Transitory Earnings Components Research Articles

Identifying Transitory Components of Earnings

Identifying Transitory Components of Earnings

Taking the 'Non' Out of Non-GAAP: Routine Non-GAAP Usage and Investor Pricing

Earnings are an important input for equity investors’ valuation decisions. Managers and analysts increasingly report non-GAAP earnings on an ongoing basis, routinely removing recurring items, such as amortization and stock-based compensation, from GAAP earnings. We document that by 2019, non-GAAP earnings were used in all prior eight quarters for 38 percent of firms. The routine use of non-GAAP earnings for the same firm quarter after quarter suggests that non-GAAP has become the “generally accepted” earnings measure for valuation purposes for a significant portion of publicly-traded firms. We provide evidence that routine non-GAAP usage allows investors to gain experience with non-GAAP earnings that facilitates their pricing of non-GAAP exclusions. Our findings point to a capital markets consequence of the shift from the traditional use of non-GAAP, in which adjustments are made for transitory earnings shocks, to the routine use of non-GAAP, in which adjustments are made for both recurring and transitory components of earnings.

Semiparametric estimation of the canonical permanent‐transitory model of earnings dynamics

This paper presents identification and estimation results for a flexible state space model. Our modification of the canonical model allows the permanent component to follow a unit root process and the transitory component to follow a semiparametric model of a higher‐order autoregressive‐moving‐average (ARMA) process. Using panel data of observed earnings, we establish identification of the nonparametric joint distributions for each of the permanent and transitory components over time. We apply the identification and estimation method to the earnings dynamics of U.S. men using the Panel Survey of Income Dynamics (PSID). The results show that the marginal distributions of permanent and transitory earnings components are more dispersed, more skewed, and have fatter tails than the normal and that earnings mobility is much lower than for the normal. We also find strong evidence for the existence of higher‐order ARMA processes in the transitory component, which lead to much different estimates of the distributions of and earnings mobility in the permanent component, implying that misspecification of the process for transitory earnings can affect estimated distributions of the permanent component and estimated earnings dynamics of that component. Thus our flexible model implies earnings dynamics for U.S. men different from much of the prior literature.

The value relevance of earnings levels in the return-earnings relation

Purpose – Prior studies provide mixed propositions on whether earnings levels or earnings changes provide the better explanatory power for variations of stock returns and whether the time-series behavior of earnings affects the value relevance of both earnings variables. This paper aims to compare the value relevance of earnings levels with that of earnings changes in the return-earnings relations. Design/methodology/approach – The unobservable components model is used to estimate permanent and transitory components of earnings. Findings – The finding shows that the proxy ability of earnings changes for unexpected earnings is sensitive to a firm's time-series earnings permanence property and is unstable and noisy when earnings contain predominantly transitory components, but that of earnings levels is not. The results support earnings levels are a stable and better value relevant proxy in the return-earnings relations. Research limitations/implications – The findings imply that the valuation role of earnings levels is important in the research relating to earnings components, earnings innovations, and equity valuation, especially when earnings permanence is of interest. Practical implications – The results provide a new understanding on the role of earnings levels in many business decisions such as executive compensations, institutional investment and conservative accounting where they often involve the choice of using levels and/or changes of earnings variables in making decisions. Originality/value – The paper contributes to the accounting literature by providing a new insight into the valuation role of earnings levels in the return-earnings relations. The stable value relevance of earnings levels also has important implications, especially for studies that use only earnings levels to assess earnings quality and earnings attributes.

Transitory earnings components and the two faces of non-generally accepted accounting principles earnings

Non-generally accepted accounting principles (non-GAAP) earnings reporting has been linked with both informative and strategic incentives. We seek to disentangle these conflicting effects by examining the association between non-GAAP earnings disclosure and transitory items in GAAP earnings, conditional on managers' reporting incentives. We report evidence of a statistically and economically significant asymmetric relation between disclosure propensity and transitory items in GAAP earnings conditional on both the sign and magnitude of the GAAP earnings surprise. Our findings suggest that non-GAAP earnings disclosures tend to be driven by a desire for informative (strategic) reporting when GAAP earnings beat (undershoot) market expectations.

Transitory Earnings Components and the Two Faces of Non-GAAP Earnings Per Share Disclosures

Non-GAAP earnings reporting has been linked with both informative and strategic incentives. We seek to disentangle these conflicting effects by examining the association between non-GAAP earnings disclosure and transitory items in GAAP earnings, conditional on managers’ reporting incentives. We report evidence of a statistically and economically significant asymmetric relation between disclosure propensity and transitory items in GAAP earnings conditional on both the sign and magnitude of the GAAP earnings surprise. Our findings suggest that non-GAAP earnings disclosures tend to be driven by a desire informative (strategic) reporting when GAAP earnings beat (undershoot) market expectations.

Conservadorismo condicional na divulgação de lucros em companhias abertas Brasileiras: diferenças entre emissoras e não emissoras de ADR e entre sistemas contábeis

O artigo examina as diferenças, em termos de qualidade informacional (conservadorismo condicional), das demonstrações contábeis de companhias brasileiras de capital aberto emissoras e não emissoras de ADR. Também são examinadas as demonstrações publicadas nos dois sistemas contábeis (PCAB e USGAAP). As hipóteses propõem que não há diferenças nos graus de conservadorismo condicional entre as firmas em razão das similaridades contratuais e institucionais, da inexistência de incentivos para alterar o comportamento dos gestores pelo processo de cross-listing e da insuficiência de motivação pela aplicação de princípios contábeis diversos. Os modelos de componentes transitórios nos lucros (BASU, 1997) e de associação entre apropriações contábeis e fluxos de caixa (BALL; SHIVAKUMAR, 2005) foram utilizados para os testes. Para estimar os coeficientes de associação dos dois modelos, utilizou-se análise de dados em painel. Os resultados confirmaram as hipóteses.

Negotiated Measurement Rules in Debt Contracts

This paper investigate negotiated accounting measurement rules in debt contracts to show how contracting variables are chosen from financial statements to increase contracting efficiency. I provide a detailed picture of contractual definitions of and worth using a large sample of bank loan agreements. The main descriptive evidence is as follows. First, debt contracts are not written on comprehensive income, though accumulated other comprehensive income is useful for measuring net assets for debt contracts. Second, one principal difference between contractual and GAAP definitions of net income is that contractual definitions exclude transitory components (extraordinary items, income from asset sales, etc.). Cross-sectionally, I find that the likelihood of defining net income differently from the GAAP definition increases with the maturity of the debt and decreases with the proxies for the contracting usefulness of transitory components. Collectively, the evidence shows that debt contracting parties choose contracting variables from financial statements in a manner consistent with efficient contracting, and that transitory components of earnings are less useful for debt contracting.

'Other Information' as an Explanatory Factor for the Market Reactions to Firms' Meeting or Beating Analyst Forecasts

Although the extant literature finds that analyst forecasts are one of the most critical thresholds for setting market's expectations, we find that the market reacts negatively to 41-percent of firms that meet or beat analyst forecasts and positively to 43-percent of firms that miss analyst forecasts. Kothari (2001) argues that seemingly counterintuitive market reactions, like these, are attributable to (1) the market reacting to information not captured in the accounting process; and, (2) the transitory nature of earnings. The extant literature provides ample evidence of the latter, suggesting that counterintuitive reactions are often attributable to the transitory components of earnings. We find evidence supporting this claim as well, but we find that the market also reacts to 'other information', and these reactions are incremental to the reactions attributable to transitory earnings. Further tests reveal that these reactions to 'other information' may be attributable to commonly identified factors in the literature, such as long-run growth, market risk, analysts' forecast precision, price decreases from the prior quarter and firm size, but we find evidence that these reactions are also attributable to information contained in analyst forecasts beyond these factors. Our findings suggest, however, that these counterintuitive market reactions are, in part, attributable to the market overestimating the persistence of 'other information'.

Qualidade informacional e conservadorismo nos resultados contábeis publicados no Brasil

O artigo avalia a presença de conservadorismo nos resultados apresentados nas demonstrações contábeis publicadas no Brasil pelas sociedades por ação no período de 1995 a 2004. Realiza-se a pesquisa em virtude da constatação de que a regulamentação brasileira, de um lado, é enfática no estabelecimento de princípio ou convenção do conservadorismo - antecipar o registro de perdas e diferir o reconhecimento de receitas - e, de outro, permite o reconhecimento prematuro de receitas não realizadas, como é o caso da reavaliação de ativos. O trabalho testou a antecipação oportuna assimétrica de perdas econômicas através do modelo de Componentes Transitórios nos Lucros (BASU, 1997) e o conservadorismo condicional através do modelo de Associação entre Apropriações Contábeis e Fluxos de Caixa (BALL; SHIVAKUMAR, 2005). A amostra considera sociedades por ações com dados para a série temporal completa, regredindo-se os dados em painel segundo os métodos mais adequados. Os resultados confirmam a hipótese de que os gestores das empresas em questão não praticam o conservadorismo condicional, embora se constate reversão dos componentes transitórios do lucro em maior magnitude no caso de variações negativas do lucro antecedente.

Permanent and transitory components of earnings, dividends, and stock prices

This study examines the dynamic responses of stock prices to shocks from fundamentals, measured by earnings and dividends. We decompose annual data of aggregate earnings, dividends, and stock prices into permanent and transitory components by taking account of cointegration between the three data series. While raw earnings and dividends together account for only 5% of the stock return variation, about 95% of the variation in stock returns can be explained by permanent earnings and permanent dividends.

A contracting perspective on earnings quality

This paper analyzes the impact of signal-to-noise-ratios and the autocorrelation of a performance measure on the principal's welfare in dynamic agencies with renegotiation. We consider the impact of changes in the persistent, transitory, and reversible components of accounting earnings on its usefulness in valuation versus contracting. Increasing the persistent components and reducing the reversible components are generally desirable for valuation, but not for contracting. Eliminating transitory components of earnings is generally desirable for valuation, but not necessarily for contracting. We discuss the contracting implications of differences in the autocorrelations of accounting earnings versus stock returns.

Earnings' Quality and Smoothing

We study a model of financial reporting and show that a credible equilibrium may exist where, compared to earnings reported without discretion, better informed managers report smoother earnings by smoothing the transitory component when news is good and report earnings that accentuate the intertemporal differences when news is bad. This policy results in smoother earnings being of higher quality, when quality is defined as a lower deviation from the long run value of the firm. We show that a very similar strategy is optimal when investors are naive and act as if managers have no discretion. Our results on earnings quality hold because a pooling equilibrium exists when the manager can distinguish only between the first period permanent and transitory earnings components. When the manager cannot distinguish among the components or when he knows the components in both periods, our results fail to hold, as we show that the equilibria in these cases are partially or fully separating ones. Furthermore, our work supports and explains a number of empirical phenomena, including alleged differences between public forecasts, whisper forecast and reported earnings, claims that better firms report higher quality earnings and the assertion that positive earnings surprises are higher quality than negative surprises.

Analysts' Interpretation of Transitory Earnings Components: Evidence from Forecast Revisions after Disclosure of the 1993 Deferred Tax Adjustment

This study examines analyst forecast revisions after the disclosure of firms' deferred tax adjustments following the U.S. Omnibus Budget Reconciliation Act of 1993 (OBRA), which raised the corporate income tax rate from 34 percent to 35 percent. This deferred tax adjustment was a one-time item, and should have had no effect on analyst estimates of future earnings. However, we find that forecast revisions issued after the disclosure of an income-decreasing deferred tax adjustment were positively related to the amount of the adjustment. The complexity of the deferred tax adjustment and the newness of SFAS 109 (which required the adjustment) may have contributed to the failure of analysts to properly interpret this one-time item when revising their earnings forecasts.

Earnings, cashflows and returns: Functional relations and the impact of firm size

The relation between stock returns, earnings and cashflows is of importance because it directly addresses the issue of whether accounting data provide value relevant information. The empirical evidence to date, however, has documented low explanatory power for earnings and inconclusive incremental information content for cashflows. This research re‐evaluates the incremental information content debate using Australian data. Our research is motivated by: recent innovations in research design, including the specification of nonlinear functional relations between accounting variables and prices, and the fact that differences in firm size characteristics may influence the relative information content of the accounting variables. We observe that: (i) a nonlinear functional relation provides greater explanatory power for both earnings and cashflows;(ii) the results are consistent with more transitory earnings components for smaller firms; and (iii) contrary to received theory, cashflows add greater incremental explanatory power for large firms.

Transitory and persistent earnings components as reflected in analysts' short-term and long-term earnings forecasts: evidence from a nonlinear model

This study uses a nonlinear framework to examine the relative proportion of transitory and persistent earnings components in financial analysts' earnings forecasts for three different time horizons (one quarter ahead, one year ahead, and three-to-five years ahead). We find that the proportion of transitory earnings components in analysts' forecasts decreases as the forecast horizon is extended. Using a nonlinear multivariate model, we find that both short-term and long-term forecast revisions are important for explaining stock price changes. Our study is important to investors because its results are consistent with analysts using short-term earnings forecasts to signal their expectations about a firm's reported GAAP earnings, and longer-term forecasts to convey their expectations about a firm's more persistent earnings. Moreover, both short-term and long-term forecasts are shown to provide value-relevant information to investors. Our study is important to researchers because it suggests that a nonlinear model is more appropriate for describing the relation between returns and analysts' forecast revisions. Prior studies, using linear models, have underestimated the value-relevance of forecast revisions, especially short-term ones.