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51a/W (May 2 2001)

{Kluwer}Rast/Rast 8_4/5148072.3d

Date: 16/9/03

Time 15:44pm

Page 561 of 572

Review of Accounting Studies, 8, 561–572, 2003 # 2003 Kluwer Academic Publishers. Manufactured in The Netherlands.

**Comparing the Value Relevance of Two Operating Income Measures
**

LAWRENCE D. BROWN Georgia State University, Atlanta, GA 30303 KUMAR SIVAKUMAR* kns@bu.edu Boston University, School of Management, 595 Commonwealth Avenue, Boston, MA 02215 Abstract. Prior research has shown that pro-forma (recurring operating) earnings reported by managers and analysts are more value relevant than GAAP net income. Since GAAP net income contains many nonoperating items that reduce its value relevance compared to operating earnings, comparing the value relevance of GAAP net income with operating earnings unduly favors operating earnings. We show that operating earnings reported by managers and analysts are more value relevant than a measure of operating earnings derived from ﬁrms’ ﬁnancial statements, as reported by Standard and Poor’s. Our evidence is important because it indicates that operating earnings reported by managers and analysts contain value relevant information beyond that provided by operating earnings obtained by sophisticated users from ﬁrms’ ﬁnancial statements. Keywords: operating income, pro-forma earnings, value relevance, predictive ability, valuation, information content JEL Classiﬁcation: G14, M40, M41

**© Kluwer Academic Publishers
**

Operating earnings have increased in importance in recent years with a growing divergence between GAAP and operating earnings and evidence of an increased value-relevance for operating relative to GAAP earnings (Abarbanell and Bernard, 2002; Bradshaw and Sloan, 2002). Previous research has focused on operating earnings disclosed by managers and analysts. An alternative source of obtaining operating earnings is through a careful analysis of ﬁrms’ ﬁnancial statements. There is concern about the discretion that self-serving managers and analysts exercise in choosing items to be excluded or included in the operating earnings they report (Turner, 2000; Henry, 2001).1 The Securities and Exchange Commission (SEC), while cautioning investors to the potential dangers of ‘‘pro forma’’ ﬁnancials, adds, ‘‘We believe that—with appropriate disclosure—accurate interpretations of and summaries of GAAP ﬁnancial statements beneﬁt investors.’’2 Together, these views suggest that operating earnings obtained from ﬁnancial statements may be more value relevant than those reported by managers and analysts. No evidence yet exists regarding the comparative value relevance of operating earnings provided by managers and analysts with those obtainable from ﬁrms’ ﬁnancial statements. We provide the ﬁrst such evidence in this paper.

*Corresponding author.

M11031

Kluwer Academic Publishers

Review of Accounting Studies (RAST)

Tradespools, Frome, Somerset

Electronic copy available at: http://ssrn.com/abstract=272180

hereafter EPSOP). Our sample period begins in 1989 because EPSOP is unavailable prior to 1988. We classify observations into three groups based on comparisons of the operating income measures with GAAP (Compustat item Q19): Group 1: EPSOP ¼ GAAP 6¼ STREET Group 2: EPSOP 6¼ GAAP 6¼ STREET Group 3: STREET ¼ GAAP 6¼ EPSOP The three groups have simple interpretations. We conduct predictive ability tests using a seasonal random walk (SRW) model (i. and (3) correlation of earnings surprises with abnormal stock returns [information content].8 We examine all ﬁrm-quarters when STREET and EPSOP differ. Somerset Electronic copy available at: http://ssrn. We summarize and interpret our results in Section 3. We impose a CRSP data requirement only for information content tests..6 We use the three procedures suggested by Aboody and Lev (1998) to assess value relevance: (1) ability to predict future earnings [predictive ability].51a/W (May 2 2001) {Kluwer}Rast/Rast 8_4/5148072. We discuss our methodologies and present results in Section 2. expected earnings in quarter t equal those in quarter t-4) so STREET and EPSOP must be available in quarter t and t-4. Compustat documentation does not disclose the source of its measure of operating earnings (Q177). from ﬁrms’ ﬁnancial statements. we use Thomson Financial I/B/E/S data to measure operating income disclosed in a ﬁrm’s earnings release (hereafter STREET). Frome. M11031 Kluwer Academic Publishers Review of Accounting Studies (RAST) Tradespools. We proceed as follows.e. most I/B/E/S data are stated as fully diluted EPS.7 Our results suggest that operating earnings reported by managers and analysts contain value relevant information beyond that provided by operating earnings obtained by sophisticated users. but S&P personnel informed us that the 10-Q and 10-K reports are the sole source and that EPSOP is not determined via a formula such as GAAP adjusted for special items.5 S&P Compustat began providing operating earnings to the marketplace in 1988. (2) association of earnings levels with stock price levels [valuation].3d Date: 16/9/03 Time 15:44pm Page 562 of 572 562 BROWN AND SIVAKUMAR © Kluwer Academic Publishers 1. exempliﬁed by S&P Compustat. The ﬁrst represents cases where I/B/E/ S. The second consists Consistent with Abarbanell and Lehavy (2002) and Bradshaw and Sloan (2002). backs out ‘‘non-recurring items’’ from GAAP. Sample Each ﬁrm-quarter observation in our sample must have I/B/E/S and Compustat data. Section 1 describes our sample. Using quarterly data from 1989 to 1997.com/abstract=272180 . but not S&P.3B2 Version Number 7.3 We use Standard and Poor’s (S&P) data to measure EPS from operations obtained from 10-Q and 10-K ﬁlings to the SEC (Compustat item Q177. It ends in 1997 because we require our data to be stated in primary EPS and beginning in 1998.4 Since the early 1980s I/B/E/S has provided operating earnings that it obtains from earnings announcements appearing on newswires as the actual EPS of ﬁrms. we show that operating income provided by managers and analysts is more value relevant than operating income obtained from 10-Q and 10-K ﬁlings to the SEC under all three procedures.

Frankel and Lee.3B2 Version Number 7. However. A strength of the valuation analysis is the use of stock price information without requiring an ‘‘event window. not actuals. Methodology and Results Each of the three approaches we use to evaluate value relevance has strengths and weaknesses. A strength of the information content analysis is the use of a short window.1. We omit cases where the two data sources agree because we seek to ascertain which source provides the more value relevant earnings numbers. a weakness include the potential for contaminated events (Brown and Kim.10 M11031 Kluwer Academic Publishers Review of Accounting Studies (RAST) Tradespools. a weakness is that simply reporting the same earnings number each quarter trivially maximizes predictive validity. The third contains observations where S&P. The advantage of using three approaches is that the validity of our overall ﬁndings is enhanced if we obtain similar results with each method. 2. divided by beginning of quarter stock price.1. making it most suitable for capturing the contemporaneous information in earnings.’’ a weakness is the assumption that stock price is in equilibrium with respect to earnings. backs out ‘‘non-recurring items’’ from GAAP.9 The means test identiﬁes the operating income measure with the smallest prediction error. where the expectation is the quarter t-4 (SRW) forecast using STREET and EPSOP respectively. Predictive Ability Predictive Ability Methodology We conduct two predictive ability tests: a parametric (means) test and a nonparametric (binomial) test. its ﬁndings may not generalize to all of our data so we also examine a second sample. © Kluwer Academic Publishers 2. Sample sizes vary across partitions and tests and are noted in the tables. on average. Prediction error is deﬁned as the absolute value of the difference between actual quarterly earnings and its expectation. Somerset .51a/W (May 2 2001) {Kluwer}Rast/Rast 8_4/5148072. each requiring STREET to differ from EPSOP in quarter t-4. 2. Our ﬁrst sample requires STREET and EPSOP to agree in quarter t. 1993). 1995.3d Date: 16/9/03 Time 15:44pm Page 563 of 572 COMPARING THE VALUE RELEVANCE OF TWO OPERATING INCOME MEASURES 563 of cases where both I/B/E/S and S&P back out ‘‘non-recurring items’’ from GAAP. which requires STREET and EPSOP to disagree in quarter t. 1998). The binomial test identiﬁes the operating income measure that most often has the smallest prediction error. but not I/B/E/S.1. We examine the ability of each of the operating earnings (EPSOP and STREET) in quarter t-4 to predict itself in quarter t in both samples. A strength of the predictive analysis is that earnings predictions are important inputs for valuation models (Ohlson. so differences in predictive accuracy are attributable to differences in predictors. Frome. It has the advantage of mitigating the ambiguity concerning measurement of quarter t earnings numbers. but disagree on their amount. We conduct predictive ability tests on two samples.

39%)* À 10. Panel B shows results for cases where STREET and EPSOP differ in quarter t-4 and t.82* (42. **Signiﬁcant at the 5% level (two-tailed tests).56* (62.01* (60. Predictive ability evidence. Percent of time that EPSOP is less accurate than STREET is reported in parentheses. T-statistics of tests that EPSOP is less accurate than STREET and percent of time that EPSOP is less accurate than STREET (in parentheses).98* (60. Period: 1989–1997. M11031 Kluwer Academic Publishers Review of Accounting Studies (RAST) Tradespools.16* (59.88* (46. where predictive error is measured as: Abs fðSTREETt – STREETtÀ4Þ – ðEPSOPt – EPSOPtÀ4Þg=Share price at beginning of quarter. STREET: Income reported by Thomson Financial I/B/E/S.93%)* EPSOP versus STREET 17. Predictive Ability Results © Kluwer Academic Publishers Table 1.1.06%)* 7. on average. Somerset .27%)* Sample Size Sample Size 8.3B2 Version Number 7.22%)* 6.36* (57. STREET predicts better than EPSOP.2. This result is consistent with the notion that when either I/B/E/S or S&P (but not both) back out items they deem to be non-recurring. but agree in quarter t.036 Panel A of Table 1 provides predictive ability results for cases where STREET and EPSOP differ in quarter t-4.948 1.99%)* 7. Tests: T-statistics are reported for tests whether predictive errors are different from 0. the ‘‘backing out’’ facilitates predictions of future earnings.035 11.51a/W (May 2 2001) {Kluwer}Rast/Rast 8_4/5148072. Panel A shows that STREET predicts signiﬁcantly more accurately than EPSOP in group 1. Nature of Disagreement Group 1: EPSOP ¼ GAAP 6¼ STREET 6940 Group 2: EPSOP 6¼ GAAP 6¼ STREET 1494 Group 3: STREET ¼ GAAP 6¼ EPSOP 1385 All three groups combined 9819 Variables: EPSOP: EPS from operations reported by S&P Compustat (Q177). managers and analysts report an operating income measure that predicts signiﬁcantly better than S&P nearly 56% of the time. When both sources back out non-operating items but disagree as to their amount (group 2). but that EPSOP predicts signiﬁcantly more accurately than STREET in group 3. do a better job than does S&P in identifying non-recurring items.45%)** 17.82* (55. Groups: The three mutually exclusive and collectively exhaustive groups are deﬁned based on the agreement or disagreement of the operating income measures (EPSOP and STREET) with GAAP (Earnings from continuing operations reported by Compustat Q19). Panel A: EPSOP and STREET Panel B: EPSOP and STREET Agree in Quarter t Disagree in Quarter t EPSOP versus STREET 12.60%)* À 2.3d Date: 16/9/03 Time 15:44pm Page 564 of 572 564 BROWN AND SIVAKUMAR 2. This result is consistent with the notion that managers and analysts. For all three groups combined. Frome. *Signiﬁcant at the 1% level (two-tailed tests).053 1. This result is consistent with the notion that managers and analysts do a better job than S&P in identifying the magnitude of non-recurring items when they agree that the GAAP number needs to be adjusted.

ð1Þ Pi. In contrast.2.t or STREETi. We compare the adjusted R-squares using alternatively STREET or EPSOP in equation (1).t ¼ bV0 þ bV1 BVi. 3. STREET is signiﬁcantly more value relevant than EPSOP in groups 1 and 2 and for all three groups combined (Vuong Z ¼ 5. For all three groups combined. In both panels. Somerset .t .t equals EPSOPi. Frome. 1997). 1997) to determine which regression has the higher adjusted R-square (Biddle et al. We decompose net income into two components and estimate the following regression model:11 2. and NI is the ‘‘bottom-line’’ quarterly net income per share number (Compustat item Q11). STREET is the more accurate measure for over 60% of the time.. We use a Vuong test to determine whether one valuation equation has a signiﬁcantly larger adjusted-R-square. The ﬁndings are virtually identical to those in panel A. which uses ‘‘bottom line’’ earnings.3B2 Version Number 7.17.. 2. and consider the operating income measure with the most explanatory power to be the more value relevant one. In sum. Valuation Results Table 2 presents valuation results. Valuation Valuation Methodology © Kluwer Academic Publishers Pi.t is common equity per share at quarter end (Compustat items Q59/Q15). BVi.t þ bV2 OPINCi. there are M11031 Kluwer Academic Publishers Review of Accounting Studies (RAST) Tradespools. showing regression slopes (betas) and adjusted Rsquares of the valuation equations for both operating income measures for each group and for all three groups combined. We modify the standard valuation model.1.2.t þ bV3 ðNI À OPINCÞi.2.2. our results in favor of STREET are robust to whether or not our two sources of operating income numbers agree (panel A) or disagree in quarter t (panel B).t is market value per share deﬁned as the closing share price three months after the ﬁscal quarter end (Compustat monthly item PRCCM). 2. We also compare coefﬁcient estimates on the OPINC variable and use a t-test to determine whether one operating income measure has a larger coefﬁcient in the valuation equation.51a/W (May 2 2001) {Kluwer}Rast/Rast 8_4/5148072.3d Date: 16/9/03 Time 15:44pm Page 565 of 572 COMPARING THE VALUE RELEVANCE OF TWO OPERATING INCOME MEASURES 565 Panel B presents results of those quarter t observations where STREET and EPSOP differ in quarter t.t. STREET is more accurate than EPSOP in groups 1 and 2 and for all three groups combined whereas EPSOP predicts signiﬁcantly more accurately than STREET in group 3.79 respectively). OPINCi..11 and 2. 1997) and which operating income coefﬁcient has the higher multiplier (Collins et al. because of our focus on operating income. Based on Vuong tests.12 We compare the valuation consequences of our two operating income measures by using a book value and earnings regression (Collins et al.t þ ei.

13 17.98 À 0.72Þ.20 47.92 and 5. Somerset . Period: 1989–1997.19 5.459 t-test for differences in slopes Vuong Z for difference in ADJ R2 Group 2: EPSOP 6¼ GAAP 6¼ STREET STREET EPSOP t-test for differences in slopes Vuong Z for difference in ADJ R2 Group 3: STREET ¼ GAAP 6¼ EPSOP STREET EPSOP t-test for differences in slopes Vuong Z for difference in ADJ R2 All three groups combined STREET EPSOP t-test for differences in slopes Vuong Z for difference in ADJ R2 4.85 0.92* 0.81* 9. Frome. The t-tests provide similar results.81.70 19. Valuation evidence.t: Common equity per share at end of quarter t (Compustat item Q59/Compustat item Q15).71 0.t À OPINCi.75 14.42 À 0.516 2.4% larger than the coefﬁcients using EPSOP for groups 1 and 2 and for all three groups combined.28 22.3B2 Version Number 7.66 0.516 0.14* 2.t þ bV2 OPINCi. OPINC: Operating income is measured either as: EPSOP: Operating income reported by Compustat (Q177).59 41.28).049 4.9%. With the exception that the results for group 3 are insigniﬁcant.024 0.38 4.31 5.05 2.69 42. BVi.024 22.72 À 12.14 respectively).11* © Kluwer Academic Publishers À 0.65 20. the valuation results mirror the predictive ability results.26 47.78 21.459 EPSOP 15.28 no signiﬁcant differences for group 3 (Vuong Z ¼ À 0. Nature of Disagreement N BV OPINC NI-OPINC ADJ R2 Group 1: EPSOP ¼ GAAP 6¼ STREET STREET 15.84 4. 2.80 48.44 À 1.28 17. Groups: The three mutually exclusive and collectively exhaustive groups are deﬁned based on the agreement or disagreement of the operating income measures (EPSOP and STREET) with GAAP (earnings from continuing operations reported by Compustat Q19). or STREET: Operating income reported by Thomson Financial I/B/E/S.51a/W (May 2 2001) {Kluwer}Rast/Rast 8_4/5148072.60 0. Estimated coefﬁcients and adjusted R2s from valuation regressions of stock price on book value and operating earnings measures. The coefﬁcient estimates for OPINC using STREET are 12.36 17.t þ bV3 ðNIi.83 13. NI-OPINC: Net income reported by Compustat (Q11) – Operating income measure EPSOP or STREET.32 42. *Signiﬁcant at the 1% level (two-tailed tests).17* 0. 4.049 0.79* Model: Pi. M11031 Kluwer Academic Publishers Review of Accounting Studies (RAST) Tradespools.96 7.04 40.9% and 11.t ¼ bV0 þ bV1 BVi. 22. STREET is signiﬁcantly more value relevant than EPSOP in groups 1 and 2 and for all three groups combined (t-values are 4. In contrast.3d Date: 16/9/03 Time 15:44pm Page 566 of 572 566 BROWN AND SIVAKUMAR Table 2.tÞ where Pi.70 8.40 46.t: Price per share three months after the ﬁscal quarter end (Compustat item PRCCM).37 3. there are no signiﬁcant differences for group 3 ðt-value ¼ À 0.

The last mean consensus estimate in the I/B/E/S Summary ﬁle prior to the quarterly earnings announcement is our proxy for expected operating income.3.3d Date: 16/9/03 Time 15:44pm Page 567 of 572 COMPARING THE VALUE RELEVANCE OF TWO OPERATING INCOME MEASURES 567 2.29 and 2. The coefﬁcient estimates using STREET are 65%.85.3. 2. Frome. where day 0 is the earnings announcement day (source: Compustat) and UOPINCit is the unexpected operating income for ﬁrm i in quarter t. We alternatively use STREET or EPSOP as our operating income measure. The t-tests for comparing slope coefﬁcients provide identical results. We use a Vuong test to determine whether one speciﬁcation has a signiﬁcantly larger adjusted R-square and a t-test to determine whether one slope coefﬁcient is signiﬁcantly larger than the other. Somerset .54 respectively).01Þ. ð2Þ © Kluwer Academic Publishers 2. Our regression model is: CARi. 4. 2. Information Content Information Content Methodology We examine information content using both a three-day and a 63-day window.t ¼ bIC0 þ bIC1 UOPINCi. deﬁned as operating income minus expected operating income divided by the beginning of quarter share price. Information Content Results: Three-Day Window Table 3 presents information content results using a three-day window surrounding the quarterly earnings announcement. The measure with the most explanatory power in the OLS regression is considered to be the most value relevant. Based on Vuong tests. it is more likely that the I/B/E/S number is known to the market during a shorter window around an announcement M11031 Kluwer Academic Publishers Review of Accounting Studies (RAST) Tradespools. I/B/E/S uses the ﬁrm’s press release whereas S&P uses the ﬁrm’s 10-Q or 10-K. 2. STREET is signiﬁcantly more value relevant than EPSOP in groups 1.2.1.t is the three-trading days or 63-trading days market-adjusted return for ﬁrm i for days À 1 to þ 1 and À 1 to þ 61 respectively (source: CRSP). Information Content Results: 63-day window The advantage of using a three-day window to examine information content is that the window is short enough to minimize problems caused by the appearance of other information (not included in the model).t . CARi. 2 and for all three groups combined (t-values are 7. There are no signiﬁcant differences for group 3 ðVuong Z ¼ 0. There are no signiﬁcant differences for group 3 ðt-value ¼ À 0.51a/W (May 2 2001) {Kluwer}Rast/Rast 8_4/5148072.3.39Þ. STREET is signiﬁcantly more value relevant than EPSOP in groups 1 and 2 and for all three groups combined (Vuong Z ¼ 1.23 and 7.27. 104% and 54% larger than coefﬁcients using EPSOP for groups 1 and 2 and for all three groups combined respectively.31 respectively). Therefore.3.3.t þ ei.3B2 Version Number 7.

54% 1.85*** 4.23* 2.251 1.52% 3.448 2.9958 7. **Signiﬁcant at the 5% level (two-tailed tests).29** © Kluwer Academic Publishers 0. The relative magnitudes of the adjusted R2s for all groups and for the three groups combined are similar to the three-day tests. ***Signiﬁcant at the 10% level (two-tailed tests).t þ ei.8707 7.39 3.31* 2.3d Date: 16/9/03 Time 15:44pm Page 568 of 572 568 BROWN AND SIVAKUMAR Table 3. The results appear in Table 4.6432 0. divided by the price per share at the beginning of the quarter.0983 À 0. Information content evidence (3-days).091 1.448 1. This larger window should include the period when ﬁrms’ 10-Qs and 10-Ks are ﬁled.27* ADJ R2 15.0356 1.393 3.51% than is the S&P number.54* Model: CARi.t: Unexpected operating income is deﬁned as the difference between the operating income number and expected operating income.t: Three trading day market-adjusted cumulative abnormal returns surrounding earnings announcement day 0.t ¼ bIC0 þ bIC1UOPINCi. The Vuong test results for the 63-trading day window differ somewhat from the three-day window results. *Signiﬁcant at the 1% level (two-tailed tests).3451 0.251 4.t where CARi. we replicate our analysis using a 63 trading day window. The expected operating income number is the last mean consensus estimate from the I/B/E/S Summary ﬁle prior to the quarterly earnings announcement. Estimated coefﬁcients and adjusted R2s from information-content regressions of three-day CARs around quarterly earnings announcements (À1 to þ1) on unexpected operating earnings.90% 2.28% 2.01 22.091 22.21% 2. Period: 1989–1997. À 1 to þ 61.27% 1.3B2 Version Number 7.51a/W (May 2 2001) {Kluwer}Rast/Rast 8_4/5148072.11% 2.1161 0. The operating income number is EPSOP or STREET. To mitigate this problem. Frome.393 15. Somerset . UOPINCi. Nature of Disagreement Group 1: EPSOP ¼ GAAP 6¼ STREET STREET EPSOP t-test for differences in slopes Vuong Z for difference in ADJ R2 Group 2: EPSOP 6¼ GAAP 6¼ STREET STREET EPSOP t-test for differences in slopes Vuong Z for difference in ADJ R2 Group 3: STREET ¼ GAAP 6¼ EPSOP STREET EPSOP t-test for differences in slopes Vuong Z for difference in ADJ R2 All three groups combined STREET EPSOP t-test for differences in slopes Vuong Z for difference in ADJ R2 N ERC ðIC1Þ 1. 2. Groups: The three mutually exclusive and collectively exhaustive groups are deﬁned based on the agreement or disagreement of the operating income measures (EPSOP and STREET) with GAAP (earnings from continuing operations reported by Compustat Q19).5464 4. but the Vuong M11031 Kluwer Academic Publishers Review of Accounting Studies (RAST) Tradespools.

3B2 Version Number 7. 2.392 1. Period: 1989–1997.090 2.7976 1.6643 2.3000 2.t: Unexpected operating income is deﬁned as the difference between the operating income number and expected operating income.28 and 0.t: Market-adjusted cumulative abnormal returns for a period of 63 days including days À1 and 0 (announcement day) and 61 days following the earnings announcement.61% 0.74*** 1.83* Model: CARi.14% 1.03% 0.t ¼ bIC0 þ bIC1 UOPINCi. there are M11031 Kluwer Academic Publishers Review of Accounting Studies (RAST) Tradespools.72 and 3.55* ADJ R2 15. using the t-test for comparison of response coefﬁcients.57% 1.1280 1.7998 3. Estimated coefﬁcients and adjusted R2s from information-content regressions of 63-day CARs around quarterly earnings announcements (À1 to þ61) on unexpected operating earnings. Nature of Disagreement Group 1: EPSOP ¼ GAAP 6¼ STREET STREET EPSOP t-test for differences in slopes Vuong Z for difference in ADJ R2 Group 2: EPSOP 6¼ GAAP 6¼ STREET STREET EPSOP t-test for differences in slopes Vuong Z for difference in ADJ R2 Group 3: STREET ¼ GAAP 6¼ EPSOP STREET EPSOP t-test for differences in slopes Vuong Z for difference in ADJ R2 All three groups combined STREET EPSOP t-test for differences in slopes Vuong Z for difference in ADJ R2 N ERC ðIC1Þ 3. Once again. divided by the price per share at the beginning of the quarter.83). Somerset .1003 5.250 1.5696 1.23% test statistics are insigniﬁcant for group 2 and for all three groups combined (Vuong Z ¼ 0.90*** 4. UOPINCi.55. 1.69% 0.t þ eit where CARi.54). the 63-day window results mirror the three-day window results. Groups: The three mutually exclusive and collectively exhaustive groups are deﬁned based on the agreement or disagreement of the operating income measures (EPSOP and STREET) with GAAP (earnings from continuing operations reported by Compustat Q19).0145 À 1. ***Signiﬁcant at the 10% level (two-tailed tests).448 1.3d Date: 16/9/03 Time 15:44pm Page 569 of 572 COMPARING THE VALUE RELEVANCE OF TWO OPERATING INCOME MEASURES 569 Table 4. Frome.54 22. **Signiﬁcant at the 5% level (two-tailed tests).250 4. *Signiﬁcant at the 1% level (two-tailed tests).090 22.28 © Kluwer Academic Publishers À 1.51a/W (May 2 2001) {Kluwer}Rast/Rast 8_4/5148072.72*** 0. The operating income number is EPSOP or STREET.12% 1. However.448 2.392 15. The expected operating income number is the last mean consensus estimate from the I/B/E/S Summary ﬁle prior to the quarterly earnings announcement. Information content evidence (63-days).45 0.56% 1. STREET is signiﬁcantly more value relevant than EPSOP in groups 1 and 2 and for all three groups combined (t-values are 5.

We ﬁnd that the operating income reported by managers and analysts is more value relevant than the one obtained by Standard and Poor’s Compustat. 1986. two anonymous referees. Charles Wasley. Francis et al. Overall. attendees of the 10th Annual Chicago Quantitative Alliance Conference. We close with some caveats.3B2 Version Number 7. Ken Shaw. Frome. 1998). Emad Mohd. Elliott and Shaw. The coefﬁcient estimates using STREET are 74%. which is not mutually exclusive of the ﬁrst. Marcus Caylor.51a/W (May 2 2001) {Kluwer}Rast/Rast 8_4/5148072. Other sophisticated users of ﬁnancial statements may measure operating income differently. University of Arkansas. Greg Waymire. and workshop participants at American University. Carolyn Callahan. valuation and information content. Karen Teitel.45). First. Elliott and Hanna. our information content results are similar to the valuation results. is that managers and analysts seek to provide value relevant information to the marketplace through their operating earnings measures. Andrew Leone. Baruch M11031 Kluwer Academic Publishers Review of Accounting Studies (RAST) Tradespools.3d Date: 16/9/03 Time 15:44pm Page 570 of 572 570 BROWN AND SIVAKUMAR no signiﬁcant differences for group 3 (t-value ¼ À 1. 59% and 43% larger than coefﬁcients using EPSOP for groups 1 and 2 and for all three groups combined. Dan Siegel. Richard Sloan (editor). a sophisticated user of ﬁrms’ ﬁnancial statements under all three methods. our sample period ends in 1997. Bill Wright. Second. Beverly Walther. 3. Ali and Zarowin. Somerset . Standard and Poor’s. One interpretation of our results is that the operating income reported by managers and analysts has fewer transitory components than operating income obtainable from ﬁrms’ ﬁnancial statements. Ramakrishnan and Thomas. Summary and Interpretation of Results We compare the value relevance of two operating income measures. Sundaresh Ramnath. one provided by managers and analysts (source: Thomson Financial I/B/E/S). We use three techniques to assess value relevance: predictive ability. 1992. we interpret our ﬁndings based on an assumption that capital markets are efﬁcient. Jerry Zimmerman. Krishnagopal Menon. our results indicate that investors may erroneously focus too much on operating earnings numbers reported by managers and analysts. so our results may not pertain to a more recent time period.. Jeff Callen. placing our paper in the tradition of research showing that permanent earnings are more value relevant than transitory earnings (Lipe. yielding numbers that may be more value relevant than those reported by managers and analysts. Mike Calegari. and one obtained from ofﬁcial ﬁlings with the SEC (source: Standard and Poor’s Compustat). Oliver Kim. 1996. If capital markets are inefﬁcient. Ross Watts. Elizabeth Demers. © Kluwer Academic Publishers Acknowledgments We appreciate the comments of Sudipta Basu. 1996. A second interpretation. Mike Willenborg. 1988. we examine the value relevance of an operating income number that is measured by one sophisticated user of 10-Q and 10-K reports. Third.

2001). Extraordinary items. 5–6). acquisition charges. For the US and Canada.cfm?abstract_id ¼ 272180). University of Rochester. Frome. See http://www. We use the terms non-recurring and non-operating synonymously. University of Maryland.’’ 4. 3.’’ 6. we require the I/B/E/S numbers to be stated in primary form. counseling investors to be wary of operating numbers disclosed in ﬁrms’ earnings releases. earnings reports are culled directly from the newswires.3B2 Version Number 7. those items deﬁned by the accountants as extraordinary such as cumulative effect of an accounting change. University of Connecticut. Boston University. at most. We use GAAP as a partitioning variable but we do not compare either operating income measure with GAAP. Somerset . Lynn Turner referred to operating earnings reported by managers as ‘‘EBS’’ or ‘‘Everything but Bad Stuff’’ (Turner.’’ 5. We obtain similar results when we include 1998 data. unwarranted. Georgia State University. This earnings per share item excludes the effect of all nonrecurring events. This is why I/B/E/S actuals may not agree with other published actuals. it often causes a discrepancy when a company reports earnings. This item excludes: 1. Compustat provides only primary EPS for EPSOP. they sometimes adjust for recurring items (Johnson and Schwartz. and suggesting they peruse Form 10-Qs. Notes 1.sec. We acknowledge the contribution of Thomson Financial for providing forecasts and actual earnings per share.ssrn. p. We use the terms non-operating and non-recurring in the same way that I/B/E/S and S&P do even though the numbers ‘‘backed-out’’ may be recurring items. ‘‘where hopefully all the facts are presented in a complete and balanced fashion.51a/W (May 2 2001) {Kluwer}Rast/Rast 8_4/5148072. i. adjusted for comparability with estimates (page 4). I/B/E/S changed its procedures in 1998 when SFAS 128 became effective. © Kluwer Academic Publishers M11031 Kluwer Academic Publishers Review of Accounting Studies (RAST) Tradespools. A previous version of this paper was titled ‘‘Comparing the Quality of Three Earnings Measures’’ (http://papers. Special items. I/B/E/S (1999) states: ‘‘I/B/E/S strives to report actual earnings as soon as they are released into the marketplace. 7) states: ‘‘Earnings from operations means diluted earnings excluding all extraordinary items (speciﬁcally. Santa Clara University.e. . we ﬁnd that both operating income measures are more value relevant than GAAP (Compustat item Q19). 8. Imposition of this requirement results in the loss of.3d Date: 16/9/03 Time 15:44pm Page 571 of 572 COMPARING THE VALUE RELEVANCE OF TWO OPERATING INCOME MEASURES 571 College. and excluding certain nonrecurring or non-operating items (but not extraordinary by accounting deﬁnition) that a majority of the contributing analysts want to exclude (usually footnote items such as most restructuring charges. 5% of our data in any year in our sample.’’ The ﬁnancial press concurs: ‘‘Companies report ‘pro forma’ earnings that are deceptive. In a previous version of our paper. 4. early debt redemption. To avoid problems of converting fully diluted to primary EPS numbers (or vice versa). Discontinued operations. While this is far and away the best method for valuing a company. 2. and downright dangerous to the ﬁnancial system . extraordinary charges and other non-operating items have been backed out. GAAP [is] the most consistent and objective way to compare results across companies and industries [and that] can’t be said of pro forma’’ (Henry. EPSOP is: ‘‘Earnings per Share (Primary) adjusted to remove the effect of all special items from the calculation. or asset sales gains or losses). 2.gov/news/headlines/proforma-ﬁn. We obtain similar results using actual earnings as a deﬂator. 9. 2001).com/sol3/ papers. Compustat (pp. While both I/B/E/S and S&P maintain that they adjust for non-recurring items. I/B/E/S (2001. 7. 2000). . and University of Toronto. With very few exceptions [I/B/E/S] receives an analyst’s forecast after discontinued operations. 3. I/B/E/S adjusts reported earnings to match analysts’ forecasts on both an annual and quarterly basis. available through the Institutional Brokers Estimate System (I/B/E/S). When he was chief accountant of the SEC. Cumulative effect of accounting change. According to Compustat. etc.).htm.

51a/W (May 2 2001) {Kluwer}Rast/Rast 8_4/5148072. ‘‘Earnings. (1986). Somerset . J. ‘‘Differences in Commercial Database Reported Earnings: Implications for Empirical Research.’’ Journal of Accounting and Economics 24. ‘‘Changes in the Value Relevance of Earnings and Book Values over the Past 40 Years. (1999). © Kluwer Academic Publishers M11031 Kluwer Academic Publishers Review of Accounting Studies (RAST) Tradespools. C. J. T. 143–181. (1996). We use the more conservative approximation technique based on unequal variances. Zarowin. D. We focus our attention on V2 because our interest is the coefﬁcient on the operating earnings measures (STREET or EPSOP). (1993). Schwartz.3d Date: 16/9/03 Time 15:44pm Page 572 of 572 572 BROWN AND SIVAKUMAR 10. and K. D. Collins. Johnson.3B2 Version Number 7. 41–66. S.’’ Journal of Accounting Research 34 (Supplement). Weiss. G. R. M.’’ Business Week May 14. R. Remarks to the 39th Annual Corporate Counsel Institute. Financial Accounting Standards Board. but disagree in quarter t. 661–687. L. 249–264. E. ‘‘Accounting Evaluation. Wallace. October 12. 135–155.’’ Accounting Review 68.’’ Journal of Accounting and Economics 24. J.’’ Statement of Financial Accounting Standards No. (1998). E. Inc. R. Ohlson. (1997). Market Expectation. 37–64. 128. L. J. (2001). ‘‘Repeated Accounting Write-offs and the Information Content of Earnings. and W. We do not discuss the coefﬁcients on book value ðV1Þ or V3 because we view them as control variables. Aboody. A. K. (1995). The I/B/E/S Glossary: A Guide to Understanding I/B/E/S Terms and Conventions. (2001). ‘‘The Information Contained in the Components of Earnings. Maydew and I. I/B/E/S International. 301–336. D. and R. and P. ‘‘Are Investors Misled by ‘Pro forma’ Earnings?’’ Working paper. (1996). Ramakrishnan. Vincent. (1988). Auditing and Finance 13. (1998). (2001). Lee. 668–680. and J. ‘‘Causes and Effects of Discretionary Asset Write-offs.’’ Journal of Accounting Research 36 (Supplement). An alternative sample is one in which STREET and EPSOP agree in quarter t À 4. Frankel. New York. and C. I/B/E/S International. More speciﬁcally. and W. M. and Cross-Sectional Stock Returns.’’ Contemporary Accounting Research 14. Bowen and J. Bradshaw. University of Iowa. ‘‘Write-offs as Accounting Procedures to Manage Perceptions. ‘‘Permanent Versus Transitory Components of Annual Earnings and Estimation Error in Earnings Response Coefﬁcients. Shaw. ‘‘The Number Game. We obtain qualitatively similar results for this sample. ‘‘Valuation of Permanent. NY. Lehavy. 161–190.’’ Journal of Accounting Research 24 (Supplement). 2000. (1992). (1997). Sloan. ‘‘The Value Relevance of Intangibles: The Case of Software Capitalization. February. 91–119.’’ Working paper. 301– 336.’’ Journal of Accounting Research 34 (Supplement). 12. Frome. ‘‘The Association Between Nonearnings Disclosures by Small Firms and Positive Abnormal Returns.’’ Journal of Accounting. and PriceIrrelevant Components of Reported Earnings. Lipe. Biddle. D. (1997). Hanna. Book Values. UNC-Chapel Hill and UC-Berkeley.. 11. New York. 100–110. ‘‘Does EVA Beat Earnings? Evidence on Associations With Stock Returns and Firm Values. NY. ‘‘GAAP Versus the Street: An Empirical Assessment of Two Alternative Deﬁnitions of Earnings. 135–155. and B. Brown.’’ Journal of Accounting and Economics 25.’’ Journal of Accounting and Economics 15. we estimate the t-value by dividing the difference between the two coefﬁcient estimates by the square root of the summation of the variances of the two coefﬁcient estimates. Elliott. (2002). G. Elliott. I/B/E/S Monthly Comments. Transitory. R. Kim. and R. Turner. D. (2002). (2000).’’ Journal of Accounting Research 40. J. and Dividends in Security Valuation. Inc. Ali. 283–319. Thomas.. presented at Northwestern University School of Law. (1998). Hanna and L. and J. Henry. Francis. W.. References Abarbanell. ‘‘Earnings Per Share.’’ Journal of Accounting Research 26 (Supplement). Lev.

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