Do Analysts Understand Street Earnings?

This post comes to us from Chih-Ying Chen of Singapore Management University.


In my forthcoming Review of Accounting Studies paper entitled Do analysts and investors fully understand the persistence of the items excluded from Street earnings?, I investigate whether analysts and investors fully understand the persistence of the items excluded from Street earnings and whether their ability to understand it has improved since the adoption of Reg G. In the past, companies commonly presented their earnings on the basis of methodologies other than Generally Accepted Accounting Principles (GAAP) in their earnings releases. These non-GAAP earnings numbers, often referred to as pro forma earnings or core earnings, exclude certain items that managers claim to be nonrecurring. Analyst-tracking services also exclude nonrecurring items when they report analyst earnings forecasts and the actual earnings of firms (often referred to as Street earnings).

Due to the lack of an authoritative definition, pro forma or Street earnings could be measured in different ways at different times. Previous research has produced results that are consistent with the claim that items excluded from pro forma or Street earnings are recurring. Concerned that pro forma financial information may obscure GAAP results and mislead investors under certain circumstances, the U.S. Securities and Exchange Commission (SEC) introduced a new disclosure regulation, Regulation G (hereafter, Reg G), which came into effect on March 28, 2003. Reg G requires public companies that disclose non-GAAP earnings to also present GAAP earnings and a reconciliation of the two. Since the adoption of Reg G, there is some evidence that the probability of disclosing non-GAAP earnings and using non-GAAP earnings exclusions to meet or beat analyst forecasts has decreased.

Since my focus is on analyst and investor understanding, I begin by comparing the association between Street exclusions and future Street earnings with analyst and investor expectations of this association. Analyst expectations are measured by the association between Street exclusions and subsequent analyst earnings forecasts, and investor expectations are inferred from stock returns around the time of the subsequent earnings announcements. Street exclusions are classified into MBF exclusions and non-MBF exclusions, where MBF exclusions are those that allow a firm to meet or beat analyst earnings forecasts (that is, the GAAP earnings number is below the consensus forecast of analysts, but the Street earnings number is not).

My empirical results show that the difference in the levels of persistence between MBF and non-MBF exclusions declined after the adoption of Reg G. Analysts underestimate the persistence of non-MBF exclusions, but the degree of this underestimation is lower in the post-Reg G period. In contrast, there is little evidence to indicate that analysts underestimate the persistence of MBF exclusions in either time period. I also find strong (weak) evidence that investors underestimate the persistence of Street exclusions in the pre- (post-) Reg G period. As it is not possible for firms with excluded gains or without Street exclusions to meet or beat analyst forecasts using Street exclusions, I also analyze a restricted sample that comprises only the observations with excluded expenses. In this sample, I find that both MBF and non-MBF exclusions are less persistent and that analysts and investors are better able to understand these exclusions in the post-Reg G period. Further analyses show that only firms that had highly persistent Street exclusions in the pre-Reg G period had substantial declines in this persistence and improvements in the ability of analysts to understand it in the post-Reg G period.

Overall, my results suggest that Reg G constrained the practice of excluding recurring expenses from Street earnings to meet or beat analyst forecasts and helps analysts and investors to understand the persistence of Street exclusions.

The full paper is available for download here.

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