The Market Pricing of Special Items that are Included Versus Excluded From 'Street' Earnings

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We re-investigate the market pricing of special items, with particular emphasis on how managers “frame” them via their inclusion or exclusion from “street” earnings. When managers include the special items in “street” earnings (i.e., “street” = GAAP), the market overprices them, believing the special items to be more persistent than they actually are. As a result, there is a negative relationship between the special items and future stock returns in the following year. However, when managers exclude special items from “street” earnings (i.e., “street” ≠ GAAP), the market recognizes their transitory characteristic and the relationship between special items and returns is insignificant in the following year. We also demonstrate that the decision to include (exclude) special items with (from) “street” earnings is associated with whether inclusion or exclusion of special items a) increases earnings numbers, b) smoothes the earnings series, or c) helps managers to meet earnings benchmarks.