Non-GAAP earnings: we’re not all bad, we’re just drawn that way

One hundred academics and non-academics recently met in Sydney, Australia, for the 2018 IASB Research Forum, to discuss some of the latest research into financial reporting matters.

The Forum is organized annually by the IASB in collaboration with an academic journal to create a platform for presentations and discussions of new accounting research of relevance to the IASB’s work. Here’s the complete abstract of one of the works presented and discussed, Non-GAAP Earnings and the Earnings Quality Trade-off:

  • Using a large sample of earnings press releases by Australian firms, we compare multiple attributes of non-GAAP earnings measures with their closest GAAP equivalent. We find that, on average, non-GAAP earnings are more persistent, smoother, more value-relevant, and have higher predictive power than their closest GAAP equivalent. However, the same set of non-GAAP earnings disclosures are also less conservative and less timely than their closest GAAP equivalent. The results are consistent with non-GAAP earnings measures reflecting a reversal of the trade-off between the valuation and stewardship roles of accounting inherent in accounting standards and the way they are applied. We also find that differences in several of these attributes between GAAP and non-GAAP earnings are more evident in larger firms, firms with lower market-to-book ratios, firms with a higher proportion of independent directors and firms that report profits rather than losses. Our evidence is consistent with the argument that accounting standards impose significant amounts of conditional conservatism at some cost to the valuation role of accounting information. Non-GAAP earnings measures can therefore be seen as a response to the challenges faced by a single GAAP performance measure in satisfying the competing demands of value relevance and stewardship.

I expect this chimes for the most part with what one would expect, based on experience and intuition. It’s not surprising that non-GAAP measures of earnings would be more persistent (that is, more likely to demonstrate continuity and durability) than their unadjusted counterparts, in that they often remove the kinds of items (non-recurring losses) which would challenge that persistence. This provides a better basis for predicting a kind of core performance, but those non-recurring losses have information value too, and a valuation approach that consistently looks past them may seem, as Hans Hoogervorst once put it, largely sugar-coated. Of course, the points I’m making here are extremely old and familiar.

The value of such a study, perhaps, is in warding off the sometimes excessively charged tone of the debate about these measures, and in underlining that a world where no one ever looked past the bottom-line IFRS-compliant numbers wouldn’t exactly be superior to the one we’re living in. As we perpetually hear, the traditional form of linear periodic financial reporting is being severely challenged by new technological capacities and paradigms (the IFRS Foundation recently announced a new initiative to look into these kinds of issues). Plainly, nothing is going to stop analysts and users from digging into data and modeling an entity’s prospects as they see fit. But it’s reasonable to hope for structures that allow optimal consistency and comparability.

Against that backdrop, it’s interesting that “Much the same pattern of increased value relevance and predictability, but less conditional conservatism for non-GAAP earnings is evident for firms with both relatively more and relatively less independent boards.” As the study notes: “Boards with more independent directors are expected to be better monitors of the financial reporting system within a firm and constrain self-serving disclosure of non-GAAP earnings.” If independent directors don’t make such a big difference, maybe it’s because they realize that tolerating the reporting of non-GAAP measures by the entities on whose boards they serve isn’t actually a “bad” thing (of course, at the risk of seeming overly cynical, it may also be that this aspect of the meeting agenda isn’t what those independent directors are primarily interested in).

The study also finds that the differences between non-GAAP and GAAP earnings are greater in larger firms. Leading in to this finding, it observes:

  • “Firm size can be negatively associated with earnings quality because larger firms would make income-deceasing accounting method choices in response to greater regulatory scrutiny…On the other hand, it is suggested that size and earnings quality is positively related because small firms are more likely to have internal control deficiencies…Of course, one difficulty with this reasoning is that earnings quality has several dimensions, and these are also context specific.

At least in Canada though, it’s rare to come across the kinds of reported internal control deficiencies that could suggest a recurring problem in earnings quality, except among much smaller, development-stage type entities (some might say that’s only because the deficiencies aren’t reported properly). I suppose that all things being equal, the bigger the firm, the bigger the income statement items it might want to downplay.

It’s interesting too that “perhaps ironically,” as the study puts it, the “evidence suggests that managers voluntarily provide performance measures to better satisfy the valuation role of accounting that the IASB sees as paramount.” By this version, such aspects of IFRS as “lower of cost or market value, asset impairment rules, restructuring charges and the requirement to recognize certain forms of contingent liabilities,” may (at least for some users) obscure as much as they illuminate. Is nothing sacred….?!

The opinions expressed are solely those of the author

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