This study investigates whether the market accurately incorporates the pricing effects of the persistence of segment-related components of earnings: aggregated segment earnings and firm-segment reconcilable differences (FSD). This study adds to the extant literature on the pricing of different components of earnings and the quality of financial reporting under the SFAS No. 131 segment reporting regime. The results indicate that mispricing does occur, when firms report positive FSDs, by the market underestimating FSD persistence. For these same firms, investors can also earn positive abnormal returns. On the contrary, we find investors earn negative abnormal returns when firms report negative FSDs. Collectively, this study provides evidence that mispricing occurs and that investors over/under estimate the importance of FSDs.
In 1997, Financial Accounting Standards Board (FASB) introduced SFAS No. 131, Disclosures about Segments on Enterprise and Related Information (hereafter referred to as SFAS No. 131). This standard was developed primarily to enable external users to view companies “through the eyes of management” by requiring firms to report segment financial information consistent with how the business is managed internally (a.k.a. the management approach). Therefore, the management approach may lead to reported segment-level earnings measures that differ from GAAP earnings measures. As a result, segment-level data in financial reports may not necessarily reconcile or exactly equate to the consolidated financial information provided at the firm level. In other words, the whole (firm-level) may not equal the sum of its parts (segment-level).
We refer to the “sum of its parts” as the total aggregated segment-level earnings. Accordingly, we compute firm-segment differences as the difference between firm-level consolidated earnings and aggregated segment-level earnings from all identifiable segments. As a result, we decompose earnings into the following two components: aggregated segment earnings and firm-segment reconcilable differences.
Under the management approach, these FSDs may arise from (1) differences in measuring performance – management discretion at the segment-level versus the “traditional” GAAP operating earnings at the firm-level, (2) unreportable segments, (3) unallocated costs and (4) unallocated revenue or gains. An illustration of the derivation of FSDs is provided as Figure 1. In fact, Berger and Hann (2007) use FSD to adjust individual segment performance, which suggests that FSDs represent the aggregated segment profitability, which is not included in segment reporting under SFAS No.131.
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Do firm-to-segment reconcilable earnings differences affect stock prices?
