Do Reconciliations Of Segment Earnings Affect Stock Prices?

Abstract

While SFAS No. 131 is intended to increase the transparency of financial reporting using a management approach, it may reduce shareholders ability to interpret segment disclosures relative to the industry approach employed under SFAS No.14. This study investigates whether segment reconciliation differences affect stock prices and whether abnormal returns can be earned using information about two components of earnings: aggregated segment earnings and segment earnings reconciliations. We compute reconciliations as the difference between firm-level consolidated earnings and aggregated segment-level earnings. Firms that report negative SERs have greater sales and profitability, greater return on equity, as well as more operating cash flows and firm growth. This suggests that firms that report aggregated segment earnings greater than firm-level consolidated earnings may be better off financially. Our findings show that mispricing does occur when firms report positive SERs by the market, underestimating the segment earnings reconciliation component of earnings persistence. Investors can also earn positive abnormal returns when investors take a long (short) position with the portfolio with the highest (lowest) absolute SERs. On the contrary, we find investors earn negative abnormal returns when firms report negative SERs. Collectively, this study provides evidence that mispricing occurs and that investors over/underestimate the importance and/or persistence of segment earnings reconciliations.

The Impact of Segment Reporting Under the IFRS 8 and SFAS 131 Management Approach: A Research Review

“…Overall, Hollie and Yu () provide evidence that SERs, in general, are incrementally persistent to the aggregated segments component of earnings. They find that both aggregated segment earnings and the SERs provide significant information regarding next year's consolidated earnings.…”

“…Hollie and Yu () investigate the impact of the SFAS 131 management approach on shareholders’ ability to interpret segment earnings disclosures. Their sample includes 649 companies with differences between aggregated segment earnings and operating profit after depreciation for 1998–2006.…”

“…Hollie and Yu () report descriptive statistics for subgroups of positive and negative SER companies. The mean of 0.020 (−0.028) for the positive (negative) SERs is significant.…”

“…Relevant research about the economic importance of segment reporting gaps is discussed below. Hollie and Yu (2012), and Ettredge and Wang (2013) examine reconciliations of segment earnings to consolidated earnings for companies reporting under SFAS 131. In a working paper, Ettredge and Wang discuss the "controversial" provision in SFAS 131 enabling companies to report measures of segment earnings that do not total to consolidated net income.…”

“…Using market-adjusted buy-and-hold annual returns as the dependent variable, they also find that aggregated segment earnings are more informative than consolidated earnings for negative gap companies. Hollie and Yu (2012) investigate the impact of the SFAS 131 management approach on shareholders' ability to interpret segment earnings disclosures. Their sample includes 649 companies with differences between aggregated segment earnings and operating profit after depreciation for 1998-2006.…”