Analysts Treatment of Nonrecurring Items in Street Earnings

ARTICLE IN PRESS
Journal of Accounting and Economics 38 (2004) 129170

www.elsevier.com/locate/econbase
Analysts treatment of nonrecurring items in

street earnings$
Zhaoyang Gu, Ting Chen
Tepper School of Business, Carnegie Mellon University, Pittsburgh, PA 15213-3890, USA
Received 3 March 2003; received in revised form 9 September 2004; accepted 23 September 2004
Available online 10 December 2004
Abstract
Given the recent controversy over deviations of street earnings from GAAP earnings, we
show that the nonrecurring items that analysts include in street earnings are more persistent
and have higher valuation multiples than those items they exclude from street earnings. In
addition, we nd no evidence that the pricing differential between the included and excluded
items leads to future abnormal returns. If, as analysts claim, the primary use of street earnings
is to value a stock, then our results suggest that analysts do have expertise in processing
earnings information and that certain items appear justiably excluded.
r 2004 Elsevier B.V. All rights reserved.
JEL classification: M41; G10
Keywords: Street earnings; Nonrecurring items; Financial analyst; Earnings forecast; Earnings persistence;
Valuation multiples
$
We thank Mark Bradshaw (the referee), Larry Brown, Zhihong Chen, Dan Givoly, Bill Kinney,
Adam Koch, Rick Lambert (the discussant), Bob Lipe, Thomas Lys (the editor), Jerry Zimmerman, and
participants of the 2003 Accounting Symposium at London Business School, the 2003 Journal of
Accounting & Economics Conference, the 2nd International Symposium on Empirical Accounting
Research at Chongqing University, and seminar at Carnegie Mellon University, for helpful comments. We
are grateful to First Call for providing data on street earnings, earnings forecasts, and nonrecurring items.
The paper was formerly titled, In or Out: Do Analysts Know What They are Doing with Nonrecurring
Items?
Corresponding author. Tel.: +1-412-268-3585; fax: +1-412-268-6837.
E-mail address: zygu@andrew.cmu.edu (Z. Gu).
0165-4101/$ - see front matter r 2004 Elsevier B.V. All rights reserved.
doi:10.1016/j.jacceco.2004.09.002
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130 Z. Gu, T. Chen / Journal of Accounting and Economics 38 (2004) 129170
1. Introduction
There has been considerable interest in the increasing reliance of nancial analysts
and analyst tracking services upon modied denitions of GAAP earnings
(Bradshaw and Sloan, 2002). Analyst tracking services such as First Call, IBES,
and Zacks collect and disseminate earnings forecasts made by individual analysts
and report subsequently realized earnings. These earnings numbers, known as
street or operating earnings (referred to as street earnings hereafter), often
differ from GAAP earnings in that they exclude certain nonrecurring or unusual
items.1 While individual analysts may disagree with respect to the treatment of a
given nonrecurring item, a tracking service examines each unusual earnings item
and chooses to include or exclude it from the EPS gure based on the analyst
majority (First Call, 1999, p. 1). This majority rule implies that specic items are
dealt with idiosyncratically rather than uniformly, and as a consequence, an unusual
item is often included in the earnings for one rm but excluded for another rm.
Prior studies have noted this phenomenon and attributed it to the inconsistent
behavior of analysts (Philbrick and Ricks, 1991; Skantz and Pierce, 2000).
We examine the rationale underlying analysts selective inclusion and exclusion of
nonrecurring items in street earnings and propose two main hypotheses. First, since
the explicit motivation of analysts in providing street earnings is to identify and
exclude transitory components of earnings, we hypothesize that the items that
analysts include in street earnings are more persistent than the items that they
exclude from street earnings. Second, First Call (1999, p. 1) states that a
corporations reported earnings are adjusted to reect the basis that the majority of
the analysts in coverage would use to value the stock (emphasis added). This
suggests that an unusual item is included in street earnings when most analysts
consider it to be more useful in security valuation than an excluded item. Thus, we
also hypothesize that the valuation multiples of the included items are higher than
those of the excluded items.
Based on First Calls footnote information on the details of the inclusion and
exclusion of nonrecurring items, we nd empirical evidence consistent with our
hypotheses. Relative to the items excluded from street earnings, included items are
more persistent and have higher valuation multiples. The differences are both
economically and statistically signicant. In addition, we nd that the markets
differential valuation of the nonrecurring items appears to be complete, and future
abnormal returns cannot be earned based upon information on the inclusions and
exclusions. Overall, our results suggest that individual nonrecurring items inherently
and qualitatively differ from each other. Analysts appear to have expertise in
identifying the more persistent and valuable nonrecurring items when making the
inclusion or exclusion decisions. If valuation is the primary use of street earnings,
1
A closely related term is pro forma earnings. Throughout this paper we use pro forma earnings to
refer to modied earnings numbers reported by management. Prior studies often use or empirically
measure pro forma earnings and street earnings interchangeably.
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Z. Gu, T. Chen / Journal of Accounting and Economics 38 (2004) 129170 131
then separating the low valuation items from the core earnings appears to be
justiable.
This paper differs from other studies and contributes to the literature in several
ways. First, it is the rst study we know of that provides a rationale for the analysts
selective treatment of nonrecurring items. Unlike earlier studies that often use
indirect evidence and attribute the phenomenon to the inconsistent behavior of
analysts, our analysis is directly based on analysts specic treatment information.2
Second, unlike other studies that explicitly (Doyle et al., 2003) or implicitly
(Bradshaw and Sloan, 2002; Bhattacharya et al., 2003; Brown and Sivakumar, 2003)
examine only the exclusions, we focus on the contrast between inclusions and
exclusions. Since both groups pertain to items that are regarded as nonrecurring,
such a comparison is particularly illustrative of analysts capability and the
underlying justication for the differential treatment. This apples-to-apples
comparison is likely to be more informative than examining only exclusions. For
example, although our evidence indicates that the exclusions also have some
predictive power for future earnings and cash ows as in other studies, we show that
the predictive power of the included items is much higher.
Third, our results contribute to the recent debate on street earnings and
support previous ndings that, from a valuation viewpoint, street earnings are
of higher quality than GAAP earnings. The differential in valuation multiples
between the included and the excluded items is supported by underlying
fundamentals rather than a misleading result derived from the inclusion or exclusion
decision itself. Our selective validation of data indicates that the majority of items
specied by First Call are discussed by management in the earnings announcements.
While analysts accept many exclusion and inclusion recommendations by manage-
ment, they still often disagree with management recommendations.3 Thus, while
part of analysts expertise is attributable to managers, to the extent that analysts
make their own judgments, their selective treatment provides a value-added service
to investors.
The rest of the paper is organized as follows. The next section discusses the
institutional background and develops our hypotheses. Section 3 describes the
research design. Section 4 describes the sample and provides summary statistics.
Empirical results are presented in Section 5, and Section 6 concludes.
2
Philbrick and Ricks (1991) nd that Value Line excludes most nonrecurring items from its actual
earnings, though occasionally a nonrecurring item is included. They suggest that IBES actuals are even
more inconsistent in the treatment of such items (p. 402). Skantz and Pierce (2000) infer that the reported
actuals by Value Line and IBES include restructuring losses and equity carve-out gains in slightly less than
40% of the cases. Philbrick and Ricks (1991, p. 413) do recognize that nonrecurring items need not be
treated the same from a valuation viewpoint. What they refer to is analysts potential incorrect treatment
when they exclude items that should be included due to their pricing implications.
3
Although large-sample studies often use analysts street earnings to proxy for managers pro forma
earnings (Brown and Sivakumar, 2003; Bradshaw and Sloan, 2002; Doyle et al., 2003), small-sample
studies with hand-collected data show that the two do not coincide in about 3040% of the cases
(Bhattacharya et al., 2003; Johnson and Schwartz, 2001).
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2. Background and hypotheses
2.1. Institutional background
First Call provides data on analyst earnings forecasts as well as actual earnings,
i.e., street EPS. Recognizing that signicant variance exists among analysts
concerning the treatment of nonrecurring items, First Calls policy is to follow the
majority view of the analysts. Specically, First Calls (1999, p. 1) treatment of
nonrecurring items is based on the following process:
For a nonextraordinary charge or gain that might be considered nonrecurring

and/or nonoperating by some, First Call editors will enter a footnote indicating
the type of nonextraordinary item, the size of the item and the period affected.
The First Call editor, based on past experience with items of this type, will decide
whether First Call expects a majority of contributing broker analysts to include or
exclude the item from their estimate. As contributing brokers submit conrma-
tions or revisions of their prior estimates, First Call will determine whether the
majority is including or excluding the item. If it proves to be different than the
original footnote entry, the First Call editor will revise the footnote to conform to
the majority.4
The inclusion and exclusion decision is presumably made at the time the
company reports (First Call, 1999, p. 2). However, the timing of the decision is not
uniform. For some rms, the existence of a nonrecurring item is known before the
earnings announcement and an inclusion or exclusion decision can be explicitly made
at the forecasting stage.5 This is consistent with the First Call procedure that all
individual analysts are asked at this stage to adjust their forecasts to conform to the
majority decision for known items (First Call, 1999, p. 1). For most other rms, the
nonrecurring items are reported for the rst time at the earnings announcement. In
this case, an adjustment is made only to the actual earnings so that the inclusion or
exclusion decision is consistent with the basis of the earlier forecasts (First Call,
4
In cases in which there is no clear consensus, First Calls rule is to include the item. First Call also has
footnote entries for extraordinary items that are always excluded. Thus, discretion on inclusion or
exclusion applies only to items considered nonextraordinary. As in other studies, we do not consider
extraordinary items in this paper.
5
For example, items such as amortization of goodwill and pre-open expense are fairly predictable, and
management sometimes prediscloses a forthcoming item. The following is a specic example: Last
month, however, Intel abruptly announced that interest and other income, including capital gains, for the
second quarter would rise to $2.3 billion, up from the $725 million it had previously forecasty . In this
case, many analysts rebelled. In the second quarter, seven of the 28 analysts who normally contribute Intel
earnings estimates to First Call declined to revise their number upward to reect the larger investment
gains, and thus werent included in the consensus, said Chuck Hill, director of research at First Call/
Thompson Financial. We go whatever basis the majority wants, he says (Hamilton, 2000). For this case,
although an inclusion decision was made before the earnings announcement, the footnote entry for the
item was dated after the announcement, likely because the actual nal amount must be entered and is
known only ex post. We note that the vast majority of the footnote entry dates are at or after the earnings
announcement, which do not always correspond to the dates at which the decisions are made.
ARTICLE IN PRESS
1999, p. 1). Although no explicit adjustment could be made at the forecasting stage,
this does not mean that analysts do not implicitly consider the nonrecurring items in
the forecasts. Activities such as mergers and acquisitions, major restructuring and
asset sales, and pending lawsuits are usually known when they occur (for example,
from press releases) and are understood to have potential effects on future income in
the form of unusual items. Even without knowing specic transactions, analysts can
always assess the unconditional probability that a nonrecurring item might occur.
Thus, while the actual amounts of the items may come as a surprise at the earnings
announcements, the existence of the items may not. It is therefore meaningful for
analysts to adjust the reported numbers to the same basis as the forecasts. However,
this also leaves the possibility that analysts arbitrarily pick a street earnings number
that simply provides the closest match to their earlier forecasts.
Appendix A provides an example of First Calls footnote entries. CNA Financial
Corp. had GAAP EPS of 0.15 in the third quarter of 1999, including two
nonrecurring items. The footnote entries indicate that analysts decided to exclude the
0.28 realized investment loss but included the 0.06 restructuring charge. Thus, the
reported street EPS is 0.43.
As indicated above, the inclusion and exclusion decision is made on a case-by-case
basis rather than a category-by-category basis. For example, instead of always
excluding restructuring charges and including goodwill amortizations, items within
each category are sometimes included in and other times excluded from street
earnings (see Table 4).
An ideal, complete data set would cover each possible category of nonrecurring
items in each rm quarter, indicating whether an item exists and how it is to be
treated. This is not what the First Call database does, however.6 Our study is limited
to only those rms with available First Call footnote entries. We nd that there exist
exclusions other than the ones specied by First Call, but both the specied and
unspecied ones behave similarly in terms of persistence and valuation implications.
There is no reason to believe that First Call is deliberately biased toward retaining
the high persistence and high valuation inclusions and omitting the high persistence
and high valuation exclusions in favor of our ndings. Even if First Call were biased
in this way, the very fact that First Call had the ability to identify and show items of
differential quality in their database would be consistent with our overall conclusion
about the expertise analysts bring to bear in processing nonrecurring items.
2.2. Hypotheses
Although it has long been documented that street earnings often deviate from
GAAP earnings (Philbrick and Ricks, 1991), it is not until recently that the nancial
press and accounting regulators became concerned with the widening gap between
the two (Bradshaw and Sloan, 2002). Proponents argue that street earnings by
analysts, or similarly pro forma earnings by management, remove the transitory
6
For example, Table 3 shows that First Call species fewer than 1000 goodwill amortizations, while
goodwill amortization occurs much more frequently in the overall population of rms.
ARTICLE IN PRESS
components in GAAP earnings and represent the core or recurring components that
better reect a companys prospects. Opponents argue, on the other hand, that these
earnings are presented as everything before bad stuff (Dow Jones, 2001) and are
used to manage investors perceptions (see more discussion in Bhattacharya et al.,
2003). As discussed above, a third possibility is that analysts opportunistically
minimize their forecast errors by choosing an inclusion or exclusion merely to obtain
an ex post earnings realization that is closest to their forecasts.
Results from academic research have been mixed so far. Studies differ in sampling,
research design, and criteria of earnings quality. When compared with GAAP
earnings, street or pro forma earnings are often found to be of higher quality in
terms of having higher persistence and valuation multiples and triggering larger
market reactions and analyst forecast revisions surrounding earnings announce-
ments (e.g., Bhattacharya et al., 2003; Bradshaw and Sloan, 2002; Brown and
Sivakumar, 2003; Johnson and Schwartz, 2001). One direct implication is that the
higher quality is caused by those items excluded from GAAP earnings, items which
are likely to represent the transitory components. Doyle et al. (2003) explicitly
examine the excluded items and nd that exclusions still exhibit considerable
predictive power for future cash ows.
Our study differs from these studies by focusing on items that are regarded as
nonrecurring, but which receive differential treatments by analysts. Since no
accounting item is uniformly either permanent or transitory, it is natural to nd that
nonrecurring items have varying degrees of persistence or valuation weight. It is also
not surprising to nd that such persistence or valuation weight is lower than that of
the core earnings. A more informative analysis is made among the nonrecurring
items: The reasons underlying an inclusion or exclusion decision are best illustrated
when contrasting items that are included with similar items that are excluded.
Since the nature of argument over street earnings is whether they successfully
remove the more transitory components from earnings, leaving the more persistent
components, our rst hypothesis, stated in alternative form, is
H1. Nonrecurring items included in street earnings are more persistent than items
excluded from street earnings.
Holthausen and Watts (2001) argue that whether certain items should be excluded
from or included in a particular earnings measure ultimately depends on the use of
the measure. Although many other uses of GAAP earnings exist, analysts argue that
they adjust GAAP earnings to street earnings to facilitate security valuation (First
Call, 1999). This claim is consistent with the fact that the primary job of analysts is to
assist investors in their investment decisions. The direct prediction from this user
perspective is that the included items are valued more than the excluded items. Thus,
our second hypothesis, stated in alternative form, is
H2. Nonrecurring items included in street earnings have higher valuation

multiples than items excluded from street earnings.
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Although the above two hypotheses are related because higher persistence is
expected to lead to higher valuation multiples, they test two distinct aspects of
nonrecurring items.7 In fact, whether they jointly hold is key to distinguishing among
alternative views of street earnings. In particular, the views of the proponents of
street earnings predict that both hypotheses hold. The view of the opponents,
however, predicts that H2 holds but H1 does not because the inclusions or exclusions
presumably mislead investors. That is, the included items have higher valuation
multiples (H2) not because of differential persistence (H1), but because the market is
not able to distinguish them from the core earnings. In addition, if analysts
opportunistically include or exclude the items only to minimize ex post forecast
errors, then neither H1 nor H2 will be supported by the data.8
Burgstahler et al. (2002) show that the market does not fully incorporate
the valuation implications of special items. Doyle et al. (2003) nd the same result
for nonspecial item exclusions but not for special item exclusions. In both
studies, the incomplete initial market reaction leads to future abnormal returns.
These results suggest that even though the market may partially understand
the differential persistence of the included and excluded items, it is likely that the
initial market valuation will not fully reect such differences. That is, we
may observe that both hypotheses H1 and H2 hold, but the valuation multiple
differential in H2 is not as large as implied by H1. If this were true, we would expect
the market to correct its initial mispricing at a later date. To assess whether the
differential market valuation of the included and excluded items is complete, and
moreover, to verify whether results in Burgstahler et al. (2002) and Doyle et al.
(2003) carry over to our sample, we examine future abnormal stock returns based on
analyst treatment of nonrecurring items. Therefore, our third hypothesis, stated in
null form, is,
H3. The information on inclusions and exclusions cannot be used to earn future
abnormal returns.
7
Another popular test criterion is information content based on market reactions or forecast revisions
surrounding earnings announcements (e.g., Bhattacharya et al., 2003; Bradshaw and Sloan, 2002; Brown
and Sivakumar, 2003; Lougee and Marquardt, 2004). We briey report results on information content in
footnote 25. However, we do not rely on these results because those tests compute earnings surprises using
analyst forecasts as earnings expectations (Bradshaw, 2003). If analysts are forecasting street earnings,
street earnings are likely to stand out among competing measures due to a mechanical relationship.
Another difculty in our study is that we only observe the total forecasts, and are not able to separate
them into expectations of the included items and expectations of the core earnings.
8
Notice, however, analysts may both behave opportunistically and consider the persistence when
making their inclusion/exclusion decisions. In this instance, both H1 and H2 may still hold but at a
reduced level of signicance. Our research design is not able to distinguish this possibility due to the lack of
a criterion of how much the differences between inclusions and exclusions should be. Note that examining
forecast errors is unlikely to be helpful because one cannot distinguish between the opportunistic behavior
and the premise of H1 and H2 that analysts were forecasting street earnings in the rst place. Both predict
that forecast errors are smaller than if the items are treated otherwise.
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First Call-specified nonrecurring items
Extra. Dirty
CORE_EPS INC EXC OEXC Items Surplus
Street EPS EXC_ALL
GAAP EPS before Extraordinary items
GAAP EPS after Extraordinary items
Comprehensive Income
Fig. 1. A general perspective on earnings measures and their decompositions. Note: INC: nonrecurring
items that First Call species as included in street earnings; EXC: nonrecurring items that First Call
species as excluded from street earnings; CORE_EPS (=Street EPSINC): core earnings before the
included items; EXC_ALL (=GAAP EPS before extraordinary itemsstreet EPS): total exclusions from
GAAP earnings to arrive at street earnings; and OEXC (=EXC_ALLEXC): exclusions other than
specied by First Call.
3. Research design
Fig. 1 presents the relations among the various earnings measures. A lower-layer
earnings measure can be viewed as a higher-layer measure with certain components
excluded.9 For example, total GAAP earnings exclude the dirty surplus from
Comprehensive Income (see Holthausen and Watts, 2001, Section 4.3 for more
discussion). GAAP earnings used in studies of street earnings exclude extraordinary
items from total GAAP earnings because analysts always exclude these items. Our
study focuses on GAAP earnings before extraordinary items (GAAP EPS
henceforth) decomposed into four components: GAAP EPS=Street EPS+EX-
C_ALL=CORE_EPS+INC+EXC+OEXC, where EXC_ALL is the total differ-
ence between GAAP and street earnings, and INC and EXC are the per share
nonrecurring items that First Call species as included in and excluded from street
earnings. Street EPS is decomposed into inclusions INC and core earnings before
inclusions CORE_EPS. Since the First Call-specied exclusions do not necessarily
fully account for the total exclusions, EXC_ALL is decomposed into EXC and the
remaining unspecied exclusions OEXC. The details on the measurement of these
variables are described in Section 4. Like most other related studies, we examine
quarterly earnings.
9
Note that the gure should be regarded as graphically describing the relation among the elements of a
set, and is not to be understood as measuring the size of the elements. The size of the lower-layer measure
can be larger than a higher-layer measure if the lower-layer measure excludes a component that is negative
(a loss item).
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3.1. Tests of persistence
Hypothesis H1 predicts that nonrecurring items included in street earnings are

more persistent than the items excluded from street earnings. We test this hypothesis
by examining the predictive power of these items for future operating performance.
Past studies often use future earnings as the performance measure (e.g., Sloan, 1996;
Burgstahler et al., 2002). Dechow (1994) shows that accrual-based earnings mitigate
the timing and matching problems of cash ows and are a better performance
measure than cash ows. We use two earnings measures, street earnings and GAAP
earnings. If analysts are able to differentiate more persistent from less persistent
items in their inclusions and exclusions, then future street earnings will be the
relevant earnings measure for the persistence test. However, one can argue that the
inclusions/exclusions are questionable in the rst place and may be used by analysts
to opportunistically achieve a series of self-predictable earnings. To address this
concern, we examine both GAAP earnings and street earnings. Doyle et al. (2003)
examine only the predictive power of exclusions for future cash ows because cash
ows are less subject to management manipulation. Following their study, we also
consider two cash ow measures: operating cash ows (OCF) and free cash ows
(FCF).
We consider a 1-year-ahead horizon. Using a 2-year-ahead horizon yields
qualitatively the same results. Our rst test is based on the following model:
Dep Varit b0 b1 CORE_EPS it =Pi;t1 b2 INC it =Pi;t1

b3 EXC it =Pi;t1 b4 OEXC it =Pi;t1 it ; 1
where for scal quarter t of rm i, Dep Varit is EPSit,1 yr/Pit or OCFit,1 yr/Pit or
FCFit,1 yr /Pit, and Pi,t1 and Pit are stock prices at the beginning and the end of the
return measurement window discussed below, respectively. The independent
variables are current quarter measures and are deated by the beginning price
Pi,t1. The dependent variables are measured over the year following the current
quarter and are thus deated by the beginning price Pit. Model (1) is similar to the
one used in Sloan (1996) for earnings persistence. While the magnitudes of the
various earnings components can differ, the coefcients measure the persistence of
the components on a comparable per unit basis. According to Hypothesis H1, the
coefcient on inclusions is expected to be higher than on exclusions. Although we
cannot predict how First Call-specied exclusions would differ from unspecied
exclusions, we expect inclusions to dominate both. Finally, since the included items
are still nonrecurring items, they are not likely to be as persistent as the core
earnings. Thus, our prediction is that b1 Xb2 4b3 and b2 4b4 :
Our second test separates the gain items from the loss items. The motivation is
that losses are likely to be more transitory than gains due to the abandonment option
(Hayn, 1995) and that rms tend to be conservative with regard to bad news (Basu,
1997). Although Hayn (1995) studies overall losses rather than individual items,
separating the gain items from the loss items provides information on the differential
extent to which these items are transitory. In addition, conservative reporting by
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rms is often achieved by using special or other nonrecurring items. Thus, our
second model is
Dep Varit b0 b1 CORE_EPS it =Pi;t1 b21 INC it =Pi;t1

b22 INC it =Pi;t1 b31 EXC it =Pi;t1
b32 EXC
it =Pi;t1 b41 OEXC it =Pi;t1
b42 OEXC
it =Pi;t1 it ; 2
where the superscripts + and indicate the positive (gains) and negative
(losses) measures of the corresponding variables. For example, INC+it refers to the
included gains (INCit40). Similar to the prediction above, we expect the coefcients
on the included gains and losses to be higher than their excluded counterparts. Thus,
we predict b1 Xb21 4b31 and b21 4b41 ; as well as b1 Xb22 4b32 and b22 4b42 : If losses
are more transitory than gains, we also expect b21 4b22 ; b31 4b32 ; and b41 4b42 :
Doyle et al. (2003) examine total exclusions and the alternative decomposition of
total exclusions into special items and nonspecial items. We expect the inclusions to
also dominate these alternative measures of exclusions. To test this, we replace EXCit
and OEXCit in (1) with total exclusions or special and nonspecial items. Doyle et al.
(2003) also include accounting accruals as an explanatory variable since Sloan (1996)
documents that accruals differ from cash ows in their persistence patterns.
The accruals, however, consist of noncash nonrecurring items, included or excluded,
and the noncash part of CORE_EPSit. Including accruals in the regression
makes the coefcients on the nonrecurring items difcult to interpret.10 Therefore
we do not include accruals in our main tests but only consider them in a robustness
check.
3.2. Valuation tests
Hypothesis H2 predicts that the included items are valued more than the excluded
items. To test this hypothesis, we use the following two models:
Retit b0 b1 BV it =Pi;t1 b2 CORE_EPS it =Pi;t1
b3 INC it =Pi;t1 b4 EXC it =Pi;t1
b5 OEXC it =Pi;t1 it 3
10
If the accruals measure were included, the noncash nonrecurring items would enter twice in separate
independent variables, once as part of nonrecurring items pooled with cash nonrecurring items, and once
as part of accruals. In estimating y b0 b1 x1 x2 b2 x2 x3 ; the total effect of x2 (think of it as
noncash nonrecurring items) is b1+b2, and that of x1 (cash nonrecurring items) is b1, while the effect of x3
(accruals other than nonrecurring items) is b2. Our interest is in the effect of total nonrecurring items
(x1+x2), with x2 not separately observable. The true multiple on (x1+x2) is not the estimated b1 as long as
b2 a0 or x2 and x3 are not perfectly negatively correlated. In our study, an even further complication is
that x3 is part of yet another variable (core earnings). Thus, it is very difcult to predict the overall effect of
including accruals (x2+x3). As we will show, including accruals in the regression dramatically changes the
coefcients on the nonrecurring items in some specications, indicating that the change is due to their
correlation with accruals rather than their own separate predictive power.
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and
Retit b0 b1 BV it =Pi;t1 b2 CORE_EPS it =Pi;t1
b31 INC
it =Pi;t1 b32 INC it =Pi;t1
b41 EXC
it =Pi;t1 b42 EXC it =Pi;t1
b51 OEXC
it =Pi;t1 b52 OEXC it =Pi;t1 it ; 4
where Retit is the compounded stock return from 2 days after quarter t1s earnings
announcement to 1 day after the current earnings announcement, and BVit is the book
value per share. This window ensures that the accounting information is available to
the market with minimal confounding effects of prior earnings announcements.11
Compared to Models (1) and (2), Models (3) and (4) include book values. In spirit,
these models are similar to those of Lipe (1986) in that they examine the valuation
effects of earnings components. The traditional interpretation is straightforward: they
are return-earnings relations that map accounting ROEs (and the book-to-market
ratios) into stock returns. They can also be viewed as modied forms of the Ohlson
(1995) valuation model that relates stock prices to accounting earnings and book
values (Easton and Harris, 1991; Brown et al., 1999).12 In Model (3), we expect the
included nonrecurring items to have higher valuation multiples than the excluded ones
but not necessarily as high as the core earnings, i.e., b2 Xb3 4b4 and b3 4b5 : Similarly,
we expect the included gains and losses to have higher multiples than their excluded
counterparts in Model (4), i.e., b2 Xb31 4b41 ; b31 4b51 ; b2 Xb32 4b42 ; and b32 4b52 : If
losses are valued less than gains, we also expect b31 4b32 ; b41 4b42 ; and b51 4b52 :
3.3. Tests of future abnormal returns
Hypothesis H3 predicts that the market reaction to the differential persistence of

the included and excluded items is complete, and the inclusions and exclusions
cannot be used to earn future abnormal returns. The test is based on the following
regression model:
ADRetit b0 b1 SURPRISE it =Pi;t1 b2 INC it =Pi;t1
b3 EXC it =Pi;t1 b4 OEXC it =Pi;t1
b5 B=M it b6 lnSIZE it b7 BETAit it ; 5
11
Since rms do not have identical announcement intervals, the length of the window varies slightly
across rms. Using alternative windows of equal length such as 90 days before the earnings announcement
or 30 days before the scal quarter-end to 60 days after does not change our results qualitatively.
12
For the valuation relation Pit b0 b1 BV it b2 EPSit ; deating by lagged price yields Pit =Pi;t1
b0 b1 BV it =Pi;t1 b2 EPSit =Pi;t1 ; or equivalently, Pit Pi;t1 =Pi;t1 b0 1 b1 BV it =Pi;t1
b2 EPSit =Pi;t1 : The left hand side variable Pit Pi;t1 =Pi;t1 is the stock return exclusive of dividends.
Brown et al. (1999) advocate this model over the original price levels model due to concerns of a potential
scale problem. The slight modication of Models (3) and (4) is the inclusion of dividends in the returns
measure (see also Easton and Harris, 1991 for inclusion of dividends). When we use Pit Pi;t1 =Pi;t1 as
the dependent variable in Models (3) and (4), we obtain qualitatively similar results. In our sensitivity tests
we briey report the results based on the price levels models.
ARTICLE IN PRESS
where ADRetit is the market-adjusted return measured as the compounded

buy-and-hold return less the return on the value-weighted market portfolio, over
one quarter, 1 and 2 years following the quarter t earnings announcement, and
SURPRISEit is the earnings surprise measured as street earnings minus analyst
consensus forecast within 90 days before the earnings announcements. Earnings
surprise is included to capture the well-documented post-earnings-announcement
drift effect. Additional variables of B/Mit (book-to-market ratio), ln(SIZEit) (rm
size), and BETAit (equity beta) are included, which are shown to be determinants
of stock returns (Fama and French, 1993). Our prediction is that b2 0; b3 0; and
b4 0:
To compare our results on future abnormal returns directly with those of
Burgstahler et al. (2002) and Doyle et al. (2003), we also follow their decomposition
of nonrecurring items. The model we use is similar to Model (5) with EXCit and
OEXCit replaced by total exclusions or special and nonspecial items. Doyle et al.
(2003) also include accruals for the purpose of controlling for the accrual anomaly
effect (Sloan, 1996). In one specication, we include accruals but caution that they
have confounding effects on the nonrecurring items as discussed earlier.
For Model (5), the independent variables are rst sorted into deciles and replaced
by the decile ranks, which are further transformed into a number between zero and
one (Bernard and Thomas, 1990). This allows for the easy interpretation that the
coefcient of a variable directly measures the abnormal return to a hedge portfolio
with a long position in rms with the highest decile rank and a short position in rms
with the lowest rank.
4. Sample and descriptive statistics
4.1. First Call data
We obtain street earnings directly from First Calls actual earnings le. Specied
inclusions (INC) and exclusions (EXC) are obtained from First Calls Footnotes le.
While most nonrecurring items are already presented on a per share basis, a small
number of them are expressed in aggregates. In such cases, we divide the total by the
appropriate number of shares to obtain per share numbers.13 Since the aggregates
are often before tax, we assume a 35% tax rate to obtain the after-tax numbers. Our
13
Earnings from First Call are generally on a fully diluted basis. For rms not reporting diluted EPS,
First Call indicates that it restates these numbers on a diluted basis for quarterly earnings from 1997. We
infer that for years prior to 1997 where diluted EPS is not available, First Call uses the basic EPS. The
number of shares for fully diluted EPS (#124) is available from Compustat quarterly les since 1997. For
years before 1997 where there is no fully diluted EPS, we use the number of shares for basic EPS. For
years before 1997 with fully diluted EPS but no number of shares, we convert the number of shares for
basic EPS to a fully diluted basis by using the most recent annual dilution factor (#171 relative to #54). In
cases in which that factor is not available, we use basic EPS relative to fully diluted EPS to approximate
the factor. Our results are not sensitive to these adjustments.
ARTICLE IN PRESS
validation of selected observations below indicates that some aggregates are already
given on an after-tax basis while some per share numbers are still before tax. If we
make no tax adjustments, our general results are not qualitatively affected. While
street earnings and forecasts are split adjusted by First Call, the footnote
nonrecurring items are not. We use First Calls split factor table to adjust these
numbers.
From now on, variable subscripts are dropped for brevity. Total exclusions
are the difference between Compustat GAAP earnings and street earnings:
EXC_ALL=GAAP EPSStreet EPS. We measure exclusions other than those
specied by First Call as OEXC=EXC_ALLEXC. All per share numbers are
split adjusted to be consistent with street earnings. Because of rounding errors
in making split adjustments to EXC and GAAP EPS, and because of measure-
ment errors in turning aggregate exclusions into per share numbers and in the
associated tax adjustments, EXC may not be exactly equal to EXC_ALL even if
EXC accounts for all the exclusions of a rm. We assume all the exclusions have been
accounted for by EXC if OEXC is less than half a cent since street EPS as reported
by First Call is rounded to the nearest cent. In such cases, OEXC takes the value
of zero.
To explore the potential sources of First Call footnote entries and to check their
validity, we randomly pick 40 observations in each of the four groups: with
inclusions (INC60), with First Call-specied exclusions accounting for total
exclusions (EXC60, OEXC=0), with other exclusions (EXC60, OEXC60), and
with no specied nonrecurring items. We then check management earnings
announcements from newswires on Lexis and Nexis. We regard rms as disclosing
pro forma earnings if management discusses earnings other than GAAP earnings
(Bradshaw and Sloan, 2002), including cases in which management talks about
nonrecurring items without necessarily giving the earnings numbers after excluding
them. Note that while some items are intended to be excluded or included by
management, others may simply be part of the requisite disclosures of components
of GAAP earnings.
Appendix B summarizes the validation results. For each of the rst three groups
with First Call footnote entries, most nonrecurring items appear in management
discussions in the earnings announcements. There are at most seven cases in a group
in which management discusses GAAP earnings only, with analysts obtaining
information on nonrecurring items elsewhere. In contrast, for the last group without
First Call footnote entries, there are only eight cases in which management mentions
an item that First Call does not specify, including two with items of trivial amounts.
First Call does make errors in their specications, including two duplications, three
exclusions (inclusions) entered as inclusions (exclusions), two losses entered as gains,
and an improper split adjustment. These errors affect both inclusions and exclusions.
For the second group that has the specied exclusions accounting for total
exclusions, analysts generally take the pro forma earnings by management directly as
street earnings. For the third group with other exclusions, only eight of them are
attributable to exclusions unspecied by First Call. As many as 16 appear
attributable to Compustat GAAP earnings that are inconsistent with management
ARTICLE IN PRESS
GAAP earnings.14 In ve cases, other exclusions arise due to imprecise tax

adjustments in our research design. Overall, it appears that while in many cases
analysts base their inclusions and exclusions on managers pro forma earnings, they
do screen managers proposed items and often make an inclusion or exclusion
decision that differs from management recommendations.
4.2. Other variables
Accounting variables other than nonrecurring items, street earnings, and earnings
forecasts are obtained from Compustat. Previous studies measure GAAP EPS as
earnings before accounting changes, discontinued operations, and extraordinary items
(Compustat #9 or #19), assuming that those items are always excluded by analysts.
While First Call treats some accounting changes and discontinued operations as part
of extraordinary items and excludes them, it regards other accounting changes and
discontinued operations as nonrecurring items to be included or excluded (see Table 4
later). To be consistent with this treatment, we measure GAAP EPS as Compustat #9
or #19, where appropriate (see footnote 13), plus accounting changes (#117) and
discontinued operations (#33). Using only #9 or #19 does not change our results
qualitatively. Operating cash ows (OCF) are from the cash ow statement (#108),
and free cash ows (FCF) are OCF net of capital expenditure (#90). Accounting
accruals (ACCRUAL) are measured as the difference between GAAP EPS and OCF.
Special items (SI, #32) are measured after taxes assuming a 35% tax rate. Because
some special items have been included in street earnings rather than always excluded
as assumed by Doyle et al. (2003), our special items measure excludes those items that
are within half a cent of INC.15 Finally, exclusions other than special items are
measured as NSI=EXC_ALL SI and are assumed to be zero if the measure is less
than half a cent per share. All aggregate ow measures are converted to a per share
basis by using the appropriate number of shares used for EPS (see footnote 13). Book
value of equity (#60) is divided by common shares outstanding at year end (#61) to
obtain the per share number (BV). Firms with negative book values are deleted where
book value is used. Market variables such as stock prices and returns are obtained
from CRSP. Firm size (SIZE) is the total market capitalization at the end of the
current quarter and equity beta (BETA) is estimated based on the weekly returns in
the 2 years before the earnings announcements (minimum 30 weeks).
14
In most of these cases, First Call-specied nonrecurring items are able to fully reconcile street earnings
with management GAAP earnings. Nonzero OEXC is obtained because it is calculated from EXC_ALL
using Compustat GAAP earnings. The deviation of Compustat GAAP from management announced
GAAP earnings is likely a result of management restatement of interim earnings at year-end. While
Compustat would go back and change the quarterly numbers, First Call does not appear to do so (we
thank Bob Lipe for pointing this out). Thus, the total difference between street and GAAP earnings partly
captures restatements rather than real exclusion of nonrecurring items. Note that prior studies using
Compustat as the source of GAAP earnings are also subject to this measurement problem.
15
By this criterion, about 3% of specials items are considered as included in street earnings, comprising
about 10% of INC. By the same half-cent criterion, about 16% of special items are considered the same as
specied excluded items, comprising about 11% of EXC.
ARTICLE IN PRESS
4.3. Descriptive statistics
Our sample is based on the March 2003 version of the First Call Historical
Database covering the period 19902003, with 2002 and 2003 reported as partial
years. Table 1 describes the selection process for usable observations of nonrecurring
items. The Footnotes le contains a total of 29,168 entries for quarterly nonrecurring
items. After excluding duplicates, entries that do not indicate inclusion or exclusion
decisions, and entries that do not have dollar amounts available, 28,542 entries are
left. These entries involve a total of 25,829 rm quarters. If a rm quarter has
multiple entries of gains or losses, we obtained the rm-quarter observation by
combining them into a single gain or loss number. This is done separately for
inclusions and exclusions. A small number of rm quarters have gains and losses or
both inclusions and exclusions, although the majorities only have a single item. We
exclude 165 rm quarters that have missing values of street earnings. An additional
3651 rm quarters are lost, especially in year 2002, either because the rms are not
covered by Compustat or because the number of shares needed to convert aggregates
into per share numbers is not available. The nal sample consists of 22,013 rm
quarters.
Table 2 indicates that the 22,013 rm quarters involve 5741 different rms,
representing roughly 42% of the approximately 13,600 rms that are covered by
both First Call and Compustat. Thus, the representation appears fairly broad. On
Table 1
Sample selection process
Number of observations
Quarterly Footnote entries with nonrecurring items specied in the 29,168

footnotes le of the March 2003 version of the First Call Historical
Database covering 19902003
Duplicate entriesa (376)
Entries that do not indicate the exclusion/inclusion decision (206)
Entries that do not indicate the amount of the nonrecurring items (44)
28,542
Converted to rm-quarter observations 25,829
Observations that do not have First Call reported actual earnings (165)
Observations that fail to merge with Compustat or lack number of shares to (3651)
convert aggregate into per share numbers
Final sample of rm-quarter observations 22,013
a
Duplicate entries include: (i) items in the same category and of the same amount for a rm quarter; (ii)
items in the same category but of different amounts on different Footnote datesitems typically entered
twice when management discusses the items rst in their earnings forecasts and then again in their earnings
announcements; and, (iii) certain items in the same category on the same Footnote dates but in different
amountssome of these items are duplicates (e.g., one in aggregate and another in per share amounts) but
some are not, which we trace back to rms earnings releases to determine whether they are in fact
duplicates or not.
ARTICLE IN PRESS
Table 2
Frequency of quarters with nonrecurring items for individual rms
# Of quarters with # Of rms % Relative to total # Of rm quarters

nonrecurring items rms with
nonrecurring items
1 1710 29.79 1710

2 1122 19.54 2244
3 824 14.35 2472
4 543 9.46 2172
5 352 6.13 1760
6 280 4.88 1680
7 198 3.45 1386
8 161 2.80 1288
9 121 2.11 1089
10 97 1.69 970
11 62 1.08 682
12 49 0.85 588
13 42 0.73 546
14 38 0.66 532
15 25 0.44 375
16 22 0.38 352
X17 95 1.65 2167
Total 5741 100.00 22,013
The table presents the number of rms that have different frequencies of quarters with nonrecurring items
during the sample period based on the 22,013 rm quarters with nonrecurring items specied in the
Footnotes le of the March 2003 version of the First Call Historical Database (see Table 1 for sample
selection).
average, a specied rm has four quarters with nonrecurring items. However, the
majority of rms (73% or 4199 rms) have four or fewer quarters, with about 30%
(1710 rms) only having a single quarter during the sample period. About 7.5%
(430) of the rms have nonrecurring items in ten or more quarters.
Table 3 presents the frequency distribution of the 28,542 entries of nonrecurring
items in Table 1. The pattern is similar if we restrict ourselves to the 22,013 rm
quarters. Several points can be noted. First, exclusions are far more frequent than
inclusions. The number of exclusions (24,514) is nearly six times that of inclusions
(4028). Second, nonrecurring items are more often losses than gains. However, the
proportion of losses is about the same for both inclusions and exclusions (66.3% vs.
69.2%).16 Analysts do not appear to always include the gains and exclude the losses.
Third, about half of the rm quarters still have other exclusions.17 These other
16
This is broadly consistent with Bhattacharya et al. (2003) who nd that 63% of GAAP earnings are
lower than IBES street earnings (i.e. loss exclusions) for their sample of pro forma earnings by managers.
17
Note that other exclusions can only be calculated based on the nal 22,013 rm quarters with
Compustat GAAP earnings available.
ARTICLE IN PRESS
Table 3
Frequency of inclusions/exclusions
Year Number of %o0 Number of %o0 Number of other %o0

inclusions exclusions exclusions
(INC60) (EXC60) (OEXC60)
1990 4 25.0 1 0.0 1 100.0

1991 14 35.7 5 80.0 11 45.6
1992 41 75.6 118 70.3 89 55.1
1993 329 72.0 800 61.4 512 57.8
1994 274 66.8 1133 60.8 599 63.8
1995 246 64.2 1437 62.1 698 56.0
1996 248 61.3 2026 68.7 923 56.6
1997 320 63.4 2278 64.1 1132 49.7
1998 444 63.1 3161 68.8 1355 53.0
1999 629 62.2 3827 66.1 1650 56.5
2000 655 68.5 3392 69.9 1553 63.7
2001 360 70.8 2552 77.6 1355 75.7
2002 436 69.5 3534 76.3 400 68.8
2003 28 75.0 250 79.6 n/a n/a
Total 4028 66.3 24,514 69.2 10,278 59.8
The table presents the frequency counts based on 28,542 useable quarterly Footnote entries with
nonrecurring items as specied in the footnotes le of the March 2003 version of the First Call Historical
Database (see Table 1 for sample selection). Inclusions (INC) and exclusions (EXC) refer to entries with
nonrecurring items specied as included in and excluded from street earnings. Other exclusions are based
on 22,013 rm quarters in the nal sample with GAAP EPS available from Compustat and measured as
OEXC=GAAP EPSStreet EPSEXC (assumed to be zero if the measure is less than half a cent).
exclusions are slightly more balanced between gains and losses. Fourth, the absolute
number of nonrecurring items steadily increases until reaching a peak in 1999, at
which point it declines before starting to pick up again in 2002.
The frequency changes of nonrecurring items are better seen in relative terms in
Fig. 2, which shows the proportion of rm quarters (Fig. 2a) and rms (Fig. 2b) with
inclusions, exclusions, and either inclusions or exclusions relative to the total First
Call coverage. Note that 1991, 1992 and 2003 are omitted due to incomplete data. It
appears that inclusions have been rather stable since 1993, when First Call coverage
became regular. However, exclusions show a signicant increase until reaching a
peak in 1999, at which point they decline before climbing back to their 1999 level in
2002. In 1999, about 13% of all rm quarters have exclusions and 15% have at least
one nonrecurring item either included or excluded (Fig. 2a). At the rm level
(Fig. 2b), about 31% of rms have at least one quarterly exclusion in 1999, and 35%
have at least one quarterly nonrecurring item either included or excluded. It appears
that the use of nonrecurring items became a prevalent phenomenon by 1999. The
increase leading up to 1999 could be because rms had increasingly reported
nonrecurring items or because analysts had paid more attention to these items
(Bradshaw and Sloan, 2002). However, we are not sure about the reasons for the
decline in 2000 and 2001 and the reversed increase in 2002.
ARTICLE IN PRESS
20%
Inclusions
16% Exclusions
Either inclusions or exclusions
12%
8%
4%
0%
(a) 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
40% Inclusions
Exclusions
Either inclusions or exclusions
32%
24%
16%
8%
0%
(b) 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Fig. 2. (a) Proportion of rm quarters with inclusions/exclusions relative to total rm quarter coverage by
First Call. (b) Proportion of rms with at least one quarterly inclusion/exclusion in a year relative to total
rm coverage by First Call. Note: The gures are based on 25,829 rm-quarters with nonrecurring items
specied in the Footnotes le of the March 2003 version of the First Call Historical Database (see Table 1
for sample selection). Fig. 2a shows the proportion of rm quarters in a year with items specied as
included in, excluded from, or either included in or excluded from street earnings relative to the total
number of rm quarters covered by First Call that year. Fig. 2b shows the proportion of rms in a year
with at least one quarterly inclusion, exclusion, or either inclusion or exclusion relative to the total number
of rms covered by First Call that year.
Table 4 provides the categorization of the 28,542 nonrecurring items based on the
First Call footnote information. Although it contains some classication errors,18 it
should provide a reasonable picture of the items composition. The four most
frequent nonrecurring items are restructuring charge (22.13%), acquisition expense
18
Our selective validation of the data (see Appendix B) indicates that rms occasionally report a single
amount that contains nonrecurring items in several categories. In this case, First Call is only able to enter a
single category in the footnotes le.
Table 4
Categorization of nonrecurring items
Type Number of Percent Number of Percent of Number of Percent of

items inclusions inclusions exclusions exclusions
Z. Gu, T. Chen / Journal of Accounting and Economics 38 (2004) 129170

(1) (2) (2)/(1) (3) (3)/(1)
Restructuring charge 6317 22.13 626 9.91 5691 90.09

Acquisition expense 3880 13.59 310 7.99 3570 92.01
Asset sale gain 3112 10.90 567 18.22 2545 81.78
Realized investment gain 2251 7.89 129 5.73 2122 94.27
Litigation charge 1131 3.96 181 16.00 950 84.00
Goodwill amortization 886 3.10 209 23.59 677 76.41
ARTICLE IN PRESS
Realized investment loss 881 3.09 44 4.99 837 95.01
Tax adjustment gain 830 2.91 172 20.72 658 79.28
Asset sale loss 681 2.39 101 14.83 580 85.17
Loss from discontinued operations 563 1.97 77 13.68 486 86.32
Inventory writedown 540 1.89 92 17.04 448 82.96
Accounting change loss 447 1.57 40 8.95 407 91.05
Litigation gain 433 1.52 66 15.24 367 84.76
In-process research and development 411 1.44 31 7.54 380 92.46
Tax adjustment loss 402 1.41 191 47.51 211 52.49
Income from discontinued operations 357 1.25 72 20.17 285 79.83
Tax settlement gain 351 1.23 60 17.09 291 82.91
Goodwill writedown 328 1.15 93 28.35 235 71.65
Pre-opening expense 243 0.85 80 32.92 163 67.08
Restructuring charge reversal 231 0.81 24 10.39 207 89.61
Other categories 2095 7.34 516 24.63 1579 75.37
No specied categories 2172 7.61 347 15.98 1825 84.02
Total 28,542 100 4028 14.11 24,514 85.89
The table is based on the 28,542 useable quarterly Footnote entries with nonrecurring items specied in the Footnotes le of the March 2003 version of the
First Call Historical Database (see Table 1 for sample selection). The categories and inclusion or exclusion decisions are based on information in the Footnotes
le.
147
ARTICLE IN PRESS
2 Street EPS Street EPS+EXC

GAAP EPS CORE_EPS
1.5
%
0.5
0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Fig. 3. Median Street EPS, Street EPS+EXC, GAAP EPS and CORE_EPS over time (in % of Pt1).
Note: The gure is based on 22,013 rm quarters with nonrecurring items specied in the Footnotes le of
the March 2003 version of the First Call Historical Database that have First Calls actual earnings
available and that successfully merge with Compustat data (see Table 1 for sample selection). Street EPS is
First Calls actual earnings. GAAP EPS is the fully diluted EPS (Compustat #9) (basic EPS #19 is used
when #9 is not available before 1997) plus accounting changes (#117) and discontinued operations (#33);
EXC is the per share nonrecurring items that First Call species as excluded from street earnings;
CORE_EPS is earnings before the nonrecurring items that First Call species as included in street EPS.
The medians of these measures in percentage of lagged prices are reported for each year.
(13.59%), asset sale gain (10.90%), and realized investment gain (7.89%). No other
category has more than 4% of the items. For each category, the majority of
items are excluded. The three categories with the highest percentage of inclusions
are tax adjustment loss (47.51%), pre-opening expense (32.92%), and goodwill
writedown (28.35%). These three categories comprise less than 3.5% of the
total items.
Fig. 3 depicts the time prole of the median sizes of street EPS, street EPS plus
EXC (what EPS would have been had the items not been excluded), GAAP EPS,
and CORE_EPS (what EPS would have been had the items not been included) for
the 22,013 rm quarters. Only measures in percentage of stock prices are presented.
Dollar measures give nearly identical patterns. Note that GAAP EPS on average is
always lower than street EPS, consistent with the results in Table 3 that excluded
items are predominantly expense items. Their magnitudes, however, seem relatively
stable over the years. Since the number of rms with excluded items has been mostly
increasing (Fig. 2), the deviation of street earnings from GAAP earnings has mostly
widened for the overall population of rms. Moreover, street EPS plus EXC is
generally close to GAAP EPS, indicating that on average the exclusions specied by
First Call provide a reasonable account of total exclusions.
The closeness of CORE_EPS (street EPSINC) to street EPS in Fig. 3 should be
interpreted with care. Because only about one-seventh of the rms have inclusions,
the average CORE_EPS is dominated by the street EPS of rms with no inclusion
effect. Fig. 4 provides a picture of the median size of nonzero inclusions and
exclusions. Although somewhat smaller in magnitude, INC does not appear to be far
from EXC. Both are negative with no obvious trend of change over time. On the
ARTICLE IN PRESS
0.1
0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
-0.1
-0.2
%
-0.3
-0.4
INC EXC OEXC
-0.5
-0.6
Fig. 4. Median size of INC, EXC and OEXC over time (in % of Pt1). Note: The gure is based on rm
quarters with nonzero measures in each category of nonrecurring items in the nal sample of 22,013
quarters. INC is the per share nonrecurring items specied as included in street EPS; EXC is the per share
nonrecurring items specied as excluded from street EPS; and OEXC is measured as GAAP EPSstreet
EPSEXC and assumed to be zero if it is less than half a cent. The medians of these measures in
percentage of lagged prices are reported for each year.
other hand, OEXC is generally smaller in magnitude than both INC and EXC except
in 2001 and 2002.19 Although this suggests that part of the reason for no
specication of other exclusions by First Call could be because they are immaterial,
we observe below that OEXC is characterized by considerable variations.
Table 5 provides the summary statistics of the various variables for rm quarter
observations. In Panel A on earnings and nonrecurring items, the median street EPS
is six cents (0.34% of stock prices) higher than GAAP EPS.20 Both inclusions INC
and exclusions EXC are negative on average. However, the means are larger in
magnitude than the medians, suggesting that there are some large loss items that are
both included and excluded. This is not surprising given the general negatively
skewed nature of nonrecurring items such as restructuring charges or other big
baths. The median of other exclusions OEXC is closer to zero, but its standard
deviation is higher than that of INC or EXC. For the positive and negative groups
within inclusions and exclusions, exclusions tend to be larger in magnitude. The
other variables in Panel B are broadly consistent with those in other studies (e.g.,
Doyle et al., 2003). Note that the 1-year-ahead street EPS is still higher than GAAP
EPS (medians 5.03% vs. 4.25%), suggesting that rms with current inclusions and
exclusions still have nontrivial exclusions in the subsequent periods. The median
19
For year 2002, OEXC is even larger in magnitude than EXC. This appears to be driven by accounting
changes and discontinued operations in GAAP earnings. Had we used fully diluted EPS without including
these two items as other studies have done, OEXC would be smaller than EXC.
20
For street EPS, GAAP EPS, and CORE_EPS, the medians have the same sign for both the raw
measures and the price-deated measures. But the means have opposite signs. This is because some large
losses have small deator prices, tilting the distribution. The problem is mitigated by winsorization in the
regressions below.
ARTICLE IN PRESS
1- and 2-year-ahead market-adjusted stock returns are negative as in Doyle et al.

(2003), possibly because rms covered by First Call tend to be large, with relatively
lower returns.
Table 5
Summary statistics of regression variables
Mean Median Std. dev.
Panel A: earnings and nonrecurring items in $ (% of lagged prices in parenthesis)

Street EPS $0.265 (0.430%) $0.190 (1.133%) $8.461 (14.145%)
GAAP EPS 0.228 (2.845) 0.130 (0.796) 17.528 (33.171)
CORE_EPS 0.274 (0.350) 0.190 (1.143) 8.466 (16.896)
INC 0.058 (0.546) 0.030 (0.157) 1.566 (28.695)
EXC_ALL 0.039 (3.146) 0.050 (0.286) 16.086 (32.173)
EXC 0.174 (2.040) 0.040 (0.248) 2.468 (22.947)
OEXC 0.247 (2.064) 0.010 (0.056) 21.267 (33.061)
SI 0.308 (2.865) 0.065 (0.440) 6.317 (20.349)
NSI 0.172 (1.427) 0.018 (0.096) 21.227 (21.772)
INC+ 0.246 (3.667) 0.060 (0.356) 2.293 (41.965)
INC 0.219 (2.823) 0.060 (0.447) 0.902 (16.635)
EXC+ 0.330 (2.364) 0.080 (0.416) 2.838 (15.381)
EXC 0.415 (4.129) 0.110 (0.741) 2.352 (25.217)
OEXC+ 1.314 (2.815) 0.063 (0.377) 33.234 (17.788)
OEXC 0.469 (5.292) 0.060 (0.376) 3.625 (39.758)
Panel B: other variables
Ret (%) 1.659 0.324 39.390
BV (% of Pt1) 65.103 51.920 70.589
OCF1 yr (% of Pt) 9.452 7.610 26.732
FCF1 yr (% of Pt) 1.557 2.000 26.900
Street EPS1 yr (% of Pt) 2.451 5.031 17.173
GAAP EPS1 yr (% of Pt) 1.101 4.249 34.714
ACCRUAL(% of Pt1) 5.051 1.373 44.312
SURPRISE (% of Pt1) 0.197 0.025 4.447
ADRet1 qt (%) 0.475 1.481 31.139
ADRet1 yr (%) 4.046 7.813 87.184
ADRet2 yr (%) 8.437 15.089 166.173
B/M 0.681 0.522 0.836
SIZE (in mil.$) 3738.693 501.752 15591.779
BETA 0.946 0.825 0.690
Variable denitions: Street EPS is the quarterly actual earnings reported by First Call; GAAP EPS is the
fully diluted EPS (Compustat #9) (basic EPS #19 is used when #9 is not available before 1997) plus per
share accounting changes (#117) and discontinued operations (#33); INC and EXC are the per share
nonrecurring items that First Call species as included in, and excluded from, street EPSif First Call
provides an aggregate amount, we turn it into a per share number and assume a 35% tax rate; EXC_ALL
is total exclusions measured as GAAP EPSstreet EPS; OEXC is the difference between total exclusions
and First Call specied exclusions (EXC_ALLEXC, assumed to be zero if it is within half a cent); SI is
special items (#32) on a per share basis assuming 35% tax rate; NSI is exclusions other than special items
measured as EXC_ALLSI; EXC_ALL, OEXC, and NSI are assumed to be zero if the measure is less than
half a cent. A superscript + or indicates only the positive or negative measures of the variable. For
the various groups of nonrecurring items, descriptive statistics are calculated for the nonzero measures
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Table 5 footnote (continued)
only. In the regressions later, these variables take a zero value for observations without the nonrecurring
item (e.g., EXC of an inclusion-only observation). The variable Ret is the compounded stock return from 2
days after the prior earnings announcement to one day after the current earnings announcement; BV is
book value per share (#60 divided by #61); OCF1 yr is the 1-year ahead operating cash ows (#108)
following the current quarter; FCF1 yr is the 1-year ahead free cash ows measured as OCFCapital
Expenditure (#90); SURPRISE is the earnings surprise measured as street earnings minus analyst
consensus forecast within 90 days before earnings announcements; ADRet is the market-adjusted return
measured as the buy-and-hold return less the return on the value-weighted market portfolio, over the
corresponding period indicated in the subscript following the earning announcements; B/M is the book-
to-market ratio; SIZE is the total market capitalization at the end of the quarter; and BETA is the equity
beta estimated from the market model based on weekly returns in the two years before the earnings
announcements (minimum 30 weeks). All variables are split adjusted where applicable.
5. Empirical results
For most of the results in this section, we conduct regressions annually for
19932001 based upon rm quarter observations, and we report the mean
coefcients and t-statistics following the FamaMcBeth procedure.21 Adjusting for
autocorrelation in the annual coefcients does not qualitatively affect our results.
Because the number of observations is very limited in the beginning years of the
sample period (Table 3), we group observations before 1993 with those from 1993 in
the annual regressions. Excluding those observations has no qualitative effect on the
results. Except for Model (5) for future abnormal returns, all regression variables are
winsorized at the 1% and 99% levels as in Doyle et al. (2003) to mitigate the effect of
outliers.22,23 No winsorization is done for Model (5) because return outliers are part
21
Note that 2002 is an incomplete year and thus is excluded from our tests below. Most of the lost
observations due to failure to merge with Compustat come from this year. In the persistence tests, 2002 has
to be excluded anyway because the required earnings and cash ows of 2003 are not yet available.
Although some observations are available for the valuation tests, we exclude this incomplete year from
these tests to be consistent with the persistence tests.
22
For various variables of nonrecurring items, winsorization is done only at the 1% and 99% levels of
the nonzero observations. For example, about one-seventh of rms have nonzero inclusions (Table 3). For
those with only exclusions, their measure of INC is zero. Winsorizing based upon all observations would
winsorize about 7% on both ends of useful INC observations.
23
While winsorizing or deleting the extreme values of the dependent variable is common in accounting
and nance research (see also, e.g., Kothari et al., 2005), it involves a tradeoff. On the one hand, true
outliers in the error terms are not captured by the independent variables but rather by the dependent
variable. On the other hand, if nonoutliers of the dependent variable were mistreated as outliers,
coefcient estimates and standard errors could be biased. We conduct simulations based on comparable
economic relations and sample sizes in the absence of outliers and nd that winsorization of the extreme
1% of the dependent variables has an almost negligible effect on coefcient estimates and R2. However,
the effect of winsorization is dramatic for our actual data. For example, if the dependent variable were not
winsorized, the R2 in column 2 of Table 6 for our main persistence test would be reduced from 0.277 to
0.198, with b2b3 insignicant. Thus, we conclude that the winsorized observations are likely to be true
outliers. If we delete, rather than winsorize, the extreme observations, our results are stronger for
valuation tests, similar for persistence tests with regard to future earnings, and weaker for persistence tests
with regard to future cash ows.
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of the risk of a trading strategy and because regressors are already decile ranked. The
number of observations varies across individual regressions depending on the data
availability of other variables.
5.1. Tests of persistence
Table 6 reports the test results for Hypothesis H1. For Model (1), only results for
GAAP earnings and operating cash ows are presented to save space. The results for
street earnings and free cash ows are similar. The coefcient estimates are reported
in the top half and their differences in the bottom half of each panel.
For GAAP earnings in Panel A, the coefcients on CORE_EPS are over 2.3 and
highly signicant (t413:0). Given the measures are relative to the stock prices, this
suggests that each 1% ROE of core earnings is able to predict over 2.3% ROE
of future earnings in the subsequent year. When only First Call-specied
nonrecurring items are considered (column 1), both INC and EXC have signicantly
positive coefcients (b2 1:170 and b3 0:362), indicating that neither inclusions
nor exclusions are strictly nonrecurring. However, their degree of persistence
differs dramatically from one another. Although b2 is only about half of b1, it is
more than two times higher than b3. The difference is highly signicant
(b2 2b3 0:809; t 3:64) and is positive in eight out of 9 years. When other
exclusions OEXC are added (column 2), INC dominates both exclusion groups in
most individual years and on average (b2 2b3 0:766; t 3:29; b2 2b4 0:574;
t 2:72). The results are nearly the same when total exclusions are considered
(column 3). For the alternative decomposition of total exclusions into special and
nonspecial items (SI and NSI) in Doyle et al. (2003) (column 4), inclusions remain
the most persistent (b2 2b3 1:224; t 4:78; b2 2b4 0:573; t 2:63). Results are
little changed with the inclusion of ACCRUAL (column 5). Unlike Burgstahler et al.
(2002), SI is insignicant in predicting future earnings in our sample, while NSI is
highly signicant.
Results on operating cash ows are reported in Panel B. The coefcients are
generally much smaller than those in Panel A. For example, the coefcients on
CORE_EPS and INC are less than half of those in Panel A. Thus, although cash
ows are generally higher than earnings due to negative accruals (Table 5), current
earnings or earnings components are able to predict less future cash ows than
future earnings. The lower predictive power is also consistent with the much lower
R2s. The signicance of individual coefcients is generally smaller. Although
inclusions INC are often marginally signicant themselves (tX1:47; p-valueo0.10,
one-tailed), their coefcients are always signicantly higher than those on First Call-
specied exclusions EXC or special items SI (b2 2b3 X0:476; tX1:79; p-valueo0.10,
one-tailed). The differences are positive in seven out of 9 years. Although other
exclusions OEXC and nonspecial items NSI seem to have coefcients that are not
different from INC statistically, economically the incremental persistence of INC is
still substantial, with b2 three times or nearly two times as high as b4. When we
include ACCRUAL in the regression as Doyle et al. (2003) do for cash ows (column
5), the results on all nonrecurring items are drastically changed and both SI and NSI
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Table 6
Regression results on tests of persistence
Panel A: gains and losses of nonrecurring items are considered together
Model : GAAP EPSit;1 yr =Pit b0 b1 CORE_EPSit =Pi;t1 b2 INC it =Pi;t1 b3 EXC it =Pi;t1 1
b4 OEXC it =Pi;t1 it
1 2 3 4 5
INTERCEPT (b0) 0.015 0.013 0.013 0.016 0.021

(1.21) (1.14) (1.13) (1.41) (1.85)
CORE_EPS (b1) 2.342 2.340 2.327 2.418 2.420
(13.15) (14.73) (13.77) (15.90) (19.52)
INC (b2) 1.170 1.136 1.150 1.264 1.335
(5.82) (5.67) (5.54) (5.92) (6.07)
EXC (b3) 0.362 0.370
(3.33) (3.48)
OEXC (b4) 0.562
(8.64)
EXC_ALL (b3) 0.370
(4.91)
SI (b3) 0.041 0.064
(0.31) (0.57)
NSI (b4) 0.691 0.768
(8.16) (8.74)
ACCRUAL (0.046)
(0.93)
Tests on coefficient differences
b1b2 1.171 1.204 1.177 1.154 1.085
(5.10) (5.53) (5.05) (4.64) (4.07)
[9] [9] [9] [9] [9]
b2b3 0.809 0.766 0.78 1.224 1.271
(3.64) (3.29) (3.84) (4.78) (4.94)
[8] [8] [7] [8] [8]
b2b4 0.574 0.573 0.567
(2.72) (2.63) (2.51)
[8] [8] [7]
Mean adj. R2 0.267 0.277 0.272 0.281 0.277
Mean N 1856 1856 1856 1800 1596
(cont.)
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Table 6 (continued)
Panel B: gains and losses of nonrecurring items are considered together
Model : OCF it;1 yr =Pit b0 b1 CORE_EPSit =Pi;t1 b2 INC it =Pi;t1

b3 EXC it =Pi;t1 b4 OEXC it =Pi;t1 it 1
1 2 3 4 5
INTERCEPT (b0) 0.093 0.093 0.093 0.091 0.082

(13.43) (13.46) (13.90) (13.54) (14.24)
CORE_EPS (b1) 1.097 1.102 1.113 1.168 1.412
(9.18) (9.22) (10.84) (11.26) (16.09)
INC (b2) 0.390 0.387 0.415 0.504 0.875
(1.47) (1.48) (1.55) (1.82) (2.73)
EXC (b3) 0.088 0.089
(1.19) (1.12)
OEXC (b4) 0.114
(1.37)
EXC_ALL (b3) 0.062
(1.24)
SI (b3) (0.239) 0.320
(3.70) (3.18)
NSI (b4) 0.176 0.487
(1.97) (5.51)
ACCRUAL 0.461
(7.51)
b1b2 0.706 0.715 0.698 0.665 0.538
(2.20) (2.24) (2.26) (2.17) (1.47)
[8] [8] [8] [8] [7]
b2b3 0.478 0.476 0.477 0.742 0.555
(1.99) (1.98) (1.81) (2.67) (1.79)
[7] [7] [7] [7] [7]
b2b4 0.273 0.328 0.388
(0.95) (1.17) (1.23)
[4] [5] [4]
Mean adj. R2 0.065 0.067 0.065 0.069 0.120
Mean N 1642 1641 1641 1594 1587
(cont.)
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Table 6 (continued)
Panel C: gains and losses of nonrecurring items are separated
Model : Dep Varit b0 b1 CORE_EPSit =Pi;t1 b21 INC

it =Pi;t1
b22 INC
it =Pi;t1 b31 EXC it =Pi;t1 b32 EXC it =Pi;t1

b41 OEXC it =Pi;t1 b42 OEXC it =Pi;t1 it 2
Dependent GAAP EPS1 yr/P Street EPS1 yr/P OCF1 yr/P FCF1 yr/P
variable
b0 0.010 0.019 0.089 0.02

(INTERCEPT)
(0.92) (4.05) (12.63) (3.06)
b1 2.289 1.854 1.179 1.209
(CORE_EPS)
(16.19) (17.79) (8.97) (9.74)
b21 (INC+) 1.437 0.057 1.390 0.025
(2.34) (0.13) (1.37) (0.03)
b22 (INC) 1.224 0.690 0.059 0.333
(5.52) (3.69) (0.42) (1.91)
b31 (EXC+) 0.163 0.041 0.319 0.217
(1.25) (0.39) (2.38) (1.11)
b32 (EXC) 0.414 0.123 0.151 0.050
(2.91) (1.89) (1.60) (0.69)
b41 (OEXC+) 0.150 0.260 0.294 0.086
(0.66) (2.11) (1.48) (0.37)
b42 (OEXC) 0.643 0.433 0.046 0.081
(6.52) (3.85) (0.50) (0.79)

b1b21 b1b22 0.852 1.065 1.797 1.164 0.211 1.12 1.234 0.876
(1.56) (4.62) (4.23) (5.83) (0.22) (5.23) (1.70) (3.76)
[7] [8] [8] [8] [7] [9] [7] [8]
b21b22 0.213 0.633 1.332 0.358
(0.38) (1.26) 1.23 (0.42)
[3] [1] [6] [2]
b21b31 b21b41 1.274 1.287 0.016 0.203 1.071 1.096 0.192 0.111
(1.89) (1.60) (0.04) (0.47) (1.12) (0.94) (0.24) (0.12)
[6] [7] [4] [3] [6] [4] [6] [2]
b22b32 b22b42 0.811 0.581 0.568 0.257 0.209 0.012 0.283 0.252
(3.48) (2.13) (2.89) (1.18) (1.67) (0.08) (1.65) (1.19)
[7] [9] [8] [7] [7] [5] [7] [5]
Mean adj. R2 0.282 0.370 0.073 0.092

Mean N 1856 1943 1641 1581
For variable denitions, see Table 5. Regressions are run for each year of 19932001. Observations before
1993 are pooled with those of 1993. The coefcients are the time-series means of annual coefcients.
Numbers in parenthesis are t-statistics obtained from dividing the means by their standard deviations.
Numbers in brackets are the numbers of years that the annual coefcients are positive. Variables are
winsorized at the 1% and 99% levels. For INC, EXC, and OEXC, winsorization is based on nonzero
observations only.
Cutoff points for t-stat signicance levels (df=8) are, for one-tailed: 1.397 (10%), 1.860 (5%), 2.897 (1%);
for two-tailed: 1.860 (10%), 2.306 (5%), 3.355 (1%).
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have signicantly positive coefcients.24 As discussed in footnote 10, the change

solely due to the inclusion of ACCRUAL is driven by the overlap between
nonrecurring items and the accrual measure, and must be interpreted with care. The
net effect of the nonrecurring items should be smaller because of the negative
coefcient on ACCRUAL that contains noncash nonrecurring items. Overall, our
results from both earnings and cash ows are consistent with Model (1) prediction
that b1 Xb2 4b3 and b2 4b4 :
Panel C reports the results for Model (2) with the gains and losses separately
considered for the prediction of future GAAP earnings, street earnings, operating
cash ows, and free cash ows. The results are the strongest for future GAAP
earnings. Both included gains and losses have coefcients that are not only
signicant on their own, but also signicantly higher than those of their excluded
counterparts. The coefcient differentials are positive in at least six out of 9 years.
For street earnings, the included losses appear to be more persistent than the
excluded losses but the gains are similar. The included gains appear to be relatively
more important to predict future operating cash ows OCF and the included losses
seem more important to predict future free cash ows FCF. Their incremental
coefcients relative to their excluded counterparts are economically substantial.
Although INC is insignicant for OCF and INC+ is insignicant for FCF, in no case
are their coefcients signicantly lower than those of the exclusions. The gain items
are generally no more persistent than the loss items (only b21b22 reported). Overall,
we interpret the results as consistent with Model (2) predictions that b1 Xb21 4b31 ;
b21 4b41 ; b1 Xb22 4b32 ; and b22 4b42 :
Additional tests are conducted for the levels version with undeated variables in
Models (1) and (2). Results are the strongest for the earnings measures with the
inclusions uniformly dominating the exclusions in predictive power. Results for the
cash ow measures are somewhat weaker. Incremental coefcients of inclusions over
exclusions are sometimes insignicant. However, there is no single case in which the
exclusions have a signicantly higher coefcient than the inclusions. We also
examine the predictive power of the nonrecurring items for future core earnings
CORE_EPS, fully diluted earnings (Compustat #9), basic earnings (#19), or
operating earnings (#177). The results are very similar to those reported for earnings
in Table 6. We also look at different quarters and nd that the results are the
strongest for items in the rst three quarters. Although the fourth quarter results are
statistically weaker, inclusions typically have higher coefcients than exclusions.
Taken as a whole, our results are consistent with Hypothesis H1. They suggest
that although the persistence of nonrecurring items differs across the future
performance measures, the included items are generally more persistent, especially
24
Since Doyle et al. (2003) measure loss items in positive numbers and gain items in negative numbers,
our positive coefcient is consistent with their negative coefcient. The coefcient on EXC_ALL when
ACCRUAL is included (unreported) becomes signicantly positive as in Doyle et al. (2003). The coefcient
on ACCRUAL is insignicant in Panel A for GAAP earnings and thus has little effect on nonrecurring
items. Doyle et al. (2003) use asset per share as the deator for the cash ow test. We also repeat the
analysis with this deator and nd qualitatively similar results. One slight difference is that EXC becomes
signicant and INC becomes highly signicant.
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for earnings, than the excluded items. Although exclusions do have some predictive
power as found in Doyle et al. (2003), it is much weaker than that of the included
items.
5.2. Valuation tests
5.2.1. Main results

Table 7 presents the test results for Hypothesis H2 based on Models (3) and (4).
Book values are positively related to the stock returns (b1 40). The multiple on
CORE_EPS, b2, is roughly equal to one and signicantly larger than zero (t46:4),
suggesting that a 1% ROE of core earnings is associated with about 1% stock
returns. For First Call-specied nonrecurring items (column 1), both INC and EXC
appear to contain value relevant information and have signicantly positive
multiples (b3 0:576; t 2:99; b4 0:204; t 2:44). However, the multiple on
INC is nearly three times as large as that on EXC, and the difference is positive in
seven out of 9 years and statistically signicant (t 2:10). Unspecied exclusions
(OEXC) also appear to contain some value relevant information with a signicant
multiple (b5 0:160; t 1:94) (column 2). Notwithstanding, inclusions dominate
both types of exclusions (b3 2b4 0:380; t 2:12; b3 2b5 0:430; t 1:99). When
the total exclusions are considered (column 3), results are almost the same.
On average, a 1% ROE of INC is associated with over 0.57% stock returns,
slightly more than half that of CORE_EPS but more than twice that of the
EXC and OEXC. The relative valuation differences among these earnings
components closely correspond to the relative persistence differences in Panel A
of Table 6. Overall, the results are consistent with the prediction of b2 Xb3 4b4
and b3 4b5 ; suggesting that the included items are valued more than the excluded
ones.
Model (4) separates the gains from the losses for the nonrecurring items. It
appears that within each inclusion and exclusion group, losses are valued less than
the gains. All the gain items are signicantly related to stock returns whether
included or not, whereas only the included losses INC are signicant. The included
gains INC+ are indistinguishable from the core earnings (b2 b31 0:105;
t 0:24). Both INC+ and INC have higher multiples than their excluded
counterparts and all of the paired multiple differentials are positive in six out of 9
years, although some are only marginally signicant. Economically, the incremental
multiples are substantial, often exceeding the multiples on the exclusions themselves.
Relative to Model (3), which yields more signicant results, Model (4) only uses
information reected in the variations within gains and losses. The test power could
be lower because information reected in the variations between gains and losses is
ignored. In general, the results are consistent with the predictions that
b2 Xb31 4b41 ; b31 4b51 ; b2 Xb32 4b42 ; and b32 4b52 :
We conduct a number of additional tests as sensitivity checks. In particular, we
examine the price levels model similar to Models (3) and (4) by regressing stock
prices on book values and earnings components. Barth et al. (2001) and Gu (2005)
argue that the returns model and the levels model address different valuation issues.
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Table 7
Regression results on tests of valuation multiples
Models : Retit b0 b1 BV it =Pi;t1 b2 CORE_EPSit =Pi;t1

b3 INC it =Pi;t1 b4 EXC it =Pi;t1 b5 OEXC it =Pi;t1 it 3
Retit b0 b1 BV it =Pi;t1 b2 CORE_EPSit =Pi;t1 b3 INC

it =Pi;t1
b4 INC
it =Pi;t1 b5 EXC it =Pi;t1 b6 EXC it =Pi;t1
b7 OEXC
it =Pi;t1 b8 OEXC it =Pi;t1 it 4
Model (3) Model (4)
1 2 3 4
INTERCEPT (b0) 0.008 0.008 0.009 INTERCEPT (b0) 0.011

(0.52) (0.51) (0.55) (0.70)
BV (b1) 0.043 0.044 0.042 BV (b1) 0.036
(2.73) (2.74) (2.66) (2.35)
CORE_EPS (b2) 1.000 0.993 1.033 CORE_EPS (b2) 1.129
(6.40) (6.48) (7.22) (7.34)
INC (b3) 0.576 0.589 0.567 INC+ (b31) 1.235
(2.99) (3.00) (2.97) (3.03)
EXC (b4) 0.204 0.209 INC (b32) 0.377
(2.44) (2.53) (1.67)
OEXC (b5) 0.160 EXC+ (b41) 0.805
(1.94) (6.44)
EXC_ALL (b4) 0.101 EXC (b42) 0.088
(2.23) (1.11)
OEXC+ (b51) 0.464
(4.11)
OEXC (b52) 0.046
(0.41)
b2b3 0.423 0.404 0.467 b2b31 b2b32 0.105 0.752
(1.59) (1.53) (1.90) (0.24) (2.63)
[5] [5] [6] [4] [8]
b3b4 0.373 0.380 0.465 b31 b32 0.858
(2.10) (2.12) (2.62) (2.29)
[7] [7] [7] [7]
b3b5 0.430 b31 b41 b31 b51 0.430 0.771
(1.99) (1.04) (2.01)
[6] [6] [6]
b32 b42 b32 b52 0.289 0.331
(1.45) (1.20)
[6] [6]
Mean adj. R2 0.042 0.043 0.043 0.048
Mean N 2122 2122 2122 2122
For variable denitions, see Table 5. Regressions are run for each year of 19932001. Observations before
1993 are pooled with those of 1993. The coefcients are the time-series means of annual coefcients. Numbers
in parenthesis are t-statistics obtained from dividing the means by their standard deviations. Numbers in
brackets are the numbers of years that the annual coefcients are positive. Variables are winsorized at the 1%
and 99% levels. For INC, EXC, and OEXC, winsorization is based on nonzero observations only.
Cutoff points for t-stat signicance levels (df = 8) are, for one-tailed: 1.397 (10%), 1.860 (5%), 2.897 (1%);
for two-tailed: 1.860 (10%), 2.306 (5%), 3.355 (1%).
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We nd that the multiple on CORE_EPS is 10.17, which means $1 of core earnings is

valued at about $10.17. For the nonrecurring items, the multiple on INC is about
1.17, which is substantially higher than 1.36 on EXC and 0.39 on OEXC. When we
separate the gains from losses, each dollar of INC+ is valued at $7.80, signicantly
higher than that of EXC+or OEXC+, which is less than $2.05. Each dollar of INC is
valued at an insignicant $0.10, and the excluded losses have lower negative
multiples. In general, the levels models produce results consistent with those from the
returns model.
For Models (3) and (4) we also use the market-adjusted returns or prices deated
by lagged prices (i.e. returns exclusive of dividends Pit/Pi,t1) as the dependent
variable, or use DBVit/Pi,t1 instead of BVit/Pi,t1. None of the inferences on the
relevant variables are affected. As in persistence tests, we nd that the results are the
strongest for items in the rst three quarters. Regressions are also run using decile
ranks by sorting each variable into deciles and then replacing them with the decile
ranks. The results are qualitatively similar, with the included items consistently
signicant and the excluded items often insignicant. Owing to data transformation,
direct comparison of coefcients is not meaningful in this case. We also examine the
3-day market reaction to earnings announcements and nd a signicantly higher
response coefcient for the included items than the excluded ones.25 Overall, we
conclude that the included items are valued more than the excluded items. Investor
perceived value of the nonrecurring items appears to be consistent with the
differences in persistence.
5.2.2. Additional tests for individual categories of nonrecurring items

Table 4 indicates that the four largest categories of nonrecurring items comprise
more than half of the total items. To examine whether the higher persistence and
valuation multiple of inclusions hold for the individual categories, we conduct a
further analysis based on a xed effect model using pooled observations. Pooled
rather than annual regressions are run because the number of inclusion observations
is limited for individual categories. With the exception of restructuring charge and
asset sale gain, only a few observations in other categories are available at the annual
level, reducing the test power. The model we use is a simple extension of Models (1)
25
In particular, we run the following regression: CAR b0 b1(CORE_EPSF )/P+b2 INC=P
+b3 EXC=P+b4 OEXC=P+; where CAR is the 3-day abnormal returns around earnings announcements
and F is the analyst consensus forecast. We obtain b1 1:014; b2 0:299; b3 0:002; and b4 0:107;
with signicant differences between b2 and b3 and between b2 and b4. Note that CORE_EPSF is different
from the earnings surprise SURPRISE=street EPS2F=CORE_EPS+INCF. Assume that the market
treats the included items differently from core earnings, that is, b1 ab2 in CAR=b0+b1
SURPRISECORE_EPS+b2SURPRISEINC=b0+b1CORE_EPSFCORE_EPS/P+b2(INCFINC)/P. Then,
the coefcients b1 and b2 are not estimated by b1 and b2 in CAR=b0+b1(CORE_EPSFCORE_EPSFINC)/
P+b2 INC/P, given only the aggregate forecast F=FCORE_EPS+FINC is observable. Thus, this test should
be interpreted with care.
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and (3) as follows:
Dep Varit b0 b1 BV it =Pi;t1 b2 CORE_EPS it =Pi;t1

Sj cj1 INC_category j it =Pi;t1
Table 8
Regression results on tests of persistence and valuation multiples for individual categories
Model : Dep Varit b0 b1 BV it =Pi;t1 b2 CORE_EPSit =Pi;t1

Sj cj1 INC_category j it =Pi;t1
cj2 EXC_category j it =Pi;t1 b3 OEXC it =Pi;t1
ST d T YRit;T it
Dependent variable GAAP EPS1 yr /P OCF1 yr /P Ret
INTERCEPT 0.019 0.112 0.012

(3.39) (19.64) (1.38)
BV 0.051
(11.65)
CORE_EPS 2.568 1.169 1.036
(69.42) (31.09) (20.79)
INC_restruc. charge 0.698 0.248 0.224
(4.81) (1.69) (1.27)
EXC_restruc. Charge 0.300 0.275 0.158
(8.37) (7.71) (3.03)
INC_acqusition expense 1.922 1.095 0.684
(7.14) (3.57) (1.78)
EXC_acqusition expense 0.611 0.374 0.159
(8.08) (4.88) (1.36)
INC_asset sale gain 0.615 0.293 0.769
(3.67) (1.75) (2.97)
EXC_asset sale gain 0.139 0.011 0.690
(1.68) (0.14) (5.45)
INC_realized invest. gain 1.438 0.411 2.024
(3.17) (0.91) (2.79)
EXC_realized invest. gain 1.633 0.689 1.031
(3.92) (1.63) (1.68)
INC_remaining items 0.981 0.059 0.763
(7.17) (0.43) (3.91)
EXC_remaining items 0.481 0.211 0.274
(11.96) (5.22) (4.72)
OEXC 0.618 0.055 0.191
(16.95) (1.49) (4.02)
Adj. R2 0.325 0.078 0.046
N 16,708 14,769 19,102
For variable denitions, see Table 5. INC_category j and EXC_category j are INC and EXC in category j
with j=restructuring charge, acquisition expense, asset sale gain, realized investment gain, and remaining
items; YRit is a year dummy for quarter t belonging to year T (T =1994, 1995,y, 2001). Regressions are
run for observations pooled over 19932001. Numbers in parenthesis are t-statistics.
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cj2 EXC_category j it =Pi;t1

b3 OEXC it =Pi;t1 ST d T YRit;T it ; 6
where Dep Varit is EPSit,1 yr/Pit or OCFit,1 yr/Pit or Retit; INC_category j and
EXC_category j are inclusions and exclusions in category j with j=restructuring
charge, acquisition expense, asset sale gain, realized investment gain, and remaining
items; and, YRit,T is a year dummy for quarter t belonging to year T (T=1994,
1995,y,2001). Book value BVit is included only in the returns specication.
Table 8 reports the coefcient estimates except for the year dummies. In predicting
future earnings, inclusions in all categories except realized investment gain have
coefcients that are more than double those on exclusions. The differences
(untabulated) are economically substantial and statistically signicant (p-value
o0.01, one-tailed). In predicting future cash ows, all categories have substantially
higher coefcients on inclusions than on exclusions. The differences are statistically
signicant for restructuring charge, acquisition expense, and assent sale gain (p-
valueo0.10, one-tailed). Valuation results are somewhat weaker. While the
coefcients on inclusions are higher than on exclusions for acquisition expense,
investment gain, and remaining items, they are similar for asset sale gain and even
lower for restructuring charge. At least part of the reason for the lower multiple for
restructuring charge appears attributable to a cross-sectional dependence problem in
the pooled regression. If restructuring charge is considered separately with all other
items grouped together to allow for annual regressions, the mean multiple on
inclusions of restructuring charge is 0.394, as opposed to 0.219 on exclusions.
Overall, the higher persistence and valuation multiples of inclusions generally hold
for the few largest categories we examine, especially for persistence with regard to
future earnings.
5.3. Tests of future abnormal returns
Table 9 presents the results for hypothesis H3 based on Model (5) on whether the
information on nonrecurring items can be used to earn future abnormal returns.
Because each independent variable has been transformed to a measure of ten ordinal
numbers with a total distance of one,26 the coefcient can be interpreted as the
26
For SURPRISE, B/M, ln(SIZE), BETA, and ACCRUAL, all observations are used to sort the
variables into deciles to be replaced by ten ordinal numbers between zero and one with increments of 1/9,
as is normally done (see, e.g., Bernard and Thomas, 1990). A modication is made for the nonrecurring
items INC, EXC, OEXC, EXC_ALL, SI, and NSI. For each of these variables, all zero observations form
a single portfolio with their zero values retained. The nonzero observations are sorted into nine roughly
equal-sized portfolios, with portfolios of gains (losses) assigned consecutive positive (negative) numbers in
increments of 1/9. For example, if 80% of the nonzero observations are gains, then the gains are sorted
into 9 80%E7 portfolios that are numbered 1/9, 2/9,y,7/9. The 20% loss items are sorted into the
remaining two portfolios numbered 2/9 and 1/9. Variable values are then replaced by their portfolio
numbers. This procedure ensures that the zero observations maintain their relative ordinal position before
the data transformation. The reason for the modication is that the measures of these variables have many
zero values. For example, out of the 22,013 quarters, about one-seventh have nonzero inclusions. The
remaining majority of observations have exclusions that have measures of zero for INC. If INC were
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Table 9
Regression results on future abnormal returns tests
Panel A: inclusion and exclusion specified by First Call
Model : ADRtit b0 b1 SURPRISE it =Pi;t1 b2 INC it =Pi;t1 b3 EX C it =Pi;t1

b4 OEX C it =Pi;t1 b5 B=M it bb lnSIZE it b7 BETAit it 5
Return (ADRet) measurement 1 quarter 1 year 2 years

window
INTERCEPT 0.010 0.064 0.174

(0.47) (1.02) (2.16)
SURPRISE 0.023 0.070 0.096
(2.18) (2.61) (1.41)
INC 0.034 0.010 0.024
(0.98) (0.36) (0.24)
EXC 0.005 0.020 0.020
(0.67) (0.94) (0.33)
OEXC 0.002 0.034 0.058
(0.21) (0.89) (1.09)
B/M 0.021 0.111 0.158
(1.18) (1.80) (0.95)
ln(SIZE) 0.002 0.044 0.111
(0.09) (0.71) (0.86)
BETA 0.023 0.002 0.259
(0.67) (0.02) (1.15)
Mean adj. R2 0.031 0.055 0.049
Mean N 1451 1432 1296
(cont.)
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Table 9 (continued)
Panel B: Total exclusions and decomposition into special items and others
Model : ADRetit;1 yr b0 b1 SURPRISE it =Pi;t1 b2 INC it =Pi;t1 b3 SI it =Pi;t1

b4 NSI it =Pi;t1 b5 B=M it bb lnSIZE it b7 BETAit it 5
1 2 3 4 5
INTERCEPT 0.024 0.004 0.019 0.016 0.028

(0.42) (0.070) (0.34) (0.29) (0.60)
SURPRISE 0.085
(3.16)
INC 0.005
(0.15)
EXC_ALL 0.005 0.010
(0.20) (0.41)
SI 0.027 0.046 0.042
(1.23) (1.94) (1.79)
NSI 0.022 0.016 0.009
(0.78) (0.57) (0.32)
ACCRUAL 0.044 0.053 0.055
(1.76) (2.10) (2.15)
B/M 0.097 0.089 0.099 0.089 0.091
(1.52) (1.41) (1.56) (1.42) (1.48)
ln(SIZE) 0.048 0.049 0.049 0.051 0.052
(0.75) (0.78) (0.79) (0.82) (0.84)
BETA 0.002 0.004 0.002 0.004 0.006
(0.02) (0.03) (0.02) (0.03) (0.05)
Mean adj. R2 0.048 0.048 0.048 0.048 0.052
Mean N 1239 1239 1239 1239 1239
For variable denitions, see Table 5. Variables SURPRISE, B/M, ln(SIZE), BETA, and ACCRUAL are
rst sorted into deciles and replaced by decile ranks, which are further transformed into a number between
zero and one with increments of 1/9. A modication is made for the nonrecurring items INC, EXC, OEXC,
EXC_ALL, SI, and NSI. For each of these variables, all zero observations form a single portfolio with
their zero values retained. The nonzero observations are sorted into nine roughly equal-sized portfolios,
with portfolios of gains (losses) assigned consecutive positive (negative) numbers in increments of 1/9. For
example, if 80% of the nonzero observations are gains, then the gains are sorted into 9 80%E7
portfolios that are numbered 1/9, 2/9,y,7/9. The 20% loss items are sorted into the remaining two
portfolios numbered 2/9 and 1/9. Variable values are replaced by their portfolio numbers. This
procedure ensures that the zero observation maintains their relative ordinal position before the data
transformation. Regressions are run for each year of 19932001. Observations before 1993 are pooled with
those of 1993. The coefcients are the time-series means of annual coefcients. Numbers in parenthesis are
t-statistics obtained from dividing the means by their standard deviations.
Cutoff points for t-stat signicance levels (df=8) are, for one-tailed: 1.397 (10%), 1.860 (5%), 2.897 (1%);
for two-tailed: 1.860 (10%), 2.306 (5%), 3.355 (1%).
ARTICLE IN PRESS
abnormal return to a hedge portfolio with a long position in those rms with the
highest measure and a short position in those with the lowest measure, all else
constant.
For the various return windows, the only consistent result is for SURPRISE. A
long (short) position in the most positive (negative) earnings surprises is able to yield
2.3% in one quarter, 7.0% in 1 year, and 9.6% in 2 years following the earnings
announcements. The control variables B/M, ln(SIZE), and BETA are mostly
insignicant. Considering the higher multiples on the included items compared to the
excluded ones reported earlier, there is no evidence that the inclusions are initially
overvalued or that the exclusions are undervalued, leading to corrections at a later
date. Their coefcients are not only statistically insignicant but also generally
smaller in magnitude compared to those on SURPRISE. Given the effect of
inclusions might be subsumed by SURPRISE since inclusions are part of street
earnings used to calculate SURPRISE, we also exclude SURPRISE and nd no
qualitative change of INC.
Burgstahler et al. (2002) and Doyle et al. (2003) nd that special items, total
exclusions, or exclusions other than special items can be used to predict future
abnormal returns, suggesting that the initial market reactions to these items are
incomplete. To examine whether their results hold in our sample, we consider
these items in Panel B for the 1-year window. Results for the 2-year window are
even weaker. Unlike Doyle et al. (2003), who nd about 5% of abnormal
returns based on EXC_ALL, we nd no such abnormal returns with or without the
presence of ACCRUAL (columns 1 and 2). When EXC_ALL is decomposed into
special items SI and nonspecial items NSI (columns 3 and 4), there appear to be
some abnormal returns based on SI only in the presence of ACCRUAL. However, as
discussed earlier, this must be taken with caution due to the overlap between the SI
and ACCRUAL measures (see footnote 10). The net effect of SI is smaller because of
the negative coefcient on ACCRUAL, which contains noncash special items. We do
not nd any signicance for NSI as Doyle et al. (2003) do. Our results are
qualitatively the same if we only use observations with nonzero exclusions or
use all special items, whether included or excluded. It appears that the only robust
results for the abnormal returns are the post-earnings announcement drift captured
by SURPRISE and the accrual anomaly captured by ACCRUAL as shown in
column 5.
More importantly, for the items we are interested in, we nd no evidence that the
market misvalues the items that analysts specify as included in or excluded from
street earnings. There are several potential explanations for the different results of
our study compared to others that document market misvaluation of special items or
(footnote continued)
sorted into deciles based on all observations, essentially all gains would be put in the highest portfolio and
all losses in the lowest portfolio. The other observations would be randomly assigned to portfolios 29
even though their zero measures are identical. Our modication makes sure that the zero observations are
still valued lower than gains but higher than losses.
ARTICLE IN PRESS
other exclusions. For example, the samples are quite different. Burgstahler
et al. (2002) use the Compustat population during 19821997. Doyle et al.
(2003) use the IBES population during 19881999. Our sample for the
abnormal returns test is based on a subsample of the First Call population
with specied nonrecurring items. In addition, the market understanding
could also be more complete when analysts provide specic information
on their awareness of the items and how they have treated them. One ex-
tension to this study then would be to contrast those items never mentioned by
analysts with the items studied here, and to observe how they differ in the market
valuation.
6. Conclusions
No accounting item is absolutely recurring or nonrecurring. In practice, the

appropriate treatment of potentially transitory components of earnings is a matter
of professional judgment. Although certain items are typically classied as
nonrecurring on the books by the accounting rules, some can be less so than
others. We show that the differential treatment of nonrecurring items in street
earnings is justiable from the valuation use of street earnings. The items
that analysts decide to include in street earnings are valued more by the market
than the excluded items. Such a valuation difference is supported by the under-
lying difference in the persistence of the items. Although the included gains and
losses differ somewhat in their persistence with regard to different future
performance measures and in their valuation multiples, both either dominate or
are never worse off than their excluded counterparts. In addition, we nd no
evidence of mispricing of inclusions or exclusions that leads to future abnormal
returns. Overall, the included items behave more closely like the core earnings and
the excluded items behave more like transitory components. Even though the
excluded items still have some predictive power and valuation effect, separating them
from the core earnings may be warranted. However, it remains an empirically
challenging question to determine what the appropriate cut-off point should be for
an item to be considered materially different from others and receive a separate
treatment.
Our paper adds to the large body of literature on analysts expertise in processing
earnings information. For example, Brown et al. (1987) demonstrate that
analysts are superior in forecasting earnings than time-series models. Barber et al.
(2001) show that analysts are able to pick and recommend superiorly performing
stocks. Since the valuation use of street earnings is likely an input for analysts
stock recommendations, their selective inclusion and exclusion of nonrecurring
items appears to be consistent with their superior stock picking capability. Although
their expertise is partially attributable to management recommendations, analysts
exert their own professional judgment and provide a value-added service to
investors.
166
Appendix A. Example of First Call footnote entries: CNA nancial corp., Quarter 3, 1999
GAAP EPS 0.15

Less: exclusions (0.28)
Street EPS 0.43
Less: inclusions (0.06)
CORE_EPS 0.49
First Calls footnote entries:
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Security Data DDC Currency Periodicity Fiscal period Footnote System Footnote Footnote Footnote
ID type end date date type code text
174700 EPS USD Q 09/30/ 11/03/1999 11/03/1999 NE L 0.28 Realized

1999 09:45 09:55 investment
loss
174700 EPS USD Q 09/30/1999 11/03/1999 11/03/1999 NI R 0.06
10:15 10:22 Restructuring
charge
Security IDFirst Call internal ID, unique for each security.

Data typeThe type of data that the value represents. For example, EPSEarnings per share and CFPSCash ow per share.
DDCData differentiator code that indicates a discontinuity in the values shown due to an event such as a merger or accounting change.
CurrencyCurrency in which the value is expressed.
PeriodicityThe period that the footnotes cover. A=Annual and Q=Quarterly.
Fiscal period endThe date of the end of the period that the footnotes cover.
Footnote dateDate and time of footnote.
System dateDate and time footnote was entered into system.
Footnote typeIndicator of whether the footnote is due to an item being included or excluded, or, due to the value being restated. The types that we use are:
NENonextraordinary items excluded from gures; NINonextraordinary items included in gures; MSMiscellaneous that do not fall into other categories.
Footnote codeCode explaining the category of the unusual item included or excluded in the First Call actual earnings. Here, LRealized investment loss;
RRestructuring charge. Other codes include: AAcquisition expense, BAcquisition gain, CLitigation charge, etc.
Footnote textAmount and more details of the unusual item. When footnote type is MS, footnote text also indicates the inclusion/exclusion decision.
Appendix B. Selective validation of First Call data
This appendix describes our selective validation of the First Call footnote entries of nonrecurring items. For rms with
inclusions (INC60), with First Call-specied exclusions accounting for all exclusions (EXC60, OEXC=0), with specied
exclusions not accounting for all exclusions (EXC60, OEXC60), and with no specied nonrecurring items, we randomly pick
40 observations in each group and search newswires on Lexis and Nexis to obtain rms earnings announcements. When

restricting the search to the words pro forma, Bhattacharya et al. (2003) nd only a small number of rms that provide pro
forma earnings. However, Bradshaw and Sloan (2002) nd that the majority of rms discuss earnings other than GAAP
earnings nowadays, which may serve as de facto pro forma earnings. We take the broader denition and regard rms as
disclosing pro forma earnings if management discusses other earnings, including cases in which management talks about
nonrecurring items without necessarily giving the earnings numbers after excluding them. These, however, do not include cases
where management talks about earnings before and after extraordinary items or EBITDA, unless First Call disagrees on
ARTICLE IN PRESS
whether an item should be regarded as extraordinary or just unusual. The results are summarized in the following table.
Group (40 cases in Pro forma Details GAAP Details

each group) earnings discussed earnings only
in earnings in earnings
announcement announcement
INC60 33 25: Street=GAAP 7 FCs own inclusions

3: Compustat error (causing 4: Street=GAAP
OEXC 6 0),
Street=GAAPmgt 3: Street6GAAP (OEXC60 with unspecied FC
6GAAPcomp exclusion)
2: Street=Pro forma, included
items different from those
discussed by management
2: FC error, exclusion entered as
inclusion
1: Street includes an item
regarded as extraordinary item
by Compustat
EXC60; OEXC=0 38 36: Street=Pro forma 2 FCs own exclusions
167
1: management discusses 2 items,
FC excludes 1
1: management does not give
168
amount of item
EXC60; OEXC60 36 16: OEXC60 because 4 3: OEXC60 due to unspecied FC exclusion
GAAPcomp6GAAPmgt
Street=Pro forma mostly 1: OEXC60 due to Compustat error,
2: also due to unspecied FC Street=GAAPmgt6GAAPcomp

exclusion,
1: also due to FC error, loss
entered as gain
8: OEXC60 due to unspecied
FC exclusion
5: OEXC60 due to tax
adjustment error,
ARTICLE IN PRESS
Street reconcilable with GAAP
5: OEXC60 due to FC error
2: duplication, in separate
categories or separately in
aggregate and per share
amounts
1: loss entered as gain
1: split adjustment error
1: inclusion entered as
exclusion
2: OEXC60 due to FC exclusion
of items regarded as
extraordinary by Compustat
No footnote entries 8 5: Street=Pro forma (FC 32 30: Street=GAAP
unspecied exclusions)
1: Street FC=GAAP (FC 1: Compustat error,
unspecied inclusions)
2: Trivial nonrecurring items Street=GAAPmgt6GAAPcomp
such that Street=Pro
forma=GAAP
1: Street6GAAP (FC unspecied exclusions)
Note: FC=First Call; Street=Street EPS (First Call actual earnings); Pro forma=Pro forma earnings discussed by management in earnings announcements;
GAAPmgt=GAAP EPS discussed by management; GAAPcomp=GAAP EPS (#9 or #19) in Compustat; If GAAPmgt=GAAPcomp, we simply use GAAP to
denote both.
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Journal of Accounting and Economics 38 (2004) 129170

Analysts treatment of nonrecurring items in

JEL classification: M41; G10

2. Background and hypotheses

2.1. Institutional background

For a nonextraordinary charge or gain that might be considered nonrecurring

H2. Nonrecurring items included in street earnings have higher valuation

First Call-specified nonrecurring items

Street EPS EXC_ALL

GAAP EPS before Extraordinary items

GAAP EPS after Extraordinary items

3.1. Tests of persistence

Hypothesis H1 predicts that nonrecurring items included in street earnings are

Dep Varit b0 b1 CORE_EPS it =Pi;t1 b2 INC it =Pi;t1

3.2. Valuation tests

3.3. Tests of future abnormal returns

Hypothesis H3 predicts that the market reaction to the differential persistence of

where ADRetit is the market-adjusted return measured as the compounded

4. Sample and descriptive statistics

4.1. First Call data

GAAP earnings.14 In ve cases, other exclusions arise due to imprecise tax

4.2. Other variables

4.3. Descriptive statistics

Quarterly Footnote entries with nonrecurring items specied in the 29,168

# Of quarters with # Of rms % Relative to total # Of rm quarters

1 1710 29.79 1710

Year Number of %o0 Number of %o0 Number of other %o0

1990 4 25.0 1 0.0 1 100.0

Type Number of Percent Number of Percent of Number of Percent of

Z. Gu, T. Chen / Journal of Accounting and Economics 38 (2004) 129170

Restructuring charge 6317 22.13 626 9.91 5691 90.09

Total 28,542 100 4028 14.11 24,514 85.89

2 Street EPS Street EPS+EXC

1- and 2-year-ahead market-adjusted stock returns are negative as in Doyle et al.

Mean Median Std. dev.

Panel A: earnings and nonrecurring items in $ (% of lagged prices in parenthesis)

Table 5 footnote (continued)

5.1. Tests of persistence

Panel A: gains and losses of nonrecurring items are considered together

INTERCEPT (b0) 0.015 0.013 0.013 0.016 0.021

Panel B: gains and losses of nonrecurring items are considered together

Model : OCF it;1 yr =Pit b0 b1 CORE_EPSit =Pi;t1 b2 INC it =Pi;t1

INTERCEPT (b0) 0.093 0.093 0.093 0.091 0.082

Model : Dep Varit b0 b1 CORE_EPSit =Pi;t1 b21 INC

b0 0.010 0.019 0.089 0.02

Tests on coefficient differences

Mean adj. R2 0.282 0.370 0.073 0.092

have signicantly positive coefcients.24 As discussed in footnote 10, the change

5.2. Valuation tests

5.2.1. Main results

Models : Retit b0 b1 BV it =Pi;t1 b2 CORE_EPSit =Pi;t1

Retit b0 b1 BV it =Pi;t1 b2 CORE_EPSit =Pi;t1 b3 INC

Model (3) Model (4)

INTERCEPT (b0) 0.008 0.008 0.009 INTERCEPT (b0) 0.011

We nd that the multiple on CORE_EPS is 10.17, which means $1 of core earnings is

5.2.2. Additional tests for individual categories of nonrecurring items

and (3) as follows:

Dep Varit b0 b1 BV it =Pi;t1 b2 CORE_EPS it =Pi;t1

Model : Dep Varit b0 b1 BV it =Pi;t1 b2 CORE_EPSit =Pi;t1

Dependent variable GAAP EPS1 yr /P OCF1 yr /P Ret

INTERCEPT 0.019 0.112 0.012

cj2 EXC_category j it =Pi;t1

5.3. Tests of future abnormal returns