Dual Time Series of Annual Earnings Based on the Direction of Sales Changes

Abstract

This study characterizes annual earnings as a mixture of two random-walk processes along two states of sales change, sales-increase and sales-decrease, thereby providing new insights into the earnings response coefficient (ERC). The dual earnings process is based on the premise that sales changes in the opposite direction convey different information about firms future cash flows or earnings. Building on the extant ERC models, this study shows that the ERC is significantly larger in sales-increase periods than in sales-decrease periods and its magnitude increases as firms experience the increase of sales in multiple consecutive years.