Mandatory Earnings Disaggregation and the Value Relevance, Persistence and Pricing of Earnings Components: South African Evidence

Abstract

Thus far, the disaggregation of non-recurring items from earnings has been investigated mostly in the United States, in the context of special items and pro forma earnings. The disclosure of these items is mainly on a voluntary basis. Managers of firms have significant discretion in the calculation of such items (McVay, 2006). In this regard, the literature suggests that non-recurring items have lower persistence than recurring items, and that recurring earnings has higher value relevance than earnings determined in accordance with Generally Accepted Accounting Practice (GAAP) (Bradshaw and Sloan, 2002; Brown and Sivakumar, 2003). However, surprisingly, non-recurring items (both special items and exclusions from pro forma earnings) are significantly mispriced in the United States (Dechow and Ge, 2006; Doyle, Lundholm and Soliman, 2003). This evidence suggests that, despite the apparently transitory nature of non-recurring items, investors are unable to estimate their implications for future earnings accurately. In this study, this anomaly is investigated by focusing on a different regulatory setting. In South Africa, firms listed on the Johannesburg Securities Exchange (JSE) are required to disclose headline earnings in addition to earnings determined in accordance with the International Financial Reporting Standards (IFRSs). Headline earnings effectively excludes some non-recurring items. In addition, firms are required to present a reconciliation between headline earnings and IFRS earnings in the financial statements. The South African setting differs from the United States in two important respects. Firstly, all firms are required to present headline earnings in South Africa, whereas pro forma earnings reporting is voluntary in the United States. Secondly, the allowable exclusions from headline earnings are formally defined and subject to external audit, while firms in the United States are allowed to define their own exclusions from pro forma earnings. This study investigates the value relevance, persistence and pricing of the earnings components that result from the headline earnings definition in South Africa. The results indicate that headline earnings exclusions contain information that is incrementally value relevant to IFRS earnings. This evidence suggests that investors find the disaggregation of headline earnings from basic earnings useful. In a sub-sample of firms with positive earnings, headline earnings appears to have higher value relevance than IFRS earnings. The persistence tests indicate that, as expected, headline earnings exclusions (the nonrecurring part of earnings) display lower persistence than headline earnings (the recurring part of earnings). The study shows -- consistent with Sloan‟s (1996) findings -- that accruals are less persistent than cash flows. This can be attributed largely to headline earnings exclusions. The pricing tests indicate that investors significantly underweight the cash flow component of earnings. Notably, neither headline earnings exclusions nor any of the other earnings components reflect significant mispricing. When additional explanatory variables are included in the analyses, the mispricing of the cash flow component disappears.