Do Firm-to-Segment Reconcilable Earnings Differences Affect Stock Prices?

While SFAS No. 131 is intended to increase the transparency of financial reporting using a "management approach", it may reduce shareholders’ ability to interpret segment disclosures relative to the 'industry approach' employed under SFAS No.14. This study investigates whether firm-segment reconcilable differences (FSD) affect stock prices and whether abnormal returns can be earned using information about two components of earnings: aggregated segment earnings and FSDs. We compute FSDs as the difference between firm-level consolidated earnings and aggregated segment-level earnings. Firms that report negative FSDs have greater sales and profitability, greater return on equity, as well as more operating cash flows and firm growth. This suggests firms that report aggregated segment earnings greater than firm-level consolidated earnings may better off financially as a firm. Our findings show that mispricing does occur, when firms report positive FSDs, by the market underestimating FSD persistence. Investors can also earn positive abnormal returns when investors take a long (short) position with the portfolio with the highest (lowest) absolute FSDs. On the contrary, we find investors earn negative abnormal returns when firms report negative FSDs. Collectively, this study provides evidence that mispricing occurs and that investors over/under estimate the importance and/or persistence of FSDs.