counting Standards Board (FASB), an organization established in 1973 to
establish accounting standards. These standards are called the generally
accepted accounting principles(GAAP), and they are used to compute the
earnings that appear in the annual report and are filed with government
agencies.^13
The other more generous concept of earnings is called operating
earnings. Operating earnings represent ongoing revenues and expenses,
omitting unusual items that occur on a one-time basis. For example, op-
erating earnings often exclude restructuring charges (for example, ex-
penses associated with a firm’s closing a plant or selling a division),
investment gains and losses, inventory write-offs, expenses associated
with mergers and spin-offs, and depreciation of “goodwill.”
Operating earnings are what Wall Street watches and what analysts
forecast. The difference between the operating earnings a firm reports
and what analysts expect it to report is what drives stocks during the
“earnings season,” which occurs in the few weeks following the end of
each quarter. When we hear that XYZ Corporation “beat the Street,” it
invariably means that its earnings came in above the average (or con-
sensus) forecast of operatingearnings.
In theory, operating earnings gives a more accurate assessment of the
long-term sustainable profits of a firm than reported earnings gives. But
the concept of operating earnings is not formally defined by the account-
ing profession, and its calculation involves much management discretion.
As management has come under increasing pressure to beat the Street’s
earnings forecasts, they are motivated to “stretch the envelope” and ex-
clude more expenses (or include more revenues) than are appropriate.
The data show the increased gap between reported and operating
earnings in recent years. From 1970 to 1990, reported earnings averaged
only 2 percent below operating earnings. Since 1991, the average differ-
ence between operating and reported earnings has widened to over 18
percent, nine times the previous average.^14 In 2002, the gap between the
two earnings concepts widened to a record 67 percent. However, in 2006,
this earnings gap had narrowed to about 7 percent.^15
During the later phases of the bull market of the 1990s, some firms,
particularly those in the technology sector, were rightly criticized for ex-CHAPTER 7 Stocks: Sources and Measures of Market Value 103
(^13) Although earnings filed with the IRS may differ from these.
(^14) It was partly the favorable reaction of investors themselves that spurred management to increase
write-offs. In the 1990 to 1991 recession, investors bought firms that had large write-offs because the
investors believed that those firms would drop losing divisions and become more profitable.
(^15) See the S&P 500 Web site on earnings.