Distinguishing Between Recurring and Nonrecurring Components of Earnings Using Unobserved Components Modelling

70 Pages Posted: 11 Aug 2022 Last revised: 8 Mar 2024

See all articles by Jesse Gardner

Jesse Gardner

Clemson University - Wilbur O. and Ann Powers College of Business

Richard G. Sloan

University of Southern California - Leventhal School of Accounting

Joon Sang Yoon

The Chinese University of Hong Kong, Shenzhen - School of Management and Economics; Shenzhen Finance Institute

Date Written: February 25, 2024

Abstract

Distinguishing between recurring and nonrecurring components of earnings is a critical task in financial analysis and valuation. Academics and quantitative investors often rely on measures of recurring and nonrecurring components derived from standardized financial databases. We use unobserved components modeling and the Kalman smoother to obtain efficient ex-post estimates of the recurring and nonrecurring components of annual earnings. We then show that popular measures are significantly misspecified and that investors appear to anticipate a significant portion of the misspecification. Finally, we identify certain misclassified items that drive misspecification and provide algorithms to improve their ex-ante classification.

Keywords: Transitory Components, Recurring Earnings, Valuation, Financial Analysis

JEL Classification: C51, G11, G32, M41

Suggested Citation

Gardner, Jesse and Sloan, Richard G. and Yoon, Joon Sang, Distinguishing Between Recurring and Nonrecurring Components of Earnings Using Unobserved Components Modelling (February 25, 2024). Journal of Accounting & Economics (JAE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=4178828 or http://dx.doi.org/10.2139/ssrn.4178828

Jesse Gardner

Clemson University - Wilbur O. and Ann Powers College of Business ( email )

Clemson, SC 29634
United States

Richard G. Sloan (Contact Author)

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States

Joon Sang Yoon

The Chinese University of Hong Kong, Shenzhen - School of Management and Economics ( email )

2001 Longxiang Road, Longgang District
Shenzhen, 518172
China

Shenzhen Finance Institute ( email )

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