Where is the Line? The Effect of Narrowed Scope of Discontinued Operations on Earnings Quality and Analysts’ Forecasts

Abstract

In the past decades, the U.S. accounting standards have been trending toward more narrowed scope for the “below-the-line” items. This study examines whether the quality of “above-the-line” (or core) earnings and analysts’ forecasts is affected by the recent major rule change in this regard (i.e., ASU2014-8), which imposes much more stringent criteria for classifying dispositions as below-the-line items (i.e., discontinued operations). Using data surrounding this rule change, we find that the frequency of reported discontinued operations significantly reduces after the change, suggesting underlying dispositions being buried in the core earnings. More importantly, we find that the persistence and response coefficient of core earnings significantly reduce and that analysts’ forecast error and dispersion increase. Thus, the narrowed scope of below-the-line items required by ASU 2014-8 introduces significant noise to core earnings and increases information asymmetry and uncertainty between managers and financial analysts. Our findings should be of interest to accounting regulators, firm managers, analysts, and investors when they interpret both above- and below-the-line items.