Do Reconciliations Of Segment Earnings Affect Stock Prices?

Abstract

While SFAS No. 131 is intended to increase the transparency of financial reporting using a “management approach,” it may reduce shareholders’ ability to interpret segment disclosures relative to the ‘industry approach’ employed under SFAS No.14. This study investigates whether segment reconciliation differences affect stock prices and whether abnormal returns can be earned using information about two components of earnings: aggregated segment earnings and segment earnings reconciliations. We compute reconciliations as the difference between firm-level consolidated earnings and aggregated segment-level earnings. Firms that report negative SERs have greater sales and profitability, greater return on equity, as well as more operating cash flows and firm growth. This suggests that firms that report aggregated segment earnings greater than firm-level consolidated earnings may be better off financially. Our findings show that mispricing does occur when firms report positive SERs by the market, underestimating the segment earnings reconciliation component of earnings persistence. Investors can also earn positive abnormal returns when investors take a long (short) position with the portfolio with the highest (lowest) absolute SERs. On the contrary, we find investors earn negative abnormal returns when firms report negative SERs. Collectively, this study provides evidence that mispricing occurs and that investors over/underestimate the importance and/or persistence of segment earnings reconciliations.