Accounting conservatism and Street earnings

Abstract

While conditional conservatism is useful to investors and creditors for various reasons, it potentially reduces the usefulness of GAAP earnings for valuation by investors. Consistent with this conjecture, we find evidence suggesting that conditional conservatism reduces GAAP earnings persistence, makes income smoothing more difficult, reduces GAAP earnings informativeness, and makes forecasting GAAP earnings more difficult for analysts. We predict and find that analysts respond to investor demands for earnings without some of the consequences of GAAP conditional conservatism and forecast Street earnings numbers with less conditional conservatism. The decrease in conditional conservatism from adjusting GAAP earnings to arrive at Street earnings leads to improvements in earnings properties (persistence, smoothing, and earnings response coefficients) and in analysts’ forecast properties (less error and less dispersion). Further, we find that as GAAP conditional conservatism increases, (1) Street earnings more likely differ from GAAP earnings, and (2) the magnitude of the difference between Street and GAAP earnings increases. Finally, we find that the exclusions used to calculate Street earnings are of higher quality (i.e., less persistence for future operating earnings) for firms with higher GAAP conditional conservatism. Our results are consistent with the notion that analysts’ exclusions improve the usefulness of Street earnings to investors as conditional conservatism of GAAP earnings increases.