Many companies consistently report lower earnings in the fourth fiscal quarter – a pattern that confounds both investors and analysts.
Quarterly earnings reports are a vital tool to help investors track and evaluate the financial performance of publicly traded companies. Those whose performance resoundingly beat analysts’ estimates can see their stock prices skyrocket – think Amazon’s US$190 billion single-day gain in market capitalisation in February 2022 following a promising fourth-quarter earnings report. However, companies that badly miss the mark can just as easily send their stock prices plummeting.
Previous research on earnings has largely focused on full-year results. In my working paper co-authored with Oliver Binz from ESMT Berlin, we found that firms consistently report lower fourth-quarter earnings compared to the rest of the year. What’s behind this dip, and do capital market participants understand this pattern?
The fourth-quarter earnings effect
We based our study on a sample of United States public companies between 1989 and 2023, and broke down their financial data into fiscal quarters. What stood out were regular large downward spikes in average earnings in the fourth quarter. This occurred throughout our entire 35-year sample period, even after controlling for economic conditions, industry-level performance and the time of year that firms designate as their fourth quarter. Specifically, companies reported fourth-quarter earnings that were, on average, 49.6 percent lower than the average of the earlier three quarters.
To understand what’s driving this effect, we split earnings into its underlying components: sales and expenses. We found that both aspects were higher during the fourth quarter, with sales figures showing a consistent increase from the first to the fourth quarter. This suggests that negative fourth-quarter earnings aren’t about falling revenue but derive entirely from an increase in expenses, particularly the cost of goods sold (COGS) and sales, general and administrative (SG&A) expenses.
Next, we segmented earnings into cash flow from operations, working capital accruals and accrual estimates (e.g. bad debt expenses, stock-based compensation and deferred tax charges). While we found operating cash flow to be systemically higher in the fourth quarter than in interim quarters, working capital accruals and accrual estimates were systematically lower – with the effect being nearly twice as strong for accrual estimates. This suggests that cross-quarter variations in managers’ accrual expense estimates are a potential factor behind the fourth-quarter earnings dip.
Strengthening accounting systems
Our findings suggest that the fall in fourth-quarter earnings isn’t driven by real changes in the firm’s underlying operations and business performance. Instead, it can be largely attributed to managers’ inaccurately low accrual expense estimates for the interim quarters, especially for COGS and SG&A expenses. Essentially, expenses that should have been recognised in the first three quarters only show up in the fourth quarter – when the realised values are known.
Dips in fourth-quarter earnings therefore don’t impact a company’s full-year results. What’s more, given that US companies are not required to separately disclose fourth-quarter earnings in their annual reports (and with US President Donald Trump recently suggesting scrapping quarterly reporting altogether), firms may face less public and regulatory pressure to get the numbers right for interim quarters compared to the full fiscal year.
We found consistent evidence that the negative fourth-quarter earnings effect is strongest for firms that invest relatively less in cost estimation by employing (and paying) fewer controllers and that have relatively poor internal reporting systems. This suggests that the effect arises in part because these firms’ accounting systems are not capable of processing complex and diverse cost estimates in a precise or timely manner.
If firms make decisions based on quarterly accrual estimates, greater accuracy could allow for better decision-making. Our study points to an opportunity for firms to improve their accounting and financial reporting systems and align their accrual expense estimates more closely with economic reality. Rather than simply treating the fourth fiscal quarter as a period to adjust estimates from the past three quarters, managers may want to use the information gleaned from these adjustments to make better estimates in the year ahead.
A missed opportunity for investors?
Despite this consistent pattern, analysts don’t seem to fully account for the fourth-quarter earnings effect – and investors may be overlooking a profit-making opportunity hiding in plain sight. Analysts systematically overestimate earnings in the fourth quarter and are mostly surprised by lower-than-expected earnings due to larger-than-expected expenses. Investors, in turn, bid down stock prices in response to negative fourth-quarter earnings surprises, just like they do in other quarters.
This is surprising because it’s well-known that analysts are overly optimistic in the fourth quarter. Importantly, although the market reaction to negative earnings persists for other quarters, it reverses entirely for the fourth quarter within roughly two months. This suggest that as time passes and additional information becomes available through other sources, it becomes clear that the initial fourth-quarter results were driven by accounting estimates rather than other factors.
For investors who increasingly base their investment decisions on quarterly figures, this understanding opens the door to a potentially profitable trading strategy: A hedged portfolio created by betting on returns reversals following lower-than-expected fourth-quarter earnings surprises, as well as selling the stocks of companies with a different fiscal calendar that report negative quarterly earnings in the same period. By exploiting seasonal earnings patterns tied to how companies structure their fiscal calendar, investors may be able to take advantage of return patterns around fourth-quarter earnings announcements to trade more strategically and profitably.
Martin Kapons
Assistant Professor of Accounting and Control
