Accounting Classification and the Predictive Content of Earnings

The accounting profession requires that firms disaggregate net income into specific components. Despite the widespread assumption that earnings disaggregation is important for assessing firm profitability, there is little empirical evidence that the classification scheme actually improves profitability forecasts. We analyze accuracy improvements in out-of-sample forecasts of one-year ahead return-on-equity (ROE) to examine the predictive content of earnings disaggregations. The results demonstrate that the classification scheme prescribed by the accounting profession does increase the predictive content of reported earnings. We find forecasting improvements from earnings disaggregation. These improvements go beyond separating extraordinary items and discontinued operations from the other components of earnings. Further disaggregation of earnings (into operating earnings, non-operating earnings and taxes, and special items) improves forecasts of ROE one year ahead.