Discretionary Reporting of Earnings Components

Abstract

This paper provides evidence that in quarterly earnings announcements, managers use discretion to strategically report a large, transitory component of prior-period earnings. Managers are more likely to report separately a prior-period transitory gain from the sale of property, plant, and equipment (PPE) than to report a loss. This strategy provides the lowest possible benchmark to evaluate current earnings, thereby allowing the manager to highlight the largest possible change in earnings. This strategic reporting behavior is consistent with a conjecture by managers that investors will forget the transitory nature of the prior-period gain/loss unless it is separately reported in the current earnings announcement. Consistent with this conjecture of an investor processing bias, the stock price reactions suggest that the market does not unravel the strategic reporting at the time earnings are announced. There is some evidence that the market corrects for this bias in the 30 days subsequent to the earnings announcement date.