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

60 Pages Posted: 22 Sep 2010 Last revised: 12 Oct 2012

Mary E. Barth

Stanford University - Graduate School of Business

Ian D. Gow

Harvard University - Accounting & Control Unit

Daniel J. Taylor

University of Pennsylvania - The Wharton School

Date Written: November 10, 2011

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.

Keywords: stock-based compensation, SFAS 123R, non-GAAP earnings, Street earnings, pro forma earnings, earnings forecast exclusions, incentives

JEL Classification: G10, M4, M41, M43, M45

Suggested Citation

Barth, Mary E. and Gow, Ian D. and Taylor, Daniel J., Why Do Pro Forma and Street Earnings Not Reflect Changes in GAAP? Evidence from SFAS 123R (November 10, 2011). Review of Accounting Studies, Forthcoming; Rock Center for Corporate Governance at Stanford University Working Paper No. 88. Available at SSRN: https://ssrn.com/abstract=1681144 or http://dx.doi.org/10.2139/ssrn.1681144

Mary E. Barth (Contact Author)

Stanford University - Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-723-9040 (Phone)
650-725-0468 (Fax)

Ian D. Gow

Harvard University - Accounting & Control Unit ( email )

Soldiers Field
Boston, MA 02163
United States
6174956530 (Phone)

Daniel Taylor

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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