Disagreement over the persistence of earnings components: evidence on the properties of management-specific adjustments to GAAP earnings

Abstract

We examine disagreement between management and Thomson Datastream over the persistence of earnings components. Using income statement and footnote disclosures, we identify the source and properties of disputed items. Disagreements typically reflect opaque reporting practices (for example, in the case of transitory operating items) and restrictive classification rules (for example, in the case of discontinued operations). Incremental and relative value relevance tests suggest that the majority of management-specific adjustments reflect appropriate classification of earnings components by insiders. Nevertheless, evidence consistent with strategic disclosure does emerge for a subset of management adjustments.

Classificatory income smoothing: The impact of a change in regime of reporting financial performance

“…14 This evidence is consistent with opportunistic disclosures of alternative EPS to discard 'bad news' and highlight a more favourable earnings number. However, Choi et al (2006b) find that the items (both gains and losses) managers exclude from alternative earnings are value irrelevant, consistent with alternative EPS measuring sustainable performance. The only evidence they find of opportunism relates to gains that managers include in alternative earnings, which appear to be value irrelevant.…”

How far can we trust earnings numbers? What research tells us about earnings management

“…Under UK GAAP FRS 3 (ASB 1992) permitted UK firms to issue alternative EPS measures in addition to net income per share, provided the definition of alternative EPS (AEPS) was consistent and provided it was no more prominently disclosed. Choi et al (2007) compared earnings data constructed by Thomson with the alternative earnings number voluntarily reported by UK firms. The Thomson number makes sense in this context because it was constructed for use by analysts.…”

“…There is also evidence that analysts excluded some exceptional items when comparing their forecasts with outcomes (see e.g. Choi et al 2007). Did some firms make classification choices to meet or beat the consensus?…”

Market Reaction to Non-GAAP Earnings Around SEC Regulation

“…Consistent with the information hypothesis, non-GAAP earnings have been found to be more informative to investors relative to GAAP financial metrics, when GAAP earnings are more subjective (e.g., Bradshaw and Sloan, 2002;Bhattacharya et al, 2003;Brown and Sivakumar, 2003;Lougee and Marquardt, 2004;Choi et al, 2007). Non-GAAP financial metrics are also more predictive of future performance, consistent with these earnings numbers providing a better representation of "core" earnings (Brown and Sivakumar, 2003).…”