting have long confirmed that the price of a company’s stock is punished when a company’s earnings fall short of forecasted earnings or, in the lingo, the company has a “negative earnings surprise.” Common wisdom, confirmed by empirical evidence, suggests that negative earnings surprises are punished proportionately more than positive earnings surprises are rewarded. A recent survey (Graham et al., 2005) confirms that this is indeed the perception among CFOs and summarizes several strategies mentioned by CFOs to temper the market’s reaction to bad news. Among them, the company may release news about leading indicators that signal the prospect of better future earnings.

A patent is one these leading indicators. Firms enjoy great discretion in their disclosure of events in the patent granting process, which investors generally view as a “good news” announcement. Benjamin Lansford, an assistant professor in the Kellogg School’s Accounting Information and Management Department, examines whether there is evidence of strategic behavior in the timing of firms’ voluntary patent announcements to mitigate a forthcoming negative earnings surprise.

Strategically announcing a milestone in the patent granting process may not come for free, however. Before November 29, 2000, patent applications and notices of allowances (NOAs) were held in confidentiality by the U.S. Patent and Trademark Office (PTO) until issuance. Thus, a firm voluntarily disclosing a patent application or NOA may provide competitors more time to “design around” that intellectual property, leading to a potential loss of competitive advantage. Given both benefits and costs associated with patent disclosure, Lansford predicted that some firms strategically disclosed patent information to mitigate negative stock market reaction to earnings disappointments.

For his study, Lansford had to select the relevant types of patent-related announcements and had to classify them as “strategic” and “non strategic.” He examined three types of patent disclosures:

  • The disclosure of an application
  • The disclosure of a notice of allowance (NOA), a notice from the PTO that the patent is near approval
  • The disclosure of an issuance (or “grant”)

Since disclosure of an application and a NOA were entirely at the discretion of the firm, Lansford defined such disclosures as strategic in nature. For patent issuances, Lansford defined disclosure made two weeks after the PTO’s approval date as a strategic disclosure (“late issuance”), since the long delay was more indicative of strategic timing rather than timely revelation of the PTO’s grant.

In addition to the defining of strategic announcements, Lansford needed to define a strategic period in terms of its potential moderating impact on a quarterly earnings announcement. He focused on the period between the day after the end of a fiscal quarter and the day before the earnings announcement is made as the “strategic period,” since this is the period when managers can release information about patent disclosure if the goal is to soften a negative market reaction to an earnings disappointment. Hence, a strategic patent announcement must be one of the types of disclosure described above and it must occur within the strategic period. Table 1 below summarizes the classification of patent announcements.

Table 1: Classification of patent announcements

During fiscal quarterBetween the day   after the end of the fiscal quarter and the day before the quarterly earnings   announcement
Application, NOA and   late issuance announcements* Non strategic period
  * Strategic disclosure type
*  Strategic period
  * Strategic disclosure type
Immediate issuance announcements* Non strategic period
* Non strategic disclosure type
* Strategic period
* Non strategic disclosure type

With these definitions at hand, Lansford searched the Dow Jones News Service for news of firms making voluntary disclosures about milestones in the patent granting process between January 1990 and November 2000 (when the PTO’s confidentiality procedures changed). Most of the news came from company press releases. He found 753 patent announcements he could use, of which 27 percent (200 announcements) he classified as strategic. He then matched the announcements to firm and stock price-related information from COMPUSTAT and CRSP, respectively.

Lansford sought to answer two principal questions. First, did the likelihood of a voluntary patent disclosure increase in the magnitude of the forthcoming negative earnings disappointment? Second, was this strategy actually successful in mitigating the effect of a negative earnings surprise?

To test this, Lansford estimated the probability of a strategic announcement. He found that the probability of a strategic patent announcement increased in the magnitude of the negative earnings surprise, and this result appeared consistent with the benefits of patent disclosure to managers increasing as the earnings disappointment became more negative.

Lansford then examined the incremental effect of the patent disclosure on a cross-sectional “earnings response coefficient model” to test whether the strategic announcement is successful in dampening the impact of the negative earnings surprise. He found that the data corroborate this hypothesis. Compared to the quarter before the patent announcement, Lansford found that the strategic disclosure of a patent event significantly dampened the market’s reaction to the negative earnings news in the patent announcement quarter. Also Lansford found that strategic patent announcements were able to mitigate the market’s reaction to the earnings disappointment more than non-strategic patent announcements.

In conclusion, Lansford’s study provides evidence that managers strategically time patent announcements when they expect the market reaction to a disappointing earnings announcement to be most negative. In addition, his results suggest that managers successfully mitigate negative market response to the earnings disappointment through strategic patent announcements. Lansford quickly points out that an important question remains unanswered: are such announcements in the interest of shareholders? For shareholders, the question is whether they actually benefit from management smoothing out negative earnings announcements, while they do face the costs of the disclosure of proprietary information that might have conferred the company a competitive edge in the market.

Further Reading

Graham, John R., Campbell R. Harvey and Shiva Rajgopal (2005). “The Economic Implications of Corporate Financial Reporting,” Journal of Accounting and Economics, 40(1-3): 3-73.

Featured Faculty

Member of the Department of Accounting Information & Management faculty from 2005 to 2010

About the Writer
Jimmy Lee was a doctoral student in the Department of Accounting Information and Management at the Kellogg School of Management, Northwestern University. He graduated in 2011.
About the Research

Benjamin N. Lansford (2006). “Strategic Coordination of Good and Bad News Disclosures: The Case of Voluntary Patent Disclosures and Negative Earnings Surprises.” Working paper, Kellogg School of Management, Northwestern University.

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