Previous research indicates that security prices do not fully reflect predictable
elements of the relationship between current and future quarterly earnings. The
authors investigate whether this finding also holds for the special item
component of earnings. Given that special items are prominent in financial
analysis and are assumed to have relatively straightforward implications for
future earnings (special items are assumed to be largely transitory), one might
expect that prices fully impound the implications of special items on future
earnings. The authors find, however, that the implications of special items on
future earnings are not fully impounded in prices. Specifically, a trading
strategy based only on the sign of special items earns small but significant
abnormal returns during a three-day window four quarters subsequent to the
original announcement of special items.
Previous research suggests that stock prices are inefficient because they only partially
impound the implications of current earnings on expected future earnings. In other
words, current earnings have implications for expected future earnings, but when
subsequent future earnings are announced, market prices react as if the predict- able
effect on expected future earnings had not been fully impounded in market prices. Prices
seem to underestimate the implications of quarterly earnings changes for subsequent
earnings by 50 percent, on average, across the four subsequent quarters.
The authors explore the limits of these findings by focusing on a component of
earnings—special items. Special items can be consid- ered to be the nonrecurring
items identified by Compustat from the income statement and the accompanying
footnotes—for example, current-year results of discontinued operations, natural
disaster losses, and nonrecurring profits or losses on the sale of assets, investments,
and securities. Whereas aggregate earnings are persistent, special items are commonly
viewed as transitory.
Previous research done on market response to the release of special item information and
managing earnings through the use of special items includes that of Elliott and Shaw
(
asset write-offs resulted in negative one- and two-day stock returns when announced, as
well as Francis, Hanna, and Vincent (
1996), who found negative market reactions to inventory write-offs but positive
reactions to restructuring charges (meaning the nature of special items made a
difference to market reaction). Elliot and Hanna (
Supplement
earnings before special items once large special items had already been recognized and
that investors believed write-offs to be more transitory than other earnings components.
Kinney and Trezevant (
found that negative special items tended to be shown on the income statement, whereas
positive special items were described in notes, and that when firms had large positive
(smoothing) or negative (big bath) special items, they chose to recognize the negative
special items if they had large earnings changes (whether positive or negative).
The authors ask whether the market fully impounds the implications of special items on
future earnings and find significant differences between the effects of positive and
negative special items on future earnings. Positive special items are less than
completely transitory in the sense that they are followed, on average, by a small but
nonzero amount of earnings of the same sign in subsequent quarters. Negative special
items, in contrast, are followed by earnings of the opposite sign in subsequent
quarters. This finding is consistent with the conjecture that negative special items
sometimes represent a shift of expenses from future periods into the current period
(e.g., through restructuring charges), which reduces current income but increases future
income.
The authors also find that prices reflect a larger proportion of the implications of
special items than do the remaining components of earnings. This result is consistent
with the proposition that because the implications of (largely) transitory special items
on future earnings are relatively clear, market prices reflect relatively more of the
implications of special items.
Focusing on the announcement of future earnings four quarters subsequent to the original
announcement (when the implications for future earnings of special items differ most
from the implications of the remaining components of earnings), the authors find that
the effect of special items on future earnings (four quarters hence) is underestimated
by about 27 percent. In contrast, the effect of an innovation in current aggregate
earnings on future earnings is underestimated by about 75 percent.
The authors also find that market expectations reflect the differences in the
implications for future earnings of positive versus negative special items. Although the
implications differ, prices impound approximately the same proportion of information for
positive versus negative special items.
To provide further evidence of a potential inefficiency, the authors examine the return
to a trading strategy in which a portfolio is formed by tracking a long position in
companies reporting negative special items four quarters earlier and a short position in
companies reporting positive special items. This portfolio earns a small but
statistically significant three-day return around the earnings announcement four
quarters subsequent to a special item.