Why Do Pro Forma and Street Earnings Not Reflect Changes in GAAP? Evidence from SFAS 123R

Abstract

This study examines how key market participants — managers and analysts — responded to SFAS 123R’s controversial requirement that firms recognize stock-based compensation expense. Despite mandated recognition of the expense, some firms’ managers exclude it from pro forma earnings and some firms’ analysts exclude it from Street earnings. We find evidence consistent with managers opportunistically excluding the expense to increase earnings, smooth earnings, and meet earnings benchmarks, but no evidence that such exclusion results in an earnings measure that better predicts future firm performance. In contrast, we find that analysts exclude the expense from earnings forecasts when the exclusion increases earnings’ predictive ability for future performance, and opportunism generally does not explain exclusion by analysts incremental to exclusion by managers. Thus, our findings indicate that opportunism is the primary explanation for exclusion of the expense from pro forma earnings and predictive ability is the primary explanation for exclusion from Street earnings. Our findings suggest the controversy surrounding the recognition of stock-based compensation expense may be attributable to cross-sectional variation in the relevance of the expense for equity valuation, as well as to differing incentives of market participants.