Letting the “Tail Wag the Dog”: The Debate over GAAP versus Street Earnings Revisited*

Abstract

A variety of alternative definitions and sources of actual earnings realizations are available to investors. In addition to “traditional” earnings numbers produced in conformity with generally accepted accounting principles (GAAP) and filed with the Securities and Exchange Commission (SEC), these alternative measures include the so-called Street earnings numbers that are based on proprietary definitions employed by commercial forecast data providers (FDPs). Increasing visibility of Street earnings in the 1990s gave rise to the hypothesis, articulated in the financial press and by government agencies and standard-setters, that firms, perhaps with the proactive or tacit support of FDPs, are using Street earnings to manipulate investor beliefs in a manner that leads to inflated stock prices (see, e.g., Levitt 1998; MacDonald 1999; Tergesen 1999). The hypothesis that Street earnings are inflated and lead to stock mispricing gained additional currency from some academic studies, which, among other things, provided evidence of stronger market reactions to Street versus GAAP earnings-based surprises (e.g., Bradshaw and Sloan 2002; Doyle, Lundholm, and Soliman 2003; Bagnoli, Eskew, and Watts 2001). A competing view has emerged which posits that evidence of stronger market reactions to Street earnings surprises reflects the fact that Street earnings are generally more informative than GAAP earnings, and thus rational investors prefer to rely on these earnings to make their investment decisions (e.g., Brown and Sivakumar 2003).