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    0706-16 Stephen Taylor Report (PDF) 0706-16 Stephen Taylor Report (PDF) Document Transcript

    • The Institute of Chartered Accountants in Australia GAAP-based financial reporting: measurement of business performance charteredaccountants.com.au Professor Stephen Taylor, The University of New South Wales, Sydney, Australia
    • The Institute of Chartered Accountants in Australia Foreword The Institute of Chartered Accountants in the Chartered Accountant brand. We also Australia (the Institute) is the professional represent the interests of members to The use of extensions to traditional financial reporting to capture performance body representing Chartered Accountants government, industry, academia and the information, for example, the value of intangibles, corporate social responsibility in Australia. Our reach extends to more than general public by actively engaging our and sustainable strategies has become common practice. For accountants, 53,000 of today and tomorrow’s business membership and local and international bodies as preparers and interpreters of traditional financial statements, there is now leaders, representing some 43,000 on public policy, government legislation and a required awareness of these new reporting extensions. Chartered Accountants and 10,000 of regulatory issues. The Institute of Chartered Accountants in Australia, the premier accounting body Australia’s best accounting graduates who The Institute can leverage advantages for its in the country, has a mandate to ensure that accounting as a discipline evolves to are currently enrolled in our world-class members as a founding member of the Global meet these changes. This monograph was commissioned by the Institute and post-graduate program. Accounting Alliance (GAA), an international written by Professor Stephen Taylor from the University of New South Wales in Our members work in diverse roles across accounting coalition formed by the world’s Sydney. It provides an overview of the ‘conventional’ financial reporting produced commerce and industry, academia, premier accounting bodies. The GAA has a by the application of generally accepted accounting principles (GAAP). It is, in many government, and public practice throughout membership of 700,000 and promotes quality ways, a prequel to the reports, Extended performance reporting: an overview of Australia and in 107 countries around the world. professional services to share information and techniques, and Extended performance reporting: a review of empirical studies, both We aim to lead the profession by delivering collaborate on international accounting issues. produced by the Institute this year. The first, a stocktake report, provides a broad visionary thought leadership projects, Established in 1928, the Institute is overview of the major developments in extended performance reporting techniques setting the benchmark for the highest constituted by Royal Charter. For further worldwide. The second reviews these methods of reporting and what recent ethical, professional and educational information about the Institute, visit studies have found as to their value. standards and enhancing and promoting charteredaccountants.com.au GAAP-based financial reporting: measurement of business performances reviews GAAP to provide a clear understanding of the base from which extensions to traditional financial reporting are moving on from. The intention in producing this monograph, and the extended performance series, is to ensure that accounting maintains its significance in the evolving reporting landscape. I hope that you find it both interesting and valuable. About this report Neil Faulkner FCA This monograph was written by Professor President Stephen Taylor from the University of New Institute of Chartered Accountants in Australia South Wales in Sydney, Australia. All materials in this monograph is current as at July 2006. In producing this monograph the author acknowledges the benefit from discussions with colleagues at the School of Accounting, University of New South Wales, and particularly the comments on earlier drafts by Jeff Coulton (UNSW), Sarah McVay (NYU) and Caitlin Ruddock (UNSW). © The Institute of Chartered Accountants in Australia 2006 First published August 2006. First edition. Published by: The Institute of Chartered Accountants in Australia Address: 37 York Street, Sydney, New South Wales 2000 Author: Professor Stephen Taylor ISBN: 1-921245-05-0 Disclaimer: This monograph presents the opinions and comments of the author and not necessarily those of the Institute of Chartered Accountants in Australia (the Institute) or its members. The contents are for general information only. They are not intended as professional advice – for that you should consult a Chartered Accountant or other suitably qualified professional. The Institute expressly disclaims all liability for any loss or damage arising from reliance upon any information contained in this paper. The Institute of Chartered Accountants in Australia ABN 50 084 642 571 The Institute of Chartered Accountants in Australia Incorporated in Australia Members’ Liability Limited. 0706-16 GAAP-based financial reporting: measurement of business performance
    • Contents Executive summary 06 Introduction 08 1 How ‘useful’ are GAAP metrics for evaluating business performance? 12 1.1 Introduction 12 1.2 Does GAAP produce ‘value relevant’ measures? 14 1.3 How fully do market participants understand accrual accounting? 17 1.4 Direct evidence on the value relevance of GAAP performance measures 19 1.5 Conservatism and GAAP reporting 22 1.6 Summary 25 2 What is the quality of GAAP accounting measures? 26 2.1 Introduction 26 2.2 Measuring earnings quality and earnings management 27 2.3 Examples of earnings management 29 2.4 Incentives to report high quality earnings 32 2.5 Summary 35 3 Evidence on ‘modified GAAP’ reporting 36 3.1 Introduction 36 3.2 Comprehensive income 38 3.3 Street earnings — is this a selective narrowing of GAAP income (and does it improve earnings as a measure of business performance)? 40 3.4 Pro-forma earnings — telling it like it is or how you want it to be seen? 43 3.5 Summary 46 4 Conclusion 47 Bibliography 48 The Institute of Chartered Accountants in Australia 05 > GAAP-based financial reporting: measurement of business performance
    • Executive summary The report provides an overview of by others. However, for the most part the > The demands placed on the financial > Survey evidence suggests that, at least in current knowledge about the state of findings from a large body of archival-empirical reporting model by its role in defining and recent times, managers are more likely to ‘conventional’ financial reporting and the accounting research are quite clear. enforcing contractual relations (the engage in economic manipulation in measurement of business performance. Major findings can be summarised as follows: contracting role) may sometimes conflict with preference to accounting manipulation. This The term ‘conventional’ implies an the role of financial reporting as inputs to suggests that the GAAP reporting framework > Forty years of academic research suggests is relatively robust, but that a by-product of analysis of what we know about financial investment evaluation procedures that existing measures of financial such robustness is dysfunctional behaviour reporting produced by the application of performance (i.e. income) and financial > For example, shifts in the measurement basis generally accepted accounting principles of GAAP towards mark-to-market could have by management position (balance sheet) are value relevant — (GAAP). It is intended to inform those negative repercussions for the contracting > Although there is some evidence suggesting that is, the measures are correlated with interested in the future of financial role of financial reporting that corporate governance is positively market values and changes therein reporting by providing a summary of key > On the other hand, conservatism in financial related to accounting quality, it is not clear > Periodic financial reporting is not very timely whether better governance ‘causes’ better evidence about the existing GAAP reporting may be desirable from a contracting — most value relevant information is quality accounting, or whether both are a model. In particular, two key questions perspective, but of little use in helping impounded into prices well before the reflection of factors such as different are addressed: investors use accounting numbers in release of periodic financial reports business models valuation models. Conservatism is also likely > What are the factors underlying the > The accrual accounting process does what to reflect regulators’ and politicians’ concerns > Managers’ attempts at highlighting ‘pro- demand for measurement of business it is supposed to do — it provides better with minimising economic losses by investors forma’ or ‘street’ earnings measures in performance? matching of economic costs and benefits preference to GAAP earnings is often alleged > The definition of high quality financial > How successful are existing, GAAP- than cash accounting to be self-serving, but there is evidence reporting and, ultimately, decisions about based methods for the measurement of > Existing measures of financial performance what is ‘best’, are inevitably dependent on suggesting that these ‘modified GAAP’ business performance? and position play an important part in the the perspective of those making such measures may be more informative than their The first question is important because the measurement of business value judgement. Put simply, accounting quality GAAP counterparts answers can help us to understand why the > Despite widespread understanding of how has many dimensions > Security analysts and other investment existing GAAP model looks like it does, in accrual accounting ‘works’, it appears as > Approximately 40 years of empirical research professionals appear to favour the exclusion contrast to alternatives which either modify though market participants do not rationally suggests that existing measures of financial of at least some non-recurring items from the measurement and/or recognition criteria evaluate periodic financial reporting performance (i.e. GAAP reporting) display at what is otherwise GAAP-compliant income. within GAAP, or fundamentally extend the measures in terms of differences between least some evidence of providing useful business reporting model to capture other attributes of cash and attributes of accrual information for contracting and investment dimensions of performance (e.g. accounting evaluation applications. On the other hand, environmental reporting). In effect, this is > ‘Value relevance’ is only part of how the the extent to which alternative models for simply saying ‘let’s understand why we have existing financial reporting model should be business reporting display such attributes (to what we have’, before we consider whether evaluated. Periodic financial reporting has its a greater or lesser extent) is largely unknown we should have something different! roots in the stewardship role of managers > There are a large number of studies that The second question is important because it who were separated from the owners and support the view that managers are able to requires the identification of criteria against who had to account for the use of the funds. manipulate GAAP accounting in response to which the success (or otherwise) of the GAAP More broadly, this is the ‘contracting’ role of capital market incentives, examples of which model can be evaluated. Of course, any such accounting include avoiding losses, earnings declines answer must reflect a somewhat subjective > The use of financial reporting to define and and earnings disappointments, as well as definition of success. Success is defined in a enforce contracts (both explicit and implicit) capital raisings number of ways, including the extent to which gives rise to important characteristics of > There are also a large number of studies that periodic performance measures such as net financial reporting, such as verifiability and show a link between accounting income are ‘value relevant’, as well as the conservatism. Such characteristics (and the manipulation and pay-offs from contracts extent to which existing measures of periodic underlying demand) are often overlooked by using accounting numbers — for example, financial reporting are susceptible to those who argue and/or enforce change in bonus plans and debt contracts. However, manipulation. Although the findings outlined the financial reporting model this evidence is generally weaker than capital are a reflection of the inevitably selective market incentives summarisation of extant accounting research, explicit recognition has been given to instances where the conclusions offered may be disputed 06 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 07 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • Introduction This monograph is motivated by concerns GAAP reporting and market prices. However, compensation is tied to a measure of The ‘economic Darwinism’ reflected above that the existing method of measuring a key plank in this review of empirical evidence accounting earnings rather than simply share should not be interpreted as a claim that the financial performance and, by implication, is the recognition that an equally if not more price movements (Sloan 1993). Share prices existing financial reporting model is not capable financial position is in need of potentially important role of financial reporting is to are a noisy measure of management of improvement. At no stage in this review is it significant changes. Financial reporting provide information useful for contracting. performance and, provided at least some of claimed that the existing GAAP-based model of encompasses not only the basic financial What do we mean by contracting? Historical this noise is not present in accounting financial reporting cannot be improved as a statements (i.e. income statement, balance evidence suggests that a primary determinant measures of performance such as periodic measure of business performance. It is one sheet and cash flow statement), but also of the demand for financial reporting (and income, then it is rational to include some thing, however, to agree that change may be the plethora of statutory reporting within extensions to dimensions such as the auditing income-related component in compensation. desirable, but another entirely to agree on what the annual report (e.g. remuneration report) of these reports) can be attributed to the Evidence on the role of accounting numbers in those changes should be. Concepts such as and even the ongoing requirements to reliance on these numbers as a means of defining and enforcing financial contracts is triple bottom line, sustainability reporting, ensure an informed market via continuous defining and subsequently enforcing financial important, because the earliest instances of intellectual capital measurement and disclosure rules. relationships.2 In modern-day terms, think of a explicit production of financial reports appear to environmental reporting all have their However, most attention on possible changes debt contract — an instrument designed for be in the context of accounting to owners for proponents. For the most part though, to the financial reporting model that result from determining and then enforcing the conditions investments in voyages of adventure (Watts & arguments in favour of what may be quite the application of GAAP are inevitably focused under which a business may borrow funds and Zimmerman 1983). Since that time contracts fundamental changes (or at least extensions) to on the periodic financial statements, and then apply such funds to investment that have ultimately come to be seen as GAAP-based financial reporting rarely especially the key summary measures that are opportunities. This contract uses various arranging terms of financing (e.g. debt commence by carefully considering what we produced under the existing financial reporting measures either directly sourced from the contracts) or for performance-based pay have currently have as the financial reporting model, model.1 These are various measures of income audited financial statements such as leverage been able to select appropriate measures on and why we have it. (often termed financial performance) and or interest coverage, or possibly measures that which to define the relationship and measure In many senses, what follows is comparable corresponding measures of accounting reflect transparent modifications of these compliance. As contracts have evolved with to the first stage of planning a trip. We cannot ‘worth’, such as owners’ equity/net numbers (e.g. net tangible assets rather than changing business circumstances, so has the hope to plan how to get to our destination if assets/book value or total assets (often termed net assets).3 Naturally, the exact design of debt demand for accounting as a technology for use we do not know where we are commencing measures of financial position). Evidence on contracts varies with the fundamental attributes in contracting. Contracting parties are not the journey. In a similar vein, it is hard to the ‘usefulness’ of these measures is therefore of the debt finance (e.g. private versus public, bound necessarily by the rules that determine rigorously evaluate recommendations for the primary focus of this monograph. fixed versus floating, secured versus GAAP reporting as produced in external change unless we have a solid grounding in Of course, assessment of ‘usefulness’ invokes unsecured, etc.). However, the overriding financial reports. However, there is likely to be a where we are currently. This monograph an obvious question — useful to whom? The lesson is clear — debt contracts use GAAP- strong overlap between accounting used within attempts to provide such a roadmap of the structure of this monograph reflects the most based numbers to define and enforce firms and that which is used externally. existing financial reporting landscape, not identifiable tension in assessing the usefulness lender/borrower relationships. Proponents of various extensions to the current saying where we should go, but rather of the GAAP model of reporting for measuring A similar contracting role for the financial GAAP-based model of financial reporting must showing where we are currently. It is worth business performance. On the one hand, the reporting system is evident in the surely be obliged to explain why measures that considering why the existing financial investment or valuation perspective suggests compensation of management, who typically they favour have not been used voluntarily reporting model works the way it does and that the usefulness of the financial reporting are entrusted to run the firm on behalf of the where it is (at least implicitly) alleged that more why it takes the form that it does. Figure 1 model can be assessed by reference to its role shareholders. A common feature of executive efficient financial contracting would result. Put summarises the structure of this review. in providing information pertinent to the compensation schemes is some form of simply, if there is really a ‘better’ measure for assessment of value. Leaving aside issues bonus, which typically is tied to either reported performance evaluation, why is it not used in related to how such an objective can be profit or measures that form part of the settings other than statutory external reporting? operationalised, the most obvious benchmark calculation of profit. There are sound reasons would appear to be the correlation between why some component of management 1 GAAP involves, at a minimum, relevant accounting standards, accounting ‘conventions’, specific regulations not in accounting standards and auditing standards and conventions. The combination of all these extant influences is what shapes financial reporting, and is what is frequently refer to as the ’GAAP model’. 2 See, for example, the review of early contracting-based explanations for accounting practices (including the demand for external auditing) provided by Watts and Zimmerman (1983). 3 Cotter (1998) demonstrates that for private debt contracts used by Australian firms, the most common restrictions placed on the borrower are on further borrowing and minimum levels of liquidity. Borrowing constraints are most commonly expressed in terms of leverage, interest coverage and prior charges, all of which are products of the GAAP financial reporting system. 08 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 09 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • Figure 1: How useful is the existing GAAP-based reporting model for measuring business performance Useful Financial towards ‘mark-to-market’ accounting may be and proposed standards produced under the Reporting viewed as at least partially inconsistent with the auspices of the International Accounting underlying economic demand for financial Standards Board (IASB). reporting. In this sense, standard-setters may Section 3 extends the approach underlying be ‘getting ahead’ of where the basis of sections 1 and 2 to consider evidence on some Value relevance Evidence Costly Contracting measurement for financial reporting should be. ‘alternatives’ to GAAP. It is hard to scientifically In section 2, current knowledge as to the examine potential extensions to the existing ‘quality’ of current GAAP reporting is reviewed. financial reporting model without actual The first dilemma here is to adequately define examples, so the focus of section 3 is on the Market reactions Use of accounting just what we mean by ‘high quality’ limited evidence to date of numbers Correlation with share accounting. The lead of recent research is extensions/modifications to GAAP reporting. price changes Modification followed recognising that it is likely that This includes those popularised by consulting of accounting accounting quality has several different firms such as Stern Stewart’s Economic Value Correlation with price dimensions. For example, predictability, value Added (EVA), and the ad-hoc modification of relevance and conservatism may all be possible GAAP by reporting firms themselves to measures of the quality of periodic accounts, produce measures such as pro-forma income. especially key summary measures such as net The purpose here is to evaluate the usefulness Financial reporting income. Having recognised that accounting of such measures relative to GAAP, as well as quality quality is a complex concept, a review of the scope for opportunistic manipulation by evidence consistent with accounting quality those the financial reports are intended to being rewarded is given — that is, evidence monitor. If, for example, managers are able to consistent with an economic demand for choose the exact definition of income (i.e. pro- Alternative measures of accounting quality. Once again, an important forma income) that they wish to highlight, is financial performance inference is that the current GAAP model has this likely to lead to less informative and/or (Modified GAAP) been shaped by a variety of economic forces. lower quality reporting? The extent of any link between the quality of Some conclusions are briefly summarised in accounting and corporate governance is also section 4. For the most part, however, this An example serves to illustrate the approach. existing GAAP model (Barth 2005). Yet even a considered. Some argue that better corporate monograph is not about conclusions per se. The method is to draw selectively on key casual inspection of 500 or more years of governance is required to ensure better It is an overview of the evidence. In short, it is research papers to highlight what may be accounting history suggests that the financial reporting. However, these claims intended to be a relief map of where we are viewed as ‘evidence’ about the current state of measurement of market values (and hence frequently ignore the existing body of evidence now. It is therefore a necessary, but not the financial reporting model. In section 1, ‘value relevance’) has not been the primary exploring such linkages. sufficient, condition for deciding how we get to evidence on the functionality of the existing concern underlying the economic demand for Proposed changes to the existing financial our target destination. A wide variety of interest model is reviewed. This section commences by periodic financial reporting (Watts 2005). reporting model can be viewed as reflecting groups, including preparers, investors, considering capital markets research intended Why is this? The most likely explanation, as one of two types — either the provision of employees, regulators, auditors, politicians and to highlight how useful GAAP accounting is, at section 1 also highlights, is that the stewardship information beyond that provided under the academics will no doubt continue to have least to equity investors. This research, role of accounting underlies the early economic existing GAAP reporting model, or similar much to say about where a search for better commencing from the path-breaking study by demand for business reporting, and the information using rather different measurement financial reporting will take us. However, that Ball and Brown (1968), is a cornerstone of susceptibility of market value accounting to rules. Examples of the former include very search inevitably is informed better by an modern thinking about how to define a manipulation meant that historic costs are often substantial deviations from the existing GAAP adequate understanding of where we are now. measure of the ‘usefulness’ of financial a preferred measurement basis in terms of the model to include broader forms of stakeholder reporting. However, an immediate dilemma reliability of financial reporting. This is especially reporting such as environmental reporting, arises. Is a ‘good’ result necessarily a high true of arm’s-length contracts (such as debt triple bottom line and the like, as well as less degree of correlation between changes in contracts) that rely on well-understood, dramatic recommendations such as the market values and periodic accounting relatively ‘reliable’ accounting rules and reporting of comprehensive income. An performance? This ‘value relevance’ conventions (i.e. GAAP) to form measures that example of the latter would be the seemingly perspective is increasingly adopted to support can be readily monitored (e.g. liquidity, leverage inexorable shift towards mark-to-market arguments in favour of market values as the and interest coverage). So section 1 highlights accounting, especially as reflected in current preferred method of measurement within the an important concern, namely that the move 10 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 11 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • 1 How ‘useful’ are GAAP metrics for evaluating business performance? The use of value relevance as a criterion for Apart from providing input into a valuation role, evaluating the performance of GAAP financial there are several other functions that GAAP Key points 1.1 Introduction statements also invokes some very important financial reporting is asked to perform, and > Claims that financial reports produced This section reviews evidence addressing the assumptions. In several forms of value which historically underlie the gradual under extant GAAP are not relevant to the question ‘does GAAP accounting produce relevance research, an important assumption is development of GAAP rules and conventions. evaluation of business performance measures that are useful for evaluating that financial markets, especially markets in The most obvious of these roles is the have been repeatedly rebutted over the business performance?’ Such a question is which share prices are established, are contracting role whereby financial reporting last 40 years fundamental to any consideration of how relatively efficient. The ‘efficient markets serves as inputs in establishing and enforcing > GAAP-based measures of financial GAAP reporting may be improved, either hypothesis’, while a useful paradigm in which contractual relations that make up the modern performance and position (income, net incrementally via changes in certain to understand the process by which firm. Obvious examples include debt contracts assets) are related to firms’ market measurement rules or much more information is impounded into the valuation and compensation contracts for employees, valuations, as well as the way in which fundamentally via substantially altered process, has come under increasing question. but there are also many other ways in which these values change over time performance measurement systems (e.g. Indeed, research that challenges the ability of GAAP numbers may be implicitly incorporated > There is theoretical, as well as empirical sustainability measures). As advocates of share market participants to understand into decision making that affects the firm. An support for the role of accounting allegedly improved or ‘better’ systems of relatively basic properties of accrual accounting obvious example here would be various forms numbers produced under GAAP as input measuring business performance speak up, or (on which GAAP financial reporting is based) of regulatory action that rely on GAAP to valuation metrics as entirely new concepts for measuring and has become more widespread in recent years numbers as input (e.g. profitability analysis in assessing business performance are offered, (Sloan 1996). In section 1.3 these rate regulation).4 > Accrual accounting as applied by GAAP the same underlying theme is inevitably present developments are briefly reviewed and their An extensive literature has evolved over the improves the ability to understand business — namely the alleged deficiencies (or even significance to any evaluation of GAAP financial last 25 years examining the contracting role performance over finite horizons failure) of GAAP accounting to produce metrics reporting is considered. This analysis to recent of accounting, commencing from the > There are legitimate concerns that capital which are useful. Of course, this in turn requires theoretical and empirical research addressing pioneering work of Watts and Zimmerman markets do not completely take account of us to identify what we mean as ‘useful’. To a ‘value relevance’ of GAAP financial reporting is (1978; 1979). Detailed reviews of this the way in which accrual accounting certain extent, the subject of this review helps extended further in section 1.4. literature are available, and direct evidence ‘works’ (i.e. the way accruals reverse) in that respect. If we are interested in the However, a more fundamental concern on the contracting role of accounting is not > The usefulness of GAAP accounting is also measurement of business performance, then expressed about the ‘value relevance’ reviewed here. Rather, in section 1.5 one highlighted by the way it has been used to presumably we are interested ultimately in construct is that it is not the only way to specific attribute of GAAP accounting is define and enforce contractual relations business valuation. Hence, one appropriate examine the usefulness of GAAP financial looked at that may impact on its use as a > The contracting role of GAAP potentially benchmark against which to assess the statements data as a measure of periodic measure of periodic business performance limits the implications that can be drawn usefulness of extant GAAP measures is a business performance. Indeed, it is possible and which is attributable to contracting from evidence about ‘value relevance’ measure of value. This insight has been a that if the value relevance criterion is the considerations. This attribute is fundamental tenet of accounting research for dominant means of assessing the performance conservatism. How the demand for > Evidence of conservatism in financial the last 40 years, dating from the pioneer study of GAAP as a measure of periodic business conservatism in GAAP potentially conflicts reporting highlights the tension between of Ball and Brown (1968). In section 1.2, the role performance, then a clear implication is that with suggestions that measurement rules the contracting and value relevance of value relevance as a criterion for evaluating GAAP accounting should measure equity within GAAP should give more weight to perspectives on how GAAP financial GAAP financial reporting as a measure of value. This has implications for the choice of market values (i.e. mark-to-market reporting should evolve. business performance is explained more fully, measurement rules within GAAP, and possibly accounting) is also considered. along with a description of several important underlies the move towards increasing use of research studies. ‘mark-to-market’ accounting. Yet it is clear that direct equity valuation is not a primary determinant of how GAAP rules and conventions have evolved over time. 4 For a detailed review of the limitations of the ‘value relevance’ construct as a guide to assessing suggested modifications and/or extensions to GAAP reporting, see Holthausen and Watts (2001). 12 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 13 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • 1.2 Does GAAP produce ‘value Of course, it is possible that GAAP financial statements produced under GAAP were ‘not > The results reported by Ball and Brown were relevant’ measures? statement data may be value relevant but not informative’ would be subject to empirical consistent with the existence of numerous ‘decision relevant’, if the information contained testing. This is exactly what the pioneering Ball other sources of information that are The concept of ‘value relevance’ is not one that in GAAP financial statements is not especially and Brown study did, by examining the correlated with earnings performance. These is explicitly recognised by those charged with timely. To the extent that GAAP provides a association between accounting performance observable signals result in much of the total setting the standards that underlie GAAP. Most measure of periodic performance, and this measurements produced under GAAP (e.g. net information in earnings being incorporated conceptual framework-type projects performance reflects factors that are income, EPS) and share price changes over the into prices before the actual announcement undertaken by standard setting agencies themselves observable over time via a large same period as captured by the financial of the earnings result recognise concepts such as ‘relevance’ and number of other sources, then it would not be statements.5 This approach typified what came > The most widely cited aspect of Ball ‘reliability’, but not the term ‘value relevance’. surprising if GAAP financial statements were to be known as ‘information content’ research. and Brown is their diagram illustrating the Nevertheless, the relation between accounting not a very timely source of ‘new’ information for correlation between three measures information produced under GAAP rules and investment decision-making purposes. In other Ball and Brown (1968) of annual earnings changes and the level and/or changes in value would seem words, while periodic financial statements The study by Ball and Brown is widely contemporaneous stock returns. to be an intuitively reasonable way for produced under GAAP may be, on average, recognised as a ‘revolution’ in accounting This is reproduced below.6 accounting researchers to operationalise these strongly correlated with the underlying periodic research, and the key points are criteria. GAAP accounting information is Figure 2: Abnormal indexes for various portfolios economic performance of the business, these summarised below. unlikely to be either relevant or reliable if it does reports may have relatively little impact at the not reflect information that is impounded into > The study is widely recognised as having time of their release due to the correlation 1.12 the firms’ share price (Barth et al. 2001). pioneered research in terms of between performance measurement under There are a number of ways that the value understanding whether accounting numbers 1.10 GAAP and other metrics which are observable relevance concept has been operationalised by produced under GAAP have ‘information to market participants during the course of the 1.08 accounting researchers. Four primary content’. The principal test for which Ball and financial period. approaches outlined by Francis and Schipper Brown is best known was mapping the Although Barth et al. (2001) argue that the term 1.06 (1999) are: relation between annual earnings changes ‘value relevance’ does not appear to have been (i.e. a proxy for earnings surprises) and firms’ 1.04 1. Financial statement information is value used in accounting research prior to the early contemporaneous annual stock returns, relevant if the accounting information leads 1990s, the foundations of this approach date adjusted for the effect of market movements. 1.02 prices by capturing intrinsic values which back to the pioneering work of Ball and Brown They examined annual earnings data for US share prices then approach 1.00 (1968). Prior to this time accounting research firms between 1957 and 1965 for a sample in 2. Financial statement information is value was either purely descriptive or of a normative excess of 2,500 firm-years 0.98 relevant if it contains variables used in a nature directed at identifying what might be > Ball and Brown showed that most of the valuation model or helps predict those argued to be ‘best’ accounting practices. association between the sign of the earnings 0.96 variables A prime example of this approach can be found change and contemporaneous annual stock 0.94 3. Financial statement information is value in Chambers (1966), who argued eloquently returns occurs prior to the release of the relevant if it changes the total mix of and passionately for the introduction of a earnings number. Hence, earnings measured 0.92 information in the marketplace system of accounting measurement known as under the prevailing GAAP rules and continuously contemporary accounting 0.90 4. Financial statement information is value principles was seen to be an informative relevant if it is correlated with ‘other’ (CoCoA). Of course, fundamental to such work metric in terms of explaining changes in 0.88 information used by investors. was the criticism, explicit or implicit, that value, but it is not especially timely as a existing accounting practice was of little value source of new information -12 -10 -8 -6 -4 -2 0 2 4 6 to users for tasks such as assessing business Month relative to annual report announcement date performance. However, with the development of modern finance theory (particularly the Variable 1 efficient markets hypothesis) and the Variable 2 concurrent availability of computerised Variable 3 databases of accounting and share price information, it is not surprising (at least with hindsight) that the claims that periodic financial 5 In the remainder of this report, the term ‘contemporaneous stock returns’ is used to capture the share price change over a period of time corresponding to a financial reporting period. 6 Similar pioneering evidence for Australian firms was reported by Brown (1970). 14 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 15 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • What ensued following Ball and Brown (1968)? recognition principle and the matching annual earnings and, finally, a four-year 1.3 How fully do market Empirical research directed towards the principle. These can be summarised as follows: aggregate measure of earnings. Over participants understand information content of accounting rapidly > Revenue recognition principle — recognise 27,000 US firm-years were examined for accrual accounting? expanded. Chief among researchers’ concerns revenue when a firm has performed all or the period 1960–1989 As mentioned in the context of explaining the was the development of better measurements substantially all of the services to be > As the length of the performance origination of capital markets-based accounting of the ‘impact’ that release of accounting performed (or provided goods) and the measurement interval was increased, the research, efficient capital markets (EMH) are an information had on share prices. This involved receipt of cash is reasonably certain relative advantage of GAAP earnings over important assumption where share prices, or identifying shorter and shorter ‘windows’ in cash flow (i.e. the contribution of accruals) > Matching principle — outlays that are directly changes therein, are relied on to assess the which to measure price changes around declined. Over very short intervals (e.g. associated with revenue recognised during performance, or value relevance, of periodic information releases, as well as better quarterly measurement), GAAP earnings was the period must be expensed in that period financial reporting under GAAP. For example, it measures of the associated earnings surprise, far more informative than cash flow. This before income for the period can is a necessary assumption in Dechow’s (1994) such as measures based on analysts’ forecasts result is primarily attributable to operating be determined. study that all value-relevant information is rather than the time series behaviour of accruals (i.e. changes in working capital) These two principles are fundamental to reflected in share prices — in effect that earnings. A further extension involved GAAP accounting providing periodic > Accruals were relatively more important in markets are informationally efficient. While this examining the determinants of the differences performance measures that more closely measuring periodic performance with the has been a fundamental tenet of capital in how prices changed in response to news reflect business performance. length of the firm’s operating cycle markets research in accounting since Ball and contained in GAAP financial statements (i.e. > Accruals were relatively more important in Brown (1968), the assumption has come under determinants of earnings response The revenue recognition principle and the measuring periodic performance as the an increasing amount of challenge. coefficients). These developments are matching principle are fundamental reasons comprehensively reviewed by Kothari (2001).7 why accrual accounting is expected to yield volatility of the firm’s working capital Sloan (1996) more informative periodic performance requirements increased Although the Ball and Brown (1968) study and Of particular interest to those wanting to those that followed suggest that information measures than simply relying on a cash-based > In effect, Dechow demonstrated that understand the usefulness of GAAP measures contained in GAAP accounting reports is useful measure of periodic performance. It is the accruals create a measure of periodic in explaining business performance is the for assessing periodic business performance accrual process, on the other hand, that is also performance that results in better matching evidence in Sloan. He directly examines the (and, ultimately, valuation), this research does widely viewed as being most subject to than a simple cash-flow based measure extent to which the very basic distinction within not necessarily address what specific manipulation, thereby possibly reducing the would provide. This result contrasts with the GAAP accounting (i.e. cash flow versus properties of GAAP are fundamental to the ability of GAAP measures such as income to view that accruals somehow ‘scramble’ the accruals) appears to be understood. result. Most simply, GAAP financial statements serve as a useful measure of business message provided by periodic cash flow Specifically, Sloan points to the differing reflect the combination of two components, performance.8 Indeed, a widely held view in > Dechow’s conclusions were premised on the persistence in the cash flow and accrual namely cash flows and accrual adjustments. texts used to teach finance courses is ‘only assumption that contemporaneous stock components of earnings. Operating accruals Indeed, GAAP accounting is really just the trust cash flow’, or ‘cash is king’. Dechow’s returns are an appropriate benchmark — that are relatively transient, whereas cash flow tends accrual accounting technology applied (via a (1994) study is therefore important in is, stock returns reflect all ‘new’ information to be more persistent. Indeed, the idea that set of rules and conventions) to what would providing a relatively straightforward method that becomes available during the period. accruals reverse is fundamental to why accrual otherwise simply be cash flow reports. This for understanding why, and how, accrual In summary, Dechow (1994) is representative accounting achieves better ‘matching’ of raises an obvious question — does accrual accounting measures produced via GAAP are of a shift in accounting researchers’ approach revenues and associated expenses, as accounting do what it is supposed to do? better measures of business performance to evaluating GAAP financial reporting. Instead discussed above. Sloan identifies several over finite periods. The key results are of focusing on the extent to which the release important implications that follow from this Dechow (1994) summarised below. of the information impacts on market most basic appreciation of how accrual Dechow is a widely cited study that directly > This study examined the circumstances participants’ expectations (via changes in share accounting ‘works’. addresses the question of whether accruals under which accruals improve the ability of prices), she considers the correlation between > He examined how efficiently stock prices generated under GAAP ‘do the job’. She earnings to measure firm performance. This market and accounting-based performance reflect information about future earnings that recognises that if earnings are to be a useful was assessed by reference to the ability of measures. In doing so, Dechow demonstrates is readily available from current earnings. He summary measure of business performance that periodic performance measures produced earnings to explain contemporaneous pointed to the differing persistence of the (relative to cash flow), then that is likely to occur via GAAP rules and principles achieve precisely market-adjusted stock returns. Several accrual and cash flow components of via two important principles which underlie what the accrual accounting process is different earnings periods were examined, earnings. Cash flows are more persistent GAAP accruals, namely the revenue designed to accomplish, namely better beginning with quarterly earnings, through than accruals, which follows from the revenue recognition and matching processes manner in which most (operating) accruals than would arise if periodic financial reporting reverse relatively quickly. Sloan examined 7 Additional background on the development of Ball and Brown and its subsequent implications is discussed by Brown (1989). simply tracked cash flows. annual earnings data for US firms between 8 This issue is considered more fully in Section 2, which addresses concerns about the ‘quality’ of GAAP financial reporting measures. 1962 and 1991, with over 40,000 firm-years included in the analysis 16 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 17 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • > Using a simple model of annual earnings > LaFond (2005) examined the extent to which > Dechow et al. examine in excess of 150,000 1.4 Direct evidence on the value prediction, Sloan showed that the accrual the ‘accrual anomaly’ of Sloan (1996) is US firm-years covering the period relevance of GAAP component of earnings was significantly less evident internationally. He examined data 1950–2003. They find that the higher performance measures persistent than the cash flow component from 17 countries over the period 1989–2003 persistence of cash flows relative to accruals is entirely due to the high persistence of cash As noted above, there has been a shift in > Sloan then showed that size-adjusted stock to provide evidence on whether there was applied to the amount of equity financing researchers’ priorities away from examining returns (a measure of ‘abnormal’ returns) can systematic variation across and within how the release of periodic accounting reports be explained by differences between the countries. Within countries, the study > Stock prices act as if investors correctly impacts market participants to what has actual persistence of cash flows and accruals examined the role of managerial discretion anticipate the lower persistence of cash become popularly termed ‘value relevance’ and the implied persistence from a model (proxied by income smoothing), applied to debt financing, but overestimate tests. These studies typically examine the explaining size-adjusted returns. This result informational environment (proxied by the persistence of cash that is applied to the relation between periodic accounting measures implied that the market puts too much analyst following) and ownership structure firm’s cash balance (i.e. cash retained within and share prices, or the ability of such weight on earnings changes that are driven > LaFond was unable to detect systematic the firm) measures to identify firms where the share by accruals, and insufficient weight on relations between the accrual anomaly > One interpretation of the results was that price differs from what would be predicted. earnings changes that are caused by cash and any of the three ‘causal’ factors investors overestimated the persistence of flow changes. Put simply, the result Central to this research is a theory linking suggested above earnings that were held within the firm. suggested that investors fail to anticipate accounting measures to value. Ohlson (1995) > LaFond also examined whether the returns Hence, the so-called accrual anomaly would fully the fact that accruals are less persistent frequently is credited with providing the associated with the accrual anomaly were appear to be a reflection of hubris regarding than cash flows underlying theory to support this approach. correlated across countries. If they were, this the future value of new investment Ohlson outlines the role of periodic accounting > Sloan also demonstrated that a trading would suggest that perhaps some part of the opportunities, as accruals and retained cash measures in explaining (or predicting) value, strategy based on this apparent market accrual anomaly was really a reflection of flow both were associated with higher using what is commonly known as the residual inefficiency would have yielded larger than future investment outlays, as well as lower systematic risk factors prevalent in income model (RIM). Although the RIM is not expected returns. These returns were stock returns. internationally integrated stock markets. attributed to Ohlson (i.e. it has existed for a clustered around subsequent earnings These results are still of concern if we expect However, there was no evidence to this effect. much longer period of time), the contribution announcements for up to three years after that markets rationally and efficiently process Given the results of Sloan (1996) and made by Ohlson was to highlight how, under the earnings result of interest. This was available information. However, what they subsequent studies such as LaFond (2005), certain assumptions, the RIM and discounted consistent with investors ‘slowly’ realising contribute that is important to the issue at hand does that leave a serious concern that a study cash flow (DCF) methods should yield the the error in their weighting of information in is that it is not a misunderstanding of the of the usefulness of accruals that underlie same result. The key inputs to the residual cash flows and accruals respectively. In properties of GAAP accruals per se that appears GAAP accounting such as Dechow (1994) is income model from the system generating literature that has followed Sloan’s study, to somewhat mislead investors. Rather, a more on shaky ground, relying as it does on market periodic accounting reports are the current the basic result has come to be known as general hubris is evident in terms of how prices rationally reflecting value-relevant measure of worth (i.e. book value) and the the ‘accrual anomaly’. retained cash is viewed. In this sense, the information? A resolution of this apparent expectation of future earnings relative to the Although Sloan’s conclusions have been original conclusion from Dechow (1994) that required accounting return on equity (i.e. controversial, they also appear to have been conflict is to be found in a recent study by accruals ‘do what they are supposed to do’ Dechow, Richardson and Sloan. accounting return on equity (ROE)). Value, as relatively robust. Several studies addressing appears reasonable. measured from periodic accounting data, is the possible methodological explanations have Dechow, Richardson and Sloan (2005) current book value plus the present value of been conducted, but there is not always abnormal earnings.10 > This study provided a more careful agreement among researchers on the examination of why the cash component of In effect, where there is no reasonable basis on appropriateness of various ‘adjustments’ which have been shown to possibly affect the results.9 earnings is more persistent than the accrual which to project accounting earnings that differ component (a fundamental part of the from the required rate of return, then market LaFond (2005) accrual anomaly). They decomposed the value and book value should be the same (i.e. Extensions to other countries, such as the cash component of earnings into three the market-to-book ratio would be one.) Where evidence in LaFond, reveals similar evidence components; first, cash retained by the firm; expected earnings differ from the required rate of the accrual anomaly. However, what is second, cash applied to debt financing; and of return, then the necessary horizon over puzzling is that the most obvious explanations third, cash applied to equity financing. Earlier for such an anomaly do not appear to have evidence on the so-called accrual anomaly any ability to explain systematic variation in treated all of the cash components of the extent of this evidence. earnings as a single measure 9 Examples of this disagreement can be found by comparing Kraft et al. (2006) with the discussion provided by Core (2006). 10 For a further discussion of the RIM approach, and also extensions to the basic model outlined by Ohlson (1995), see Penman (2004) and Palepu, Healy and Bernard (2004). 18 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 19 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • which forecasting must occur is the period Following the theoretical work of Ohlson reports. However, as the authors themselves > The valuation prediction model used over which the difference between actual (1995) and others, it has become common recognise, this does not automatically mean progressively more disaggregated measures accounting ROE and required accounting ROE for researchers examining the linkage between that GAAP reporting should be modified to of income in order to establish whether is expected to persist. Importantly, competitive accounting measures and share price levels to explicitly measure brand values accruals increase the usefulness of cash- forces as well as the accrual accounting cite the RIM as justification for this approach. 3. How do accruals improve the value relevance based earnings for measuring value process itself mean that expected abnormal Most commonly, the method is to regress a of GAAP financial statements? Barth et al. > The results indicated that prediction errors earnings are unlikely to persist over a large measure of market value (share price) on (2004) use the RIM approach to predict were reduced when the accrual component number of periods. This has the advantage of current earnings and book value. The relative equity values, and find that separating out of income is included separately in the creating a finite forecasting horizon, in contrast weight attached to each of these two summary the accrual component of expected income valuation model. to the DCF (and related) approaches to measures should reflect the relevant improves the predictive power of the estimating value. characteristics of the firms (and financial valuation model. This research extends the Barth, Clement, Foster and Kasznik (1998) The existence of a formal model providing period) used for this estimation. Although the inferences made from Dechow (1994) to a Barth, Clement, Foster and Kasznik considered a theoretical link between periodic GAAP linkage between the RIM and this approach somewhat broader notion of value relevance. whether a commercial estimate of brand values accounting results and value is an important (to either explain or predict equity values) is had incremental value relevance over and These three studies are summarised below. consideration in examining the ‘usefulness’ not without some dispute (Ohlson 1998), above financial statement data. of the existing system of periodic reporting researchers have adopted this approach to Francis and Schipper (1999) > They examined over 1,200 brand valuations for measuring business performance. address a number of claims that fall under Francis and Schipper considered the extent for 595 US firm-year observations covering the broad notion of ‘value relevance’. In the to which GAAP financial statements may have the period 1992–1997 Some evidence in support of the practical summary below three examples of the advantages evident from the RIM approach is progressively lost value relevance over time. > To test the value relevance of brands, Barth questions addressed are highlighted: provided by Penman and Sougiannis. This > They operationalised value relevance in two et al. regressed share price on book value, evidence is reviewed below. 1. Have GAAP financial statements become ways; first, a measure of what investors earnings and the brand valuation, which is less value relevant over time? Many critics could have earned based on foreknowledge not recognised within GAAP financial Penman and Sougiannis (1998) have argued that GAAP financial reporting is of the financial statements; and second, the statements. They also examined the > Penman and Sougiannis investigated the unable to adequately reflect the performance ability of earnings to explain association between changes in brand value practical advantage of accounting-based drivers of the modern corporation. This contemporaneous stock returns, and the and contemporaneous stock returns. In both valuation multiples (including a RIM) relative criticism became especially popular during combined ability of earnings and book value cases, they also included several additional to cash flow techniques (i.e. dividend the so-called ‘tech boom’ of the late 1990s. to explain stock prices controls, and their results were robust to discount model and DCF). In theory, all Francis and Schipper (1999) is one of the first these additional controls, as well as a > The authors examined data from US firms methods reflect the same assumptions, and studies to systematically address this claim, simultaneous equations approach to control over the period 1952–1994 should yield the same valuation estimates. and demonstrate that, contrary to populist for the possibility that brand values reflect and anecdotal evidence, GAAP financial > Although the authors found some decline However, this is dependent on the use of share prices (i.e. causality may go in the reporting has continued to demonstrate a in the value relevance of earnings, they also differential forecasting horizons appropriate opposite direction to the hypothesis) strong association with market pricing documented a corresponding increase in the to each model > Barth et al. found that brand valuations not value relevance of balance sheet information > Using a sample of US data averaging over 2. Are there ‘obvious’ measures that GAAP recognised in GAAP financial statements (e.g. measures of book value) 4,000 firm-years each year between 1973 reporting excludes, but which are important were value relevant. They also found that to determining the value of modern > When the analysis is confined to ‘high-tech’ and 1990, the authors compared prediction brand valuations were positively associated businesses? The answer to many may be a firms, the authors found little evidence of errors for each technique based on different with advertising expense, brand operating self-evident ‘yes’, but it is difficult to subject systematic changes over time. forecasting horizons margin and brand market share. However, > The results showed that the practical potential improvements to empirical analysis Barth, Beaver, Hand and Landsman (2004) the brand valuations were not significantly advantage of accrual accounting-based unless the data is otherwise available. related to sales growth. This study examined the usefulness of accruals valuation methods, particularly the RIM, was One example is the value of brands, which for predicting equity values. due to the greater efficiency in forecasting. in many cases reflect the overall importance of what are often termed ‘intangible’ > Barth et al. examined over 17,000 US DCF and dividend discounting models firm-years between 1987 and 2001 require longer forecasting horizons to yield assets. Barth et al. (1998) examine the similar prediction errors additional information contained in a > They examined the prediction errors for proprietary measure of brand values which a model of equity value (i.e. share price) > One interpretation of the results was that prediction based on the insights of Ohlson GAAP excludes from measurement. accrual accounting assists in bringing (1995) that equity value is a weighted They find that these brand values are ‘value expected outcomes into the reporting multiple of book value, earnings and relevant’ over and above the information process more quickly than would occur ‘other information’ contained in periodic GAAP-based financial using a cash-based system. 20 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 21 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting | Measurement of business performance
    • 1.5 Conservatism and GAAP gains, but anticipate all losses’. In effect, It is also seems pertinent to note that the returns, including a dummy variable and reporting this results in an asymmetrical timeliness — overwhelming number of criticisms about the interaction effect which identified cases periodic financial reporting reflects bad ‘timeliness’ of GAAP earnings put forward by where stock returns were negative (a proxy The use of a value relevance criterion for economic news more quickly than good. regulators, politicians and investor groups for bad news). A second test regressed the considering the usefulness of the existing A simple example provided by Basu (1997) refers to a failure to reflect bad economic news current earnings change on the previous GAAP-based system of periodic financial illustrates the asymmetrical treatment of good on a timely basis. It is extremely rare to find a earnings change, with a dummy variable and reporting (and possible extensions/ versus bad economic news. Imagine a machine firm’s financial statements criticised for failing interaction effect identifying cases where the modifications thereto) ignores the many other for which the estimated useful life changes to reflect good economic news quickly enough! prior earnings change was negative ways in which business performance is part-way through the period over which it is This extends to criticisms about the effect of > Both tests suggested that annual earnings measured (or monitored) for purposes other depreciated. Typically, if the estimated useful corporate governance mechanisms such as reported by US firms are conditionally than valuation per se. For example, life is now shorter, there will be an immediate audit quality on the quality of financial reporting conservative. Bad economic news is measurement of business performance is an adjustment to ‘catch up’ the accumulated (Ruddock et al. 2006). reflected in earnings much more quickly, and integral part of executive compensation contracts, which specify GAAP (or GAAP- depreciation to an amount appropriate to the The essential insight gained from the above is negative earnings changes are much more related) performance measures as part of the shorter expected life. On the other hand, if the that timely loss recognition (conditional likely to reverse than positive earnings set of criteria against which executive estimated life is now longer, the only conservatism) is likely to be valued as an changes, consistent with bad news being performance is assessed and rewarded. adjustment is normally to depreciate the attribute of periodic financial reporting, even reflected more quickly. Similarly, the provision of debt financing remaining balance over the (now) longer if it means that such measures are less timely Ball and Shivakumar (2005) typically entails some commitments on behalf estimated economic life. Prior depreciation under certain circumstances (i.e. good expense is not reversed. Clearly, the ‘bad’ economic news) than they might otherwise be. A study by Ball and Shivakumar examined the of the borrowing entity which are defined and economic news of a shorter than expected Researchers have contributed to an extent of conditional conservatism in a large monitored using variables derived from the useful life is recognised in full through the understanding of this phenomenon in a sample of private and public UK firms. GAAP financial statements. income statement in the period in which that number of ways. First, they have documented > They hypothesised that conservatism would The use of GAAP-based measures in various news occurs. However, the ‘good’ economic systematic evidence of timely loss recognition be less prevalent in private firms, as market types of contracting creates a demand for news that the expected useful life is longer only as an attribute clearly evident in GAAP financial demands for conservative reporting is less certain properties within GAAP-based works its way into income progressively over statements (Basu 1997). Second, they have likely to be prevalent among firms that are accounting. These properties may be at odds the remaining expected life of the machine, via shown circumstances where timely loss not publicly traded with a pure ‘value relevance’ perspective. One lower than previously charged annual recognition is more likely to be valued, and > They examined data for the period such example is the demand for conservatism. depreciation expense. hence apparent (Ball & Shivakumar 2005; Ball 1989–1999, with over 54,000 firm-years for What is conservatism in financial reporting? et al. 2005). Third, they have reconciled timely publicly-traded UK firms and over 140,000 Timely loss recognition of this type means that Fundamentally there are two types of economic loss recognition with the audit firm-years for UK firms that did not have a the extent to which periodic financial conservatism (Watts 2003a; 2003b). First, process and notions of audit quality (Ruddock stock exchange listing (i.e. ‘private firms’) statements prepared in accordance with GAAP there is what can be termed unconditional et al. 2006). Finally, they have identified timely are able to reflect economic circumstances is > Ball and Shivakumar used two methods for conservatism. This simply reflects a preference recognition of economic losses as a dependent on the type of economic measuring conservatism. Like Basu (1997), for accounting methods that result in lower (or component of the surprisingly high frequency circumstance. However, there are several they examined the time series behaviour of the lowest possible) value of assets and hence with which publicly-traded firms report losses, reasons why such an asymmetry may be earnings changes, and second, they owners’ equity. This is a systematic bias in and the persistence of such losses (Balkrishna desirable. First, it may improve the governance examined the extent to which the relation accounting, and as such can be readily et al. 2006). Each of these studies is briefly role of financial reporting. Managers who between accruals and operating cash flows adjusted. It is hard to see how such a reviewed below. know that selection of negative net present varies depending on the sign of operating systematic bias would improve periodic value (NPV) investments will show up relatively Basu (1997) cash flow financial reporting. While it does not assist in quickly in reported income are less likely to do > The finding that private firms’ earnings achieving greater value relevance, it also is In this study, Basu tested for the extent to so, even if there are benefits to them from were significantly less conservative than unlikely to be of value in facilitating more which earnings reported by US firms displayed doing so (Ball & Shivakumar 2005). Second, those of publicly-traded firms was robust efficient contracting arrangements between the evidence of reflecting bad news more quickly the efficiency of debt contracts that utilise to controls for differences between the two various parties of which the firm is comprised. than good news (i.e. conditional conservatism). financial statement variables is likely to be groups such as leverage, size, industry and In contrast, conditional conservatism arises enhanced, as loan covenants are likely to be > He examined in excess of 43,000 firm-years fiscal year. The result also cannot be where financial reporting requires a higher triggered more quickly. drawn from the period 1963–1990 explained by risk or tax differences. standard of verification for the reporting of > Two primary tests were used to identify good news as compared to bad. This reflects conditional conservatism. First, earnings a perspective similar to that of ‘anticipate no were regressed on contemporaneous stock 22 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 23 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • Ball, Robin and Sadka (2005) > Conditional conservatism was evident in 1.6 Summary It is evident, and of equal importance, that This study by Ball, Robin and Sadka Australian GAAP, and was not reduced where Criticism of periodic financial statements periodic measurement of business compared the role of contracting-based auditors provided relatively high levels of produced in accordance with GAAP is nothing performance is also critical to the definition and explanations versus ‘value relevance theories’ non-audit services (NAS). In general, firms new. Some have long argued for different enforcement of many types of contractual in explaining the role of GAAP reporting and audited by Big N auditors reported annual measurement or recognition rules within the relationships that are central to the creation and hence certain attributes of published GAAP earnings which displayed a higher degree of basic GAAP framework, such as a move operation of a business entity. It is hardly financial statements. conditional conservatism. towards increased use of ‘mark-to-market’ surprising then that many properties of financial accounting. On the other hand, some have reporting have evolved over a lengthy period of > They examined the extent of conditional and Balkrishna, Coulton and Taylor (2006) argued that certain financial measures that are time, even where they may seem to be at least unconditional conservatism across 22 Balkrishna, Coulton and Taylor examined the excluded from GAAP leave out important partially at odds with a pure value relevance different countries, and their relation to the frequency of losses reported by publicly-traded dimensions of business performance perspective. One such example is the timely varying importance of debt and equity firms in Australia over the period 1993–2003. (e.g. the absence of brand valuations for recognition of economic losses (i.e. conditional markets in those countries (measured as the > They found that losses were surprisingly intangible assets). Finally, there are those who conservatism). Evidence of such properties in size of debt or equity markets relative to GDP) frequent (over 35 per cent of all firm-years argue for a wholesale change in the business GAAP financial reporting also serves as a > They measured conditional conservatism were losses) warning to those who would change the GAAP using a regression of annual earnings on reporting model, either to broaden the notion > Losses were also surprisingly persistent, and of business performance itself and/or to expand model so substantially that these properties contemporaneous stock returns (Basu 1997), would be lost. Such changes are unlikely to the probability of loss reversal declined as the the stakeholder group to whom the existing and measured unconditional conservatism improve the overall efficiency of the financial history of losses extends GAAP-based reporting model is directed. from the intercept of the conditional reporting model. conservatism regression, as well as book- > Conditional conservatism was more evident The claim that the existing GAAP-based model to-market ratios among firm-years that represented reported is not ‘useful’ has been repeatedly subject to losses, consistent with the argument that the empirical testing. In a variety of contexts, > They found that conditional conservatism high frequency of losses over the last 15 or across a large number of national GAAP increased with the importance of debt so years was, at least partly, a reflection of frameworks, GAAP-based periodic markets, but is not related to the importance conservatism in Australian GAAP. performance measures have been shown of equity markets. On the other hand, measures of unconditional conservatism In summary, it is apparent that the timely to have value relevance and hence to be were unrelated to either debt or equity recognition of economic losses is an important useful to investors and others interested in market size property of GAAP financial statements, and that understanding and/or estimating the value of such ‘conditional conservatism’ is evident in the firm. Such evidence provides a baseline > Ball et al. interpreted these results as many different systems of GAAP around the against which suggested improvements or supporting the contracting–based (debt- world. This highlights the need to interpret even wholesale changes to the GAAP model based) explanation of GAAP accounting, evidence of value relevance somewhat can be considered, although, if a suggested but not consistent with an equity market, or carefully, especially when it is used to argue for performance metric is not widely available, it is ‘value relevance’ explanation. extensions to the GAAP model, or even hard to either confirm or rebut the claim that it Ruddock, Taylor and Taylor (2006) modifications to existing measurement/ would represent an improvement on the This study examined the extent of conditional valuation practices under GAAP. existing model of periodic financial reporting. conservatism in Australian GAAP financial Broadly speaking, it appears as though accrual reporting, and its relation to indicators of accounting, as applied by GAAP, provides a audit quality. significantly better measure of periodic > They examined over 3,700 Australian firm- business performance than a cash- based years drawn from the period 1993–2000 system of measurement. It is also evident that accounting numbers are an equally credible > Conditional conservatism was measured basis (compared to cash flows) on which to using a regression of annual earnings on estimate business value. contemporaneous stock returns, the time series of annual earnings changes, and the relation between accruals and operating cash flow (Ball & Shivakumar, 2005) 24 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 25 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • 2 What is the quality of GAAP accounting measures? Key points 2.1 Introduction GAAP-based earnings can be manipulated may 2.2 Measuring earnings quality > The quality of GAAP financial data is a The evidence summarised in section 1 also serve to facilitate the ability of managers to and earnings management critical consideration in whether highlights how existing GAAP-based measures signal their expectations. GAAP rules, in certain Although there is simply no single, performance metrics drawn from GAAP of business performance are useful in a variety cases, may serve to reduce the ability of unambiguous, all-encompassing definition of are likely to be useful measures of periodic of contexts. However, this evidence does not periodic financial statements to provide an earnings quality available, the term ‘earnings business performance speak to the question of the ‘quality’ of unbiased measure of business performance, quality’ is widely used. Schipper and Vincent measures of business performance produced both current and expected. In section 2.3, > The definition of accounting quality (2003) suggest that definitions of earnings by GAAP. This section addresses that concern. examples of research that show some evidence (or earnings quality) depends on the quality fall into three broad categories: of both opportunistic manipulation, as well as users’ perspective What do we mean by the ‘quality’ of measures 1. Decision usefulness. This is a contextual managerial signaling are reviewed, along with > Considerable research demonstrates of business performance? For the most part, evidence of so-called benchmark-beating, definition, in that it depends on both the user some evidence of earnings management this section focuses on measures of earnings whereby managers of listed firms have been and the contemplated use of earnings. As where incentives to engage in such quality. Earnings is a pre-eminent measure of argued to place undue emphasis on meeting or already outlined in Section 1, there are a manipulation exist periodic business performance, and is also not beating well-established market benchmarks, variety of users for whom the ‘ideal’ > The same flexibility within GAAP that independent of balance sheet-based measures such as avoiding a loss, beating last period’s attributes of earnings differ (contrast the permits some degree of earnings of financial position. Hence, for the most part earnings, or beating analysts’ forecasts. ‘value relevance’ perspective with the management also facilitates the ability to this section reviews concepts of earnings reasons suggested as to why conservatism quality. In section 2.2, alternative ways of In section 2.4, the incentives that exist for high signal future prospects may be an important attribute of periodic measuring earnings quality are reviewed briefly. quality financial reporting are reviewed. In > Capital markets are frequently alleged to earnings). Users of GAAP earnings include The most important point to recognise is that particular, evidence that shows that markets encourage managers to engage in shareholders, bondholders, management, the concept of earnings quality is likely to be reward firms that report high quality earnings benchmark beating regulators and government contingent on the specific users’ requirements. (and other GAAP measures) or, conversely, that > Managers seemingly are more likely to low quality financial reporting is penalised are 2. Economic earnings constructs. Under this For example, an analyst may be particularly engage in real economic decisions to considered. The most generalisable form of this approach to assessing earnings quality, concerned with the ability to extrapolate from manage earnings rather than risk the costs evidence is to show that the quality of financial assessment is made on the basis of the current earnings to generate forecasts of future associated with GAAP violation reporting is inversely related to firms’ cost of extent to which reported earnings represents earnings (Dechow & Schrand 2005). On the capital, and this is the focus of the research (unobservable) Hicksian (or economic) > Capital markets appear to reward other hand, actions that managers may take to studies reviewed on this point. The role of income. Not surprisingly, uncertainty about accounting quality try and improve earnings predictability may corporate governance in influencing the quality whether economic income corresponds to > Managers bear economic consequences have the effect of adding noise (or a systematic of financial reporting is also considered, changes in market value mean that this if they engage in serious accounting bias) to the ability of earnings to measure although it is somewhat unclear as to whether construct in not empirically tractable, and manipulation current business performance. It is therefore so-called ‘better’ governance causes higher has not been explored > Corporate governance mechanisms not surprising that researchers interested in measuring earnings quality (and subsequently, quality financial reporting, or whether higher 3. Stewardship. The stewardship perspective (auditor, board composition, audit quality financial reporting leads to better suggests that constructs such as verifiability committee composition) appear to the determinants of earnings quality) have used a variety of measures. These are also governance. The section concludes with (and hence conservatism) are potentially encourage higher quality accounting. some observations about the extent to which important attributes of high quality earnings. summarised in section 2.2. evidence on the quality of GAAP financial Research addressing the broader notion of Much of the interest in earnings quality stems reporting (especially earnings quality) is from widespread anecdotal evidence of earnings quality has often focused on the pertinent to the assessment of how extent of earnings management. Earnings managerial manipulation of reported earnings. successfully GAAP-based financial reporting Such manipulation is often alleged to be self- management refers to the deliberate meets the needs of a variety of uses for intervention by management in the financial serving, with the result that it reduces the assessing periodic business performance. usefulness of earnings (and related GAAP- reporting process to ‘push’ earnings in a based metrics) as measures of periodic particular direction. High profile scandals are performance. This not only reduces the ‘value usually portrayed as examples of earnings relevance’ of GAAP accounting reports, but management.11 Of course, these are invariably also its usefulness for a variety of other examples of alleged earnings overstatement, contracting mechanisms, such as a measure around which performance-based bonuses can be calculated. However, the extent to which 11 For example, at WorldCom it has been shown that earnings were overstated by the capitalisation of expenses. At HIH Insurance, the underestimation of insurance liabilities resulted in earnings that were overstated. 26 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 27 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • whereas earnings management can be either Whether this is in part attributable to a ‘post- Possible indicators of earnings quality The message from this summary is that the upward or downward. Indeed, a vocal critic of Enron’ environmental change is hard to > Accrual quality. This could entail simple quality of earnings (and associated financial alleged earnings management in a broader determine. Put simply, Graham et al. find that measurement of accruals, or unexpected statement measures) is likely to reflect several context (Levitt 1998) has explicitly identified most financial executives are willing to make accruals, or some estimation of how dimensions. No single measure is likely to the downwards management of earnings to small or moderate economic sacrifices in successfully current (i.e. operating) accruals capture the ability of say, earnings, to provide a create ‘cookie jar’ reserves as a practice of economic value in order to avoid ‘under- map into current, lagged and lead cash flows ‘high quality’ measure of periodic business some concern. delivering’ earnings results. (Dechow & Dichev 2002)12 performance. Equally, it is dangerous to But how do we measure the extent of earnings The implications of the Graham et al. survey are > Persistence. Persistent earnings are often conclude that just because there is evidence of management? Researchers have given troubling for attempts to document and seen as desirable because they represent concern on one of these dimensions, then considerable attention to this issue. Over the measure earnings management. Any ‘outsider’, earnings that recur. Analysts often focus on earnings is therefore a low quality measure of last 20 or so years, it has become common to including researchers, is going to have great measures of ‘sustainable earnings’ (also see business performance. Indeed, caution is even focus on the accrual component of earnings as difficulty in observing and quantifying earnings the discussion in section 3) warranted in interpreting any one so-called the source of any manipulation. This management of the type that Graham et al. indicator as evidence of low versus high quality > Predictability. Predictability is often valued by presumably reflects a view that manipulation suggest is most prevalent. This is an inherent earnings. This is highlighted in the following financial analysts. It is also an important via the accrual process (especially where this limitation in interpreting much of the research section with respect to the most widely-used consideration in valuation, which requires entails ‘judgement’ that cannot be shown to be that follows in this section. measure of earnings management, namely prediction of future results outside GAAP) is less costly than making actual unexpected accruals. Researchers have had considerable success > Smoothness. While the practice of economic decisions that have direct cash in measuring accruals-based earnings smoothing earnings has been condemned 2.3 Examples of earnings flow consequences and hence earnings management. Following the insight contained (Levitt 1998), benefits have also been consequences as well. However, recent management in Jones (1991), the most common practice is identified, such as increased informativeness evidence calls into question the validity As noted above, the common assumption is to estimate the expected value of the accrual about future earnings (Tucker & Zarowin 2006) of this assumption. that earnings management is ‘bad’. Much of component of periodic earnings by modelling > Value relevance. This is discussed extensively the empirical research addressing factors Although earnings management via accruals the observed total accrual as a function of sales in section 1. It is based on the premise that associated with earnings management (i.e. the continues to be the focus of regulatory concern changes and the extent of depreciable (and GAAP financial reporting should track incentives to engage in earnings management) and is pre-eminent in empirical research, there amortisable) assets. Extensions to this changes in market values reflects this view. It is also possible, however, are costs associated with attempted earnings approach have included adjusting sales > Timeliness. Timely earnings (i.e. revealing that the divergence of the accrual component management via accruals. Obviously where the changes for the change in receivables (Dechow, economic news quickly) are desirable of earnings from what is expected may be attempt goes beyond what is probably Sloan & Sweeny 1995), including lagged where other timely sources of information indicative of more informative, rather than less acceptable under GAAP, it is to be expected performance (Dechow, Richardson & Tuna are not available informative earnings. The first two studies that the auditor will challenge managers’ 2003) and performance matching (Kothari, > Conservatism. This is also discussed in detail described below highlight this tension. On the preferences, with the possible threat of a Leone & Wasley 2005). The result is a measure in section 1. It reflects a demand that the one hand, the study by Teoh et al. (1998) of modified audit report. Similarly, there is the risk of ‘unexpected accruals’. One interpretation of verification standards for good economic earnings management (and its consequences) of regulatory intervention and discipline. On the an unexpected accrual closer to zero is that news be higher than the corresponding by firms making initial public offerings (IPOs) is other hand, it is much more difficult for auditors earnings are higher quality. standards for bad economic news. a widely-cited example of apparent and regulatory agencies to challenge economic As noted above, however, there are many opportunistic management of earnings, in a decisions taken by management, where the different ways of thinking about earnings setting where earnings information is likely an effect on reported income occurs via cash quality, depending on what the use of earnings especially important measure to investors (i.e. flows rather than an accrual adjustment. is intended to be. Indeed, studies that attempt there is limited information available). Not only Graham, Harvey and Rajgopal (2005) surveyed to measure the overall quality of earnings (as is there strong evidence of IPO firms engaging a large number of US financial executives (over distinct from just ‘earnings management’) have in a ‘ramping up’ of their earnings at the time of 400) to get a better insight into management’s increasingly used a combination of proxy the IPO, but this manipulation also appears to thinking about earnings management. Their variables to capture earnings quality (Francis, result in an artificially high share price in the results contradict much of what researchers LaFond, Olsson & Schipper 2004; 2005). period immediately following the IPO. To the have assumed about the higher likelihood of Although the Francis et al. studies are outlined extent that this is the ‘average’ behaviour, then earnings management via accruals (rather than in more detail in section 2.4, it is useful to have cash flows). So-called ‘real’ earnings an understanding of the different ways in which management appears to be preferable to earnings quality might be assessed: managers, on the basis that even within-GAAP 12 The Dechow and Dichev (2002) measure of accrual quality is not without critics (Wysocki, 2005). It is possible that it captures income ‘adjustments’ are likely to be controversial. smoothing, which may be earnings management to either help or hinder accurate assessment of current period business performance. 28 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 29 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • Figure 4: Australian benchmark beating – avoiding earnings decline low quality earnings measures provide a partial ‘shift‘ earnings may be an important part of explanation for the widely-recognised pattern managers’ tool-bag for communicating N of negative stock returns following an IPO. efficiently with investors and others. 600 On the other hand, the study by Louis and Finally, the Coulton et al. (2005) evidence 500 Robinson (2005) highlights the dangers in confirms (for Australian firms) widespread simply interpreting unexpected accruals ‘street folklore’ that firms attempt to avoid 400 (especially positive unexpected accruals) as ‘just missing’ pertinent benchmarks. evidence of self-serving manipulation of Reproduced below are two figures from that 300 periodic income. The danger is that earnings study. In this case, a simple picture would may be dismissed too easily as a useful 200 appear very informative. However, it needs to measure of periodic performance. In the case be borne in mind that the future performance 100 of Louis and Robinson, they show that firms by benchmark beaters is no worse than those make positive unexpected accruals in earnings 0 released immediately prior to stock splits, and that just miss reporting a profit and/or an 0. 0 -0 4 -0 3 -0 2 -0 1 -0 0 -0 9 -0 8 -0 7 -0 6 -0 5 -0 4 -0 3 -0 2 -0 1 -0 0 -0 9 -0 8 -0 7 -0 6 -0 5 -0 4 -0 3 -0 2 -0 1 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 .0 .2 .2 .2 .2 .2 .1 .1 .1 .1 .1 .1 .1 .1 .1 .1 .0 .0 .0 .0 .0 .0 .0 .0 .0 increase in earnings. If anything, it is better, 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. -0 the market sees that as evidence of better prospects in the future. Post stock-split stock consistent with benchmark beating reflecting Changes in operating income deflated by total assets returns reinforce the view that, in this case, the a method of signalling information about market is not being misled by the upwards future prospects rather than obscuring the earnings management. In short, the ability to underlying performance. Teoh, Wong and Rao (1998) Louis and Robinson (2005) This study documented the extent of earnings Louis and Robinson considered the extent to which unexpected accruals reflected management by US IPOs, and whether such managerial optimism rather than managerial earnings management could help explain the opportunism. Figure 3: Australian benchmark beating – avoiding a loss poor post-listing returns that are a common > They examined the link between unexpected feature of IPO pricing. N accruals (a measure of earnings > They examined around 1,700 US IPOs management) and stock splits, a phenomena 400 between 1980 and 1990 often interpreted as a method of signalling 350 > Teoh et al. used the ‘standard’ measure of managers’ optimism about the future. Their unexpected accruals as their primary measure sample comprised over 2,200 stock splits by 300 of earnings management. They also US firms between 1990 and 2002 250 attempted to control for differences in > Louis and Robinson found that the quarterly performance unique to IPO firms by adjusting earnings results immediately prior to the 200 this measure relative to the unexpected stock split were managed upwards. This 150 accrual of a similar sized, non-IPO firm result was robust to the exact method of > The time series behaviour of unexpected estimating unexpected accruals 100 accruals was strongly consistent with the > They also find that stock splits were, as 50 idea that IPO firms attempted to inflate expected, accompanied by a positive market earnings either just prior to, or just following reaction to the announcement (i.e. a positive 0 the IPO abnormal return) 0. 0 -0 4 -0 3 -0 2 -0 1 -0 0 -0 9 -0 8 -0 7 -0 6 -0 5 -0 4 -0 3 -0 2 -0 1 -0 0 -0 9 -0 8 -0 7 -0 6 -0 5 -0 4 -0 3 -0 2 -0 1 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 > Earnings management measures estimated .0 .2 .2 .2 .2 .2 .1 .1 .1 .1 .1 .1 .1 .1 .1 .1 .0 .0 .0 .0 .0 .0 .0 .0 .0 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. 0. > The abnormal return at the stock split -0 Operating income deflated by total assets in the year of the IPO forecast the long-term announcement was significantly positively decline in post-issue earnings performance. associated with the measure of earnings This was consistent with opportunistic management. This effect appeared to be earnings management immediate, as future returns were not > Earnings management measures also had systematically associated with the extent of predictive power for the sign and size of post- upwards earnings management prior to the IPO stock returns. This was also consistent stock split with the stock market failing to efficiently incorporate information in the measure of earnings management. 30 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 31 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • > Louis and Robinson interpreted these results 2.4 Incentives to report high relatively poor future employment prospects. Francis, LaFond, Olsson as showing that the market viewed upwards quality earnings Although cases of earnings restatements are and Schipper (2004) earnings management prior to the stock split still relatively extreme cases of possible This study investigated the link between It has already been noted that a large body of as a signal of management optimism, rather accounting manipulation, these results suggest earnings attributes and the cost of equity. empirical evidence documents various contexts than a measure of managerial opportunism. that market forces also act to constrain in which managers face incentives to engage in > They examined the seven attributes listed attempts at accounting manipulation. Coulton, Taylor and Taylor (2005) earnings management and where, on average, in section 2.3 above (accrual quality, there is some evidence of this behaviour. Corporate governance also has a potentially persistence, predictability, smoothness, value The extent to which Australian firms reported Broadly speaking, these incentives stem from important role to play in ensuring high quality relevance, timeliness and conservatism) and small profits and/or small increases in earnings either the use of accounting numbers in accounting and hence the usefulness of several alternative methods for estimating (i.e. the extent to which Australian firms defining and enforcing contractual relationships measures such as reported income as the cost of equity capital, including an ex ante engage in benchmark beating) was the (e.g. debt contracts, compensation contracts) indicators of business performance. Klein estimate based on future dividend forecasts. subject of this study. or share market incentives such as the sale of (2002) provides evidence of reduced earnings Their sample covered the period 1975–2001, > They examined annual results for over management where the board of directors, equity (Fields et al., 2001). However, it is also with an average of over 1,400 US firm- 6,000 Australian firm-years between and especially the audit committee, is important to recognise an increasing amount specific observations each year 1993 and 2002 controlled by outside directors who are less of evidence that suggests there are strong > Firms with the least favourable measures of > Coulton et al. showed that there was a incentives to report under GAAP rules and likely to be controlled by the CEO. However, each attribute, considered individually, significantly larger number of Australian conventions in such a way as to produce ‘high showing a relation between governance typically had a significantly higher cost of firms that reported very small earnings (and quality’ earnings (and balance sheets). mechanisms such as these and higher quality equity capital earnings increases) than reported very small accounting does not rule out the possibility that The most fundamental incentive, broadly > The largest cost of equity effects were for the losses (or small declines in earnings). This is causality runs the other way, namely that firms speaking, is the achievement of a higher share accounting-based attributes (compared to prima facie evidence of benchmark beating with high quality accounting are more able to price, which in turn implies a lower cost of market based attributes such as value by Australian firms with respect to widely attract good directors. This is a topic which, equity. A similar incentive exists with respect to relevance or timeliness). Using a measure of claimed benchmarks of interest to capital along with the influence of other forms of the costs of debt. Francis, LaFond, Olsson and accrual quality based on the relation between market participants corporate governance on accounting quality, Schipper (2004; 2005) provide evidence that accruals and lagged, lead and > However, Coulton et al. also showed that is likely to be the subject of future research. accounting quality is rewarded. Moreover, they contemporaneous cash flows, Francis et al. unexpected accruals (a popular measure of show that to the extent accounting quality is Finally, it is also worth noting that the difficulties reported a 260 basis point spread between earnings management) were similar for the innate rather than being the result of in adequately defining what we mean by high the best and worst accrual quality deciles groups that just beat and just missed the managerial discretion, then this is also priced quality accounting should serve as a cautionary relevant benchmark. This result calls into note to those who would dismiss GAAP > The primary results reported by Francis et al. by market participants. An advantage of these question the extent to which benchmark earnings (and related measures) as subject to were robust to including a series of controls studies is that they are not ‘context specific’. beating is evidence of earnings management excessive manipulation. For example, former for ‘innate‘ accounting quality. By innate Rather, they provide relatively generalised SEC chairman Arthur Levitt strongly criticised accounting quality, the authors meant the > Coulton et al. also found no evidence that evidence that accounting quality is priced practices that amounted to income smoothing extent to which firm and industry specific benchmark beaters do worse in terms of (and rewarded) by capital markets. (Levitt 1998). However, evidence provided by factors explained accounting quality. future earnings performance. If accruals Of course, for managers, directors and auditors were used as a temporary means of Tucker and Zarowin (2006) shows that the (at a minimum) there are also likely to be direct ‘getting over the line’, then this would be component of accruals that is most likely to effects on human capital value when expected to result in a subsequent decline represent income smoothing is associated with employees are associated with the provision in earnings performance. a better understanding by market participants of low quality accounting. Actual convictions of future earnings. In effect, it appears as for fraudulent accounting are relatively rare, though income smoothing can be informative. and represent only the most egregious cases Taken in conjunction with evidence (Wysocki of accounting manipulation. However, in lesser 2005) that the measure of accrual quality relied (albeit still serious) cases, some direct effects on in a number of empirical studies (Dechow & may be felt by those involved. Desai, Hogan Dichev 2002) may simply capture income and Wilkins (2006) provide evidence consistent smoothing, the evidence provided by Tucker with this hypothesis by showing that managers and Zarowin is an important reminder of the responsible for the restatement of previously difficulties associated with unambiguously reported earnings suffer in the form of a greater identifying the exercise of managerial discretion than expected chance of termination, and within GAAP accounting as implying that accounting is low quality. 32 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 33 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • Francis, LaFond, Olsson Klein (2002) 2.5 Summary There is no doubt that research over the last and Schipper (2005) Klein’s study examined the relation between In section 1 evidence was presented showing 30 years, commencing with Watts and Francis, LaFond, Olsson and Schipper audit committee and board characteristics that, contrary to what might be termed Zimmerman (1978), has shown that certain examined the relationship between accrual and the extent of earnings management, ‘populist criticism’, measures of business contractual and capital market considerations quality and the cost of debt and equity. as measured by the magnitude of performance produced as part of GAAP (e.g. are associated with some degree of accounting unexpected accruals. income) are useful as measures of business manipulation. Just as importantly, however, > They examined over 90,000 US firm-year recent research provides at least three observations over the period 1970–2001. > A sample of 692 US firm-years drawn from performance. However, this ‘on average’ conclusion must compete against high profile cautionary notes. First, it is apparent that Accrual quality reflected the ability of lead, 1992 and 1993 was used anecdotes of relatively egregious manipulation suppliers of finance (i.e. debt markets and lagged and current cash flows to explain > The results suggested that firms with equity markets) reward high quality accounting. operating accruals of accounting to produce measures that clearly relatively audit committees comprised Second, there are disciplinary and governance have borne no relationship to the underlying > Firms with poorer accrual quality had higher predominantly of outside directors engaged mechanisms that further discourage and/or economic circumstances of the businesses costs of debt. They had higher ratios of in less earnings management restrict managers’ ability to engage in concerned. Consequently, the evidence interest expense to interest bearing debt and > The results also extended to the reviewed in this section on the extent of accounting manipulation. Finally, it is simply lower debt ratings than firms classified as composition of the entire board, as firms possible accounting manipulation, the factors not always obvious whether managerial having high accruals quality with boards dominated by outside that give rise to such behaviour, and the intervention within the boundaries allowed by > Firms with lower accrual quality had directors were also less likely to engage potential constraints on such behaviour GAAP is necessarily an attempt to obscure the significantly lower price–earnings ratios, in earnings management. are of equal importance to the evidence underlying performance of the firm. Rather, consistent with a higher cost of equity The overall conclusion was that boards reviewed in section 1. there is a legitimate expectation that the > The cost of capital effect of a unit of structured to be more independent of the CEO discretion allowed managers within GAAP discretionary accrual quality was less than are more effective in monitoring the corporate may serve to facilitate more effective the effect of a unit of innate accrual quality. financial reporting process. communication about current and future performance. In this respect, managerial Tucker and Zarowin (2006) Desai, Hogan and Wilkins (2006) ‘manipulation’ is a means of increasing the This recent study examined whether income This recent study examined whether aggressive usefulness of GAAP metrics as a measure of smoothing (defined as the negative correlation accounting by US firms (as captured by periodic business performance rather than a between a firm’s unexpected accruals and its earnings restatements) resulted in tangible means of obscuring it. ‘pre-managed’ earnings) garbled earnings reputation penalties for managers of firms information or improved its informativeness. announcing restatements. > Using US data from 1988–2000, Tucker and > They examined 146 US firms announcing an Zarowin found that annual stock returns earnings restatement during 1997 or 1998 more closely reflected future earnings > They found that 60 per cent of restating firms results when current period income was experienced a turnover of at least one top relatively ‘smoothed’. This result extended to manager in the two years following the the extent to which information about future restatement. The ratio for a control group of cash flows was impounded into current firms was only 35 per cent stock prices > Subsequent employment prospects of the > The results reported by Tucker and Zarowin displaced managers were shown to be support the view that managers use their poorer than those of displaced managers reporting discretion (in this case, smoothing from the control firms of reported income) to increase the > The overall conclusion was that private informativeness of reported earnings. penalties for GAAP violations are severe and may serve as a partial substitute for public enforcement. 34 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 35 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • 3 Evidence on ‘modified GAAP’ reporting Key points 3.1 Introduction 4. There are a wide variety of business Why has there been this progressive > ‘Modified GAAP’ equals altered This section reviews evidence on the use performance measurement metrics tightening of what is excluded from a GAAP- definitions of what is included in income. of what can be termed ‘modified GAAP’ advertised by consulting firms, all of which based measure of operating performance? This can be additions beyond current net reporting of business performance. There are have at least some common ground with Almost inevitably, this reflects concerns that income (to yield ‘comprehensive fundamentally four types of modification GAAP earnings. Some of these measures flexibility in determining what constitutes income’), or exclusions (i.e. above the line to GAAP-based measures of periodic are also touted as superior measures of operating income results in the opportunistic adjustments) to yield either ‘street performance, where the modifications business performance for the use of external shifting of various items between earnings’ or ‘pro-forma earnings’ nevertheless retain the fundamental properties investors. One such example is the extraordinary and operating components of that underlie the production of GAAP income. Economic Value Added (EVA) measure reported income. However, while anecdotal > Comprehensive income is favoured by These modifications are all directed at altering promoted by Stern Stewart.13 evidence may appear to support this view, it is some regulatory domains, but there is little what would otherwise be a definition of The first three forms of modification to still ultimately an empirical question as to empirical evidence to support the periodic income that is fully compliant with GAAP reporting are concentrated on whether ad-hoc adjustments made by firms requirement to provide this information in GAAP, such as operating income or net income. in what follows. As the focus is on external themselves (i.e. pro-forma reporting) or by addition to existing financial statements The four fundamental forms of modification are measurement and evaluation of business security analysts and providers of such data > ‘Pro-forma reporting’ is where a selective (i.e. street earnings) result in earnings as follows: performance, the fourth type of modified exclusion of income components occurs. measures which are more or less useful than 1. Selective modification of GAAP earnings by GAAP (i.e. measures of business performance This is sometimes termed ‘street the corresponding GAAP number. the reporting firms themselves, resulting in promoted by individual consulting firms) has earnings’, corresponding to earnings these firms reporting what are usually been excluded because these appear to have However, the three forms of modification measures found on the major databases termed ‘pro-forma’ earnings as their primary aim the provision of useful reviewed below represent differing degrees of providing earnings forecasts (e.g. Value measures for internal performance departure from GAAP. In the case of pro-forma Line, Institutional Brokers Estimation 2. In a more systematic fashion than (1), the evaluation and capital budgeting/rationing. earnings and street earnings, there is Service (IBES) and First Call) use of so-called ‘street’ earnings numbers. Where they have been promoted as a sometimes a considerable degree of departure > It is hard to know exactly what ‘street’ These are the numbers which analysts measure useful for external users, this is from GAAP, especially in terms of removing earnings are, as providers of forecast data typically are asked to forecast and which are seemingly of secondary importance. what may be described as ‘non-recurring’ are effectively a ‘black box’ in terms of the then aggregated and reported, subject to components of income. On the other hand, precise adjustments made possible adjustments, by commercial It is not surprising that preparers and users of periodic financial reports should show interest comprehensive income represents a shift in the > Evidence suggests that pro-forma or street providers of forecast data such as IBES, opposite direction, whereby everything within Zacks and others in modifying periodic performance measures, earnings may be more informative than GAAP income is retained, but the definition of as even standard-setters themselves have done earnings measures that conform with 3. In the opposite direction to the ‘typical’ income is extended to incorporate any changes so over time. For example, the definition of GAAP. This is especially true where the exclusion of selected income components to that affect differences between opening and what constitutes operating income, as distinct differences relate to non-recurring items. arrive at either pro-forma or ‘street’ earnings, closing book value. In this sense, both forms of from items that are separately recognised as there is support for the reporting of so-called ‘extraordinary’, has changed substantially. modification reflect different perspectives on ‘comprehensive income’. This is a measure Standard-setters around the world have what constitutes high quality earnings. One GAAP GAAP that extends the current bottom line to reason often advanced in support of street progressively tightened the definition of include various other movements within extraordinary items, and more recently earnings or pro-forma earnings is that such ‘other owners’ transient owners’ equity, and is effectively a earnings numbers are more predictable. On the equity changes components Australian GAAP has seen the complete reconciliation of the change in consecutive elimination of the separate recognition of what other hand, comprehensive income has been balance sheets were termed ‘abnormal’ items. Earlier attempts advocated on the basis that it is closer to an at tightening the regulations on what constitute ‘economic’ definition of earnings, namely the comprehensive street earnings change in net assets over the period of income extraordinary items were met, at least in part, by the increased highlighting of certain items as measurement. In the remainder of this section ‘abnormal’, a category that has now been selected evidence on the attributes of each type Street earnings eliminated from the terminology of Australian of modified GAAP reporting is highlighted. adjusted in an GAAP financial reporting.14 ad-hoc way pro-forma earnings 13 Other widely marketed ‘proprietary’ reporting systems include Value Reporting, Cash Flow Return on Investment (CFROI) and Economic Profit. These are all more closely linked to the standard GAAP reporting model than their proponents are likely to want to admit. 14 A detailed discussion of these changes is provided by Whittred et al. (2004). 36 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 37 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • 3.2 Comprehensive income Clearly, the definition of CI under SFAS 130 is Dhaliwal, Subramanyam What are the lessons to be drawn? While CI One way in which the ‘standard’ output of the relatively restricted, addressing areas where and Trezevant (1999) represents only a modest extension to the GAAP financial reporting model has already gains and losses have been recognised as Dhaliwal et al. examined data for over 11,000 conventional net income measure, the results been extended is via the requirement direct movements in owners’ equity, rather US firm-years drawn from the years 1994 suggest that relatively more ‘comprehensive’ implemented by the Financial Accounting than passing through the income statement. and 1995. measures of performance add little, if anything, Standards Board (FASB) for US firms to report In effect, CI provides a measure of income that to a measure of performance that is more is closer to the clean surplus concept (Ohlson > Although this period preceded the narrowly focused on operations. Moreover, it is ‘comprehensive income’ (CI). In contrast to introduction of mandatory CI, the items of less-regulated attempts to adjust GAAP income 1995) reviewed in section 1. However, worth asking whether the evidence provided by although CI may be viewed as a relatively which CI is comprised were all readily Dhaliwal et al. even addresses broader notions to exclude certain components via pro-forma or observable as part of balance sheet-related street earnings, CI extends net income to narrow extension of existing GAAP income of usefulness. For example, is there any measures, the introduction of a requirement to disclosures. Hence, Dhaliwal et al. evidence that various contracting applications include other changes in owners’ equity that reconstructed a measure of CI consistent represent non-capital items taken directly to the report CI as defined in SFAS 130 has yielded an of net income (or similar) are in any way opportunity to test at least one narrow with the requirements subsequently ‘modified’ to look more like a measure of balance sheet. Under SFAS 130, Reporting introduced via SFAS 130 Comprehensive Income, CI is comprised of net extension of the standard measure of earnings comprehensive income? If such applications from the GAAP model. > Dhaliwal et al. conducted two types of are also likely to focus on operating income plus ‘other comprehensive income’. analysis. First, they compared the ability of performance and implications for future This is summarised in Figure 5 below: With no reference to empirical research, the GAAP income (net income) and CI to explain operating performance, it is hardly surprising Chartered Financial Analysts (CFA) Institute Figure 5: What is comprehensive income? contemporaneous annual stock returns, as that no evidence can be found of voluntary (2005) has advocated the adoption of a well as their respective contributions to modifications to net (or operating) income to measure of CI in other reporting regimes, models focusing on explaining variation in extend these measures beyond capturing stating that ‘all changes in net assets must be Net income recorded in a single financial statement, the price. These results do not support the claim (more narrowly) operating performance. that CI is a ‘better’ measure of periodic In short, what evidence we have available Statement of Changes in Net Assets Available performance than GAAP income. A possible suggests that stock market participants prefer to Common Shareholders’. This call for reform Other comprehensive (in this case, extension) of GAAP is typical of caveat to these results is that one of the measures of periodic performance that are income components of ‘other comprehensive ‘focused’ on operating performance, while the how debate can occur in the absence of any income’, namely gains/losses on marketable absence of any evidence showing that broader review of empirical evidence. While CI securities, does have some incremental measures of performance (such as CI) are used measured in compliance with SFAS 130 does explanatory power beyond GAAP income in contractual arrangements, such as in debt Comprehensive not exactly match the recommendation made > Dhaliwal et al. conducted a second set of and compensation contracts, serves to reinforce income by the CFA Institute, it is sufficiently close to further highlight the value in reviewing extant tests to compare the ability of CI and GAAP the conclusion that there is little, if any, evidence empirical research. net income to predict future earnings and at this point to support the statutory cash flows. A key application of financial data requirement to provide a measure of CI. Unrealised gains/losses for the analyst community is to serve as input on ‘available for sale’ to prediction models, so this type of evidence securities as defined is a useful supplement to direct tests of ‘value by SFAS 115 relevance’. However, once again, the authors found no evidence to support claims that CI is a better measure of periodic performance Net losses associated with than GAAP net income. minimum liability pension adjustments (SFAS 87) Foreign currency translation adjustments (SFAS 52) 15 See the critique offered by Abarbanell and Lehavy (2005). Examples of the ‘confusion’ between what exactly ‘pro-forma’ earnings really Other comprehensive means include Doyle et al. (2003) and Brown and Sivakumar (2003). income 38 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 39 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • 3.3 Street earnings — is this a Bradshaw and Sloan (2002) The results reported by Bradshaw and Sloan > Doyle et al. examined quarterly earnings selective narrowing of GAAP This study examined the differences between (2002) have two possible explanations (as data for US firms between 1988 and 1999, GAAP and IBES measures of quarterly earnings recognised by the authors). First, an increased with a total sample size in excess of income (and does it improve for US firms over the period 1986–1997. emphasis on street earnings may represent 140,000 firm-quarters earnings as a measure of an effective strategy by managers (and > Their sample size exceeded 100,000 firm- > Doyle et al. found that one dollar of excluded business performance)? possibly analysts as well) to achieve higher expenses (i.e. expenses recognised within quarters. IBES coverage of US listed firms is The debate about street versus GAAP valuations by reporting and/or emphasising GAAP quarterly income but excluded from nowhere near as extensive prior to this time, earnings (and the role within that debate (usually) higher street earnings numbers. This the street figure) predicted $3.33 fewer so the analysis effectively covered the ‘life’ about pro-forma earnings) is a relatively explanation is hard to reconcile with the idea dollars of cash flow over the next three years. of IBES as a supplier of street earnings recent phenomenon. For most of the last of a relatively efficient capital market, but it is This is more than 40 of the predictive value of estimates up to 1997 40 years, researchers have been focused consistent with allegations made by critics of street earnings. This result was driven by the on understanding the properties of GAAP > IBES earnings demonstrate increasing financial reporting, such as Levitt (1998). exclusion of items other than those which are accounting, resulting in research of the type divergence from GAAP earnings over the However, a second explanation is simply that labeled ‘special items’, such as the described in sections 1 and 2. More recently, period examined by Bradshaw and Sloan. increased emphasis by market participants on elimination of goodwill amortisation. This however, it has been alleged frequently that They note that this divergence appears to street earnings reflects a rational attempt to suggests that these expenses do in fact recur there has been a rise in the frequency with have occurred from approximately 1990 adjust GAAP earnings for non-recurring items and consume future cash flow which firms attempt to prompt analysts and onwards, but do not provide any explicit (i.e. transitory components) so as to create a statistical test of this hypothesis > Although Doyle et al. found that stock others to focus on measures of earnings superior measure for determining future cash returns around earnings announcements that exclude at least some components > IBES earnings showed a statistically stronger flows and, ultimately, value. Of course, the were declining in the amount of GAAP (typically expenses) that are claimed to association with contemporaneous quarterly two explanations are not mutually exclusive, expenses that were excluded from street be ‘non-recurring’. stock returns than was the case for GAAP but it is noteworthy that the former is largely earnings, the adjustment did not appear It is important to understand that, strictly quarterly earnings, at least for periods consistent with the opportunistic sufficient, as stock returns for the speaking, street earnings and pro-forma following 1992, where the divergence manipulation of the GAAP reporting model, following three years were significantly earnings are not the same, despite the fact that between GAAP and street measures of while the latter is reflective of an efficient decreasing in the amount of the in several cases researchers have used these quarterly earnings was greatest search for the ‘best’ measure that can be exclusions from GAAP income terms interchangeably.15 Street earnings is > IBES appeared to have filtered from obtained from ‘adjusted GAAP’. > While Doyle et al.’s results appear to support specifically an ‘adjusted’ earnings per share operating profit what in US terms are known Some further evidence on the usefulness of the ‘opportunistic’ view of street earnings number captured by commercial data service as ‘special items’. These special items have street versus GAAP earnings numbers (relative to GAAP), at least two concerns providers, such as IBES, First Call and Value become more frequent over the period reinforces the results, but does not necessarily arise. First, why is the focus on incrementally Line. On the other hand, pro-forma earnings is studied by Bradshaw and Sloan, and are resolve the underlying dilemma as to why street explaining the following three years of the number reported in actual firm press more likely to be negative than positive. earnings appear more strongly correlated with aggregate cash flow? If the answer reflects releases, typically in preference to the regular, However, it was not possible to separately market-based measures such as the role of future cash flow in the valuation GAAP-conforming number. While in some identify the extent to which increasing contemporaneous stock returns. These papers process, then why not just examine the cases pro-forma and street earnings may be the differences between GAAP and street are as follows: ability of the different measures to explain same, street earnings are more likely to reflect earnings (using IBES) were caused by Doyle, Lundholm and Soliman (2003) price (i.e. value)? Second, in tests such as relatively systematic modification to GAAP changes in the definition of street earnings those of Doyle et al., it is almost inevitable rules, simply because they are the product of a versus increased identification of special Although Doyle et al. (2003) refer to ‘pro-forma that additional disaggregating of a periodic commercial data provider who must attempt to items that (typically) reflect non-recurring earnings’, their paper was in fact an analysis of result will have incremental explanatory ‘standardise’ as much of their product as expenses and were therefore eliminated from earnings components relating IBES (i.e. street power (Easton, 2003). possible. These services provide a tracking of the definition of street earnings. This was earnings) with those reported under GAAP. firms’ performance over time, so even though because the process applied by IBES (or any Their focus is on the difference between these their output is inevitably a ‘black box’ to other provider of such data) is effectively a two figures, whether such differences are external users, some degree of consistency ‘black box’ to external users useful in predicting future cash flows (a test of could reasonably be assumed. On the other > There was also some evidence identified by ‘usefulness’) and to what extent such hand, pro-forma reporting is the product of Bradshaw and Sloan of managers making potentially useful information excluded from individual firms themselves. In the research increasing reference to street earnings street earnings is also ignored by investors. summary below, the focus is on street earnings. numbers in press releases discussing Evidence on pro-forma earnings is reviewed in quarterly earnings results. section 3.4 below. 40 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 41 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • Brown and Sivakumar (2003) Abarbanell and Lehavy (2005) The review of evidence comparing street versus 3.4 Pro-forma earnings — telling it Like Doyle et al., Brown and Sivakumar Abarbanell and Lehavy’s study identified a GAAP earnings provided above is in some like it is or how you want it to referred to ‘pro-forma’ earnings but actually number of dangers in attempting to make an respects inconclusive. On the one hand, there be seen? compared street earnings (i.e. earnings evaluation of street earnings versus GAAP does appear to be an increase in investors’ and analysts’ emphasis on street earnings. Just as street earnings (measures collected and reported by IBES) with GAAP. earnings numbers. However, this is consistent with analysts and collated by commercial data services such as > They examined quarterly earnings for US > They examined quarterly earnings as IBES) represent a modified form of GAAP investors being concerned with obtaining a firms between 1989 and 1997. Three types of reported by IBES (i.e. street earnings) and reporting, so too does the use of pro-forma ‘better’ measure of sustainable earnings than tests were performed, each of which directly Compustat (i.e. GAAP earning) for 8,000 reporting. The key difference, however, is that current GAAP rules allow for, although it is also compared GAAP and street measures of US firms between 1985 and 1998. In total, whereas there is inevitably some degree of apparent that differences between GAAP and quarterly income they examined in excess of 150,000 firm- standardisation within the approach applied by street earnings may not be as widespread as > The predictive ability of GAAP and street quarters. There were three specific types a commercial service such as IBES to eliminate anecdotal evidence would have us believe. earnings was tested by comparing the of difference between street earnings and transient components of reported GAAP Nevertheless, it would appear that analysts accuracy of each measure as a predictor of GAAP earnings highlighted income, pro-forma reporting in its strict prefer a measure of earnings that is focused the corresponding quarterly result one year > First, there was a higher frequency of cases more on earnings that are sustainable, or definition simply refers to firm-specific later. Street earnings is a significantly better where street earnings exceeded GAAP ‘continuing earnings’. decisions to modify GAAP income in ways that predictor than GAAP earnings earnings by extreme amounts compared to may be quite idiosyncratic. While the growth in instances where GAAP earnings exceeded It is also possible that street earnings reflect a significance in street earnings has been noted > The valuation relevance of each measure was deliberate attempt by firms to take advantage of tested by examining their respective street earnings by extreme amounts. This above, the rise (but most recently a possible fall) suggested that street earnings tend to this preference, by selectively excluding certain in the use of pro-forma reporting has been associations with stock prices. Street components of GAAP income that are actually earnings were shown to have a significantly more frequently exclude extreme items more controversial. Most likely, the distrust of that are income decreasing than are informative about future earnings, cash flows pro-forma reporting reflects the fact that the higher association with stock price than and, ultimately, value. Unfortunately, the GAAP earnings income increasing ‘rules’ are simply whatever the reporting firm inability to ‘see inside the box’ and know determines them to be. > Information content was measured as the > Second, there appeared to be a permanent exactly how to undo differences between street correlation between each measure of shift in the average difference between street and GAAP earnings (due to the proprietary Distrust of firms making their own ad-hoc quarterly income and either the three-day and GAAP earnings in the early 1990s. It is nature of the data collection process by adjustments to GAAP reporting is widespread. stock return surrounding the earnings likely that this reflected changes in commercial providers such as IBES) means For example, the former Chief Accountant of announcement (i.e. earnings surprise tests) procedures by services collecting analysts’ that we cannot devise a strong test of this the Securities and Exchange Commission in the or the stock return for the corresponding forecasts of earnings (the commercial explanation, at least with respect to street US, Lyn Turner, christened this practice ‘EBS — quarter. The results supported the conclusion providers such as IBES), as well as certain earnings. However, if one takes a strict Earnings before Bad Stuff’. Such labels clearly that street earnings have greater information GAAP accounting changes that have definition of pro-forma earnings, that is, that imply the assertion that reporting of pro-forma content than GAAP earnings permanently altered the relation between pro-forma earnings is an ad-hoc adjusted result earnings is a way of attempting to make firms’ > If one assumes capital markets are relatively street and GAAP earnings that is firm-specific, then research examining performance look better than it really was. The efficient, then the results suggested that > Third, there was a very high incidence (over the properties of pro-forma earnings releases high profile anecdotal example described in street earnings more successfully eliminate 50 per cent of all observations) where GAAP (and associated disclosures) may be very Figure 6 captures this type of concern. transitory components from GAAP income. earnings and street earnings were identical relevant in helping us to understand the These transitory components provide little > The inference from these results was that the extent to which GAAP earnings is ‘usefully’ additional information to investors. To the extent to which street and GAAP earnings modified versus the extent to which it may extent a commercial service such as IBES differ may be overstated, especially when be opportunistically manipulated. The next simply reflects what security analysts ‘do’, driven by anecdotal examples of differences section reviews this evidence. then the results are also consistent with > It was also apparent that at least some of analysts trying to provide the market with the apparent advantage of street earnings earnings measures that are more informative documented in earlier studies may have about future performance and, hence, been driven by a relatively small number of current value, than is the case from earnings extreme differences between GAAP and that are entirely in accord with GAAP. street earnings. When such differences are more carefully identified, the conclusion of investors preferring or relying on street earnings relative to GAAP earnings does not hold. In effect, it may be a case of ‘horses for courses’. 42 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 43 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • Figure 6: Enron and pro-forma earnings Bhattacharaya, Black, Christenson Johnson and Schwartz (2005) The evidence summarised above yields a and Larson (2003) The Johnson and Schwartz study examined number of conclusions. First, large scale 16 October 2001: Enron Press release — items This study identified a sample of over 1,100 press releases highlighting pro-forma earnings empirical studies do not support the anecdotal were reported in the order shown. press releases of quarterly pro-forma earnings announcements by US firms for the period evidence that pro-forma reporting is simply an for the period 1998–2000. June through August 2000. attempt to mislead market participants. Of 1 Recurring third quarter earnings of $0.43 per course, examples such as Enron (as shown in diluted share, an increase of 26 per cent over > They considered the extent to which > This period corresponded with what many Figure 5) raise serious concerns that allowing the corresponding quarter in 2000 pro-forma earnings reported by the firms market commentators characterised as the firms to selectively modify GAAP reporting concerned differed from either GAAP or start of the so called ‘market bubble’ rules is a licence for exploitation. On the other 2 ‘Recurring earnings’ estimates of $1.80 per street earnings, whether market bursting. In contrast to Bhattacharya et al. hand, the empirical evidence does not seem to share for 2001 and $2.15 for 2002 participants perceived pro-forma earnings (2003), this study compared attributes of support the contention that the Enron example to be more informative than either GAAP firms which reported pro-forma earnings is ‘typical’ of all pro-forma reporting. Rather, it 3 GAAP loss for the quarter of $0.84 per or street earnings and, finally, whether with those that did not. In effect, it was appears as though many of the modifications to share, compared to GAAP profit a year market participants viewed pro-forma based on comparing pro-forma disclosers GAAP that are reflected in pro-forma reporting earlier of $0.34 earnings to be a more permanent with non-disclosers, rather than using a have the effect of eliminating transient earnings measure of firm profitability than either within-sample approach components. It has long been accepted (and 4 Differences between GAAP profit and street or GAAP earnings > Initial evidence based on pricing multiples shown empirically) that transient components ‘recurring earnings’ are due to non-recurring > Pro-forma earnings releases identified by suggested that firms reporting pro-forma of earnings are less relevant to the valuation charges which have ‘clouded the Bhattacharaya et al. tended to be made by earnings may be priced at a higher multiple process, as evidenced by the relation between performance and earnings potential of the firms reporting GAAP losses for the than other firms. However, the difference in earnings and either stock returns or stock core energy business’. corresponding quarter. Pro-forma pricing multiples cannot be explained by the prices. This result is also apparent when announcers were concentrated in the service pro-forma earnings numbers themselves examining market reaction to pro-forma Six weeks after the press release summarised and high-tech industry groups. In around 25 > At the announcement of quarterly earnings, earnings news, as well as the role of pro-forma above, Enron sought bankruptcy protection per cent of cases, the pro-forma earnings there was no evidence that firms announcing earnings in the valuation process. It is also under US law! numbers was actually lower than GAAP pro-forma earnings were priced at a apparent when looking at the way analysts Not surprisingly, there have been several earnings, yet was still reported first in the premium. It therefore appeared that investors react to the release of pro-forma earnings. studies directed at comparing the usefulness press release. It is hard to reconcile such did not focus ‘exclusively’ on pro-forma Whether the regulation of pro-forma reporting of GAAP versus pro-forma earnings behaviour with the idea that pro-forma earnings in a way that would be consistent serves to increase or decrease its usefulness is measures. These studies inevitably rely on the earnings is simply the opportunistic with a naive reaction to such information. an open question. It is apparent that since the identification of firms who have released overstatement of performance Entwhistle, Feltham and Mbagwu (2006) heady days of the dot-com boom (and some form of pro-forma earnings result, and > The short term (i.e. three-day window) stock subsequent bust) that the introduction of new are therefore usually reliant on some degree returns around pro-forma earnings This study examined whether US firms’ reporting of pro-forma earnings has changed regulations (such as the Sarbanes-Oxley of manual data identification. As a result, announcements indicated that the market legislation in the US) may have been associated sample sizes and time period covered tend to placed greater weight on these numbers with the introduction of regulation. with a reduction in the frequency with which be much smaller than comparable studies than GAAP earnings > They examined data gathered from earnings relatively extreme differences occur between which compare GAAP and street earnings > Analysts forecast revisions around the release releases by S&P 500 firms over the period GAAP earnings and the figures reported under numbers. Some examples of this evidence are of pro-forma earnings were consistent with 2001–2004. Whereas academic evidence of the generic label ‘pro-forma earnings’. This is reviewed below. analysts viewing this as a better measure of the type summarised above pre-dates the still an open question, and one on which permanent earnings (i.e. less affected by regulatory reaction in the US towards pro- research can be expected in the near future. transient earnings components). forma reporting, this study examined how things have changed > Pro-forma reporting appears to have become less biased, as evidenced by a decline in the frequency with which pro-forma earnings exceeded its GAAP equivalent. Pro-forma reporting also appears to have become less frequent. 44 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 45 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
    • 4 Conclusion 3.5 Summary Is it possible that pro-forma reporting illustrates Criticisms of measures of business It is also apparent from extant research studies This section takes a somewhat different that regulation (such as those that underlie performance produced under GAAP (such that extensions/modifications to GAAP may perspective to the evidence and argument GAAP) actually limits the usefulness of financial as income) have become more widespread add to the informativeness of measures such reviewed in sections 1 and 2. Whereas those reporting for the measurement of business in recent years. These criticisms take a as income for assessing business performance. sections focused exclusively on documenting performance? Possibly, but we simply do not number of forms, but broadly they fall into While concerns may be legitimately held about evidence on the properties of GAAP have sufficient evidence at this time to say three categories. allowing managers to ‘choose’ a definition of accounting, this section has reviewed whether external financial reporting is better First, there are the accusations that as business earnings most likely to paint the best possible evidence on extensions/modifications to served by a degree of firm-specific innovation models have changed (e.g. the move towards picture, it is apparent that the type of GAAP. In particular, it has considered the use or not. Contracting theory (as reviewed in service industries) the GAAP model of modifications to GAAP income made by of two alternative metrics, namely ‘street section 1) provides strong economic grounds performance measurement has failed to keep analysts and investment services are aimed at earnings’, as reported by commercial for the significance of verifiability within the up. Implications drawn from this criticism range getting a more representative picture of providers of analyst forecast data (e.g. IBES, financial reporting model, and greater firm- from possible extensions/modifications to repeating, or sustainable, earnings. However, First Call and Value Line), and the firm-specific specific innovation would seemingly make GAAP-based performance measures, through it is also important to note that such measures ‘creation’ of earnings metrics under the label such verification more difficult. However, it is alternative measurement methods within maintain the fundamental characteristics of ‘pro-forma earnings’. apparent that much of the firm-specific existing GAAP principles, to completely new GAAP-based income measures, such as the innovation evident in pro-forma reporting is performance metrics measured and reported revenue recognition principles and rules and This evidence is significant for at least two informative for the reporting firm in question. entirely outside the existing GAAP model. the associated matching convention. reasons. First, it provides us with some Whether there is an appropriate trade-off Progress is to be expected in any endeavour, appreciation of whether extensions to widely- Second, there is the accusation that existing between extant regulation and allowing firm- and so suggestions for improvements to used GAAP-based metrics, such as earnings, GAAP allows sufficient flexibility to result in specific definition of performance is clearly an systems for measuring business performance are of themselves useful. The answer to this measures of performance that are issue that broader measures of performance are not surprising. However, it is also easy to question is, on balance, yes. Measures compromised by managerial manipulation. beyond GAAP will only serve to further test. get carried away and ignore the achievements portrayed as street or pro-forma earnings are, However, where this accusation is used as a for the most part, measures of periodic justification for fundamentally different forms of the existing model for measuring business performance that exclude relatively transient of business reporting (e.g. sustainability, triple performance. GAAP accounting measures have components of GAAP earnings. While many bottom line, etc.), it may be equally fair to ask proven to be a relatively robust way of of these items (such as write-offs) may be whether the measures proposed are just as assessing performance, and at a minimum informative of themselves, they are not as likely, if not more likely, to be subject to critics and proponents of change need to informative as other GAAP income opportunistic manipulation. Evidence of the identify how their preferred solution is not components about future earnings and cash type reviewed in section 2 suggests that there subject to many of the same criticisms directed flows. It is not surprising that the exclusion of are market, governance and disciplinary factors at the existing reporting model. The transitory components of GAAP earnings might that encourage high quality financial reporting. fundamental tenets of existing GAAP have had increase the innovativeness of periodic However, even establishing exactly what the a long development period, and are relatively performance measures. term ‘high quality’ means is subject to the exact well understood by various users. While GAAP purpose for which the accounting measures can inevitably be improved and extended, it is A second reason for a review of extensions are used. For example, what constitutes high simply not correct to conclude that measures to conventional GAAP-based measures of quality financial reporting to a lender may based on GAAP are unsuitable for measuring performance is that it provides insight into involve far more conservatism than a business performance. the (much) broader debate about whether we can significantly improve on extant GAAP shareholder might consider optimal. accounting. Sections 1 and 2 together highlighted how ‘successful’ the current GAAP model is for measuring business performance (and the subsequent application of measures of performance in tasks such as valuation). Does this mean that GAAP can be viewed as ‘one size fits all’? Of course not! In that sense, it is not surprising that measures such as pro-forma reporting, although likely open to abuse, nevertheless on balance appear to be useful to analysts and investors. 46 The Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia 47 > GAAP-based financial reporting: measurement of business performance GAAP-based financial reporting: measurement of business performance
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