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
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Foreword
The use of extensions to traditional financial reporting to capture performance
information, for example, the value of intangibles, corporate social responsibility
and sustainable strategies has become common practice. For accountants,
as preparers and interpreters of traditional financial statements, there is now
a required awareness of these new reporting extensions.
The Institute of Chartered Accountants in Australia, the premier accounting body
in the country, has a mandate to ensure that accounting as a discipline evolves to
meet these changes. This monograph was commissioned by the Institute and
written by Professor Stephen Taylor from the University of New South Wales in
Sydney. It provides an overview of the ‘conventional’ financial reporting produced
by the application of generally accepted accounting principles (GAAP). It is, in many
ways, a prequel to the reports, Extended performance reporting: an overview of
techniques, and Extended performance reporting: a review of empirical studies, both
produced by the Institute this year. The first, a stocktake report, provides a broad
overview of the major developments in extended performance reporting techniques
worldwide. The second reviews these methods of reporting and what recent
studies have found as to their value.
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
This monograph was written by Professor
Stephen Taylor from the University of New
South Wales in Sydney, Australia.
Neil Faulkner FCA
President
Institute of Chartered Accountants in 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.
ABN 50 084 642 571 The Institute of Chartered Accountants in Australia Incorporated in Australia Members’ Liability Limited. 0706-16
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
Contents
Executive summary
06
Introduction
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1 How ‘useful’ are GAAP metrics for evaluating business performance?
1.1 Introduction
1.2 Does GAAP produce ‘value relevant’ measures?
1.3 How fully do market participants understand accrual accounting?
1.4 Direct evidence on the value relevance of GAAP performance measures
1.5 Conservatism and GAAP reporting
1.6 Summary
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2 What is the quality of GAAP accounting measures?
2.1 Introduction
2.2 Measuring earnings quality and earnings management
2.3 Examples of earnings management
2.4 Incentives to report high quality earnings
2.5 Summary
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3 Evidence on ‘modified GAAP’ reporting
3.1 Introduction
3.2 Comprehensive income
3.3 Street earnings — is this a selective narrowing of GAAP income (and does it improve
earnings as a measure of business performance)?
3.4 Pro-forma earnings — telling it like it is or how you want it to be seen?
3.5 Summary
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4 Conclusion
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Bibliography
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GAAP-based financial reporting: measurement of business performance
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05 >
Executive summary
The report provides an overview of
current knowledge about the state of
‘conventional’ financial reporting and the
measurement of business performance.
The term ‘conventional’ implies an
analysis of what we know about financial
reporting produced by the application of
generally accepted accounting principles
(GAAP). It is intended to inform those
interested in the future of financial
reporting by providing a summary of key
evidence about the existing GAAP
model. In particular, two key questions
are addressed:
> What are the factors underlying the
demand for measurement of business
performance?
> How successful are existing, GAAPbased methods for the measurement of
business performance?
The first question is important because the
answers can help us to understand why the
existing GAAP model looks like it does, in
contrast to alternatives which either modify
the measurement and/or recognition criteria
within GAAP, or fundamentally extend the
business reporting model to capture other
dimensions of performance (e.g.
environmental reporting). In effect, this is
simply saying ‘let’s understand why we have
what we have’, before we consider whether
we should have something different!
The second question is important because it
requires the identification of criteria against
which the success (or otherwise) of the GAAP
model can be evaluated. Of course, any such
answer must reflect a somewhat subjective
definition of success. Success is defined in a
number of ways, including the extent to which
periodic performance measures such as net
income are ‘value relevant’, as well as the
extent to which existing measures of periodic
financial reporting are susceptible to
manipulation. Although the findings outlined
are a reflection of the inevitably selective
summarisation of extant accounting research,
explicit recognition has been given to instances
where the conclusions offered may be disputed
06
by others. However, for the most part the
findings from a large body of archival-empirical
accounting research are quite clear.
Major findings can be summarised as follows:
> Forty years of academic research suggests
that existing measures of financial
performance (i.e. income) and financial
position (balance sheet) are value relevant —
that is, the measures are correlated with
market values and changes therein
> Periodic financial reporting is not very timely
— most value relevant information is
impounded into prices well before the
release of periodic financial reports
> The accrual accounting process does what
it is supposed to do — it provides better
matching of economic costs and benefits
than cash accounting
> Existing measures of financial performance
and position play an important part in the
measurement of business value
> Despite widespread understanding of how
accrual accounting ‘works’, it appears as
though market participants do not rationally
evaluate periodic financial reporting
measures in terms of differences between
attributes of cash and attributes of accrual
accounting
> ‘Value relevance’ is only part of how the
existing financial reporting model should be
evaluated. Periodic financial reporting has its
roots in the stewardship role of managers
who were separated from the owners and
who had to account for the use of the funds.
More broadly, this is the ‘contracting’ role of
accounting
> The use of financial reporting to define and
enforce contracts (both explicit and implicit)
gives rise to important characteristics of
financial reporting, such as verifiability and
conservatism. Such characteristics (and the
underlying demand) are often overlooked by
those who argue and/or enforce change in
the financial reporting model
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
> The demands placed on the financial
reporting model by its role in defining and
enforcing contractual relations (the
contracting role) may sometimes conflict with
the role of financial reporting as inputs to
investment evaluation procedures
> For example, shifts in the measurement basis
of GAAP towards mark-to-market could have
negative repercussions for the contracting
role of financial reporting
> On the other hand, conservatism in financial
reporting may be desirable from a contracting
perspective, but of little use in helping
investors use accounting numbers in
valuation models. Conservatism is also likely
to reflect regulators’ and politicians’ concerns
with minimising economic losses by investors
> The definition of high quality financial
reporting and, ultimately, decisions about
what is ‘best’, are inevitably dependent on
the perspective of those making such
judgement. Put simply, accounting quality
has many dimensions
> Approximately 40 years of empirical research
suggests that existing measures of financial
performance (i.e. GAAP reporting) display at
least some evidence of providing useful
information for contracting and investment
evaluation applications. On the other hand,
the extent to which alternative models for
business reporting display such attributes (to
a greater or lesser extent) is largely unknown
> There are a large number of studies that
support the view that managers are able to
manipulate GAAP accounting in response to
capital market incentives, examples of which
include avoiding losses, earnings declines
and earnings disappointments, as well as
capital raisings
> There are also a large number of studies that
show a link between accounting
manipulation and pay-offs from contracts
using accounting numbers — for example,
bonus plans and debt contracts. However,
this evidence is generally weaker than capital
market incentives
> Survey evidence suggests that, at least in
recent times, managers are more likely to
engage in economic manipulation in
preference to accounting manipulation. This
suggests that the GAAP reporting framework
is relatively robust, but that a by-product of
such robustness is dysfunctional behaviour
by management
> Although there is some evidence suggesting
that corporate governance is positively
related to accounting quality, it is not clear
whether better governance ‘causes’ better
quality accounting, or whether both are a
reflection of factors such as different
business models
> Managers’ attempts at highlighting ‘proforma’ or ‘street’ earnings measures in
preference to GAAP earnings is often alleged
to be self-serving, but there is evidence
suggesting that these ‘modified GAAP’
measures may be more informative than their
GAAP counterparts
> Security analysts and other investment
professionals appear to favour the exclusion
of at least some non-recurring items from
what is otherwise GAAP-compliant income.
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
07 >
Introduction
This monograph is motivated by concerns
that the existing method of measuring
financial performance and, by implication,
financial position is in need of potentially
significant changes. Financial reporting
encompasses not only the basic financial
statements (i.e. income statement, balance
sheet and cash flow statement), but also
the plethora of statutory reporting within
the annual report (e.g. remuneration report)
and even the ongoing requirements to
ensure an informed market via continuous
disclosure rules.
However, most attention on possible changes
to the financial reporting model that result from
the application of GAAP are inevitably focused
on the periodic financial statements, and
especially the key summary measures that are
produced under the existing financial reporting
model.1 These are various measures of income
(often termed financial performance) and
corresponding measures of accounting
‘worth’, such as owners’ equity/net
assets/book value or total assets (often termed
measures of financial position). Evidence on
the ‘usefulness’ of these measures is therefore
the primary focus of this monograph.
Of course, assessment of ‘usefulness’ invokes
an obvious question — useful to whom? The
structure of this monograph reflects the most
identifiable tension in assessing the usefulness
of the GAAP model of reporting for measuring
business performance. On the one hand, the
investment or valuation perspective suggests
that the usefulness of the financial reporting
model can be assessed by reference to its role
in providing information pertinent to the
assessment of value. Leaving aside issues
related to how such an objective can be
operationalised, the most obvious benchmark
would appear to be the correlation between
GAAP reporting and market prices. However,
a key plank in this review of empirical evidence
is the recognition that an equally if not more
important role of financial reporting is to
provide information useful for contracting.
What do we mean by contracting? Historical
evidence suggests that a primary determinant
of the demand for financial reporting (and
extensions to dimensions such as the auditing
of these reports) can be attributed to the
reliance on these numbers as a means of
defining and subsequently enforcing financial
relationships.2 In modern-day terms, think of a
debt contract — an instrument designed for
determining and then enforcing the conditions
under which a business may borrow funds and
then apply such funds to investment
opportunities. This contract uses various
measures either directly sourced from the
audited financial statements such as leverage
or interest coverage, or possibly measures that
reflect transparent modifications of these
numbers (e.g. net tangible assets rather than
net assets).3 Naturally, the exact design of debt
contracts varies with the fundamental attributes
of the debt finance (e.g. private versus public,
fixed versus floating, secured versus
unsecured, etc.). However, the overriding
lesson is clear — debt contracts use GAAPbased numbers to define and enforce
lender/borrower relationships.
A similar contracting role for the financial
reporting system is evident in the
compensation of management, who typically
are entrusted to run the firm on behalf of the
shareholders. A common feature of executive
compensation schemes is some form of
bonus, which typically is tied to either reported
profit or measures that form part of the
calculation of profit. There are sound reasons
why some component of management
compensation is tied to a measure of
accounting earnings rather than simply share
price movements (Sloan 1993). Share prices
are a noisy measure of management
performance and, provided at least some of
this noise is not present in accounting
measures of performance such as periodic
income, then it is rational to include some
income-related component in compensation.
Evidence on the role of accounting numbers in
defining and enforcing financial contracts is
important, because the earliest instances of
explicit production of financial reports appear to
be in the context of accounting to owners for
investments in voyages of adventure (Watts &
Zimmerman 1983). Since that time contracts
that have ultimately come to be seen as
arranging terms of financing (e.g. debt
contracts) or for performance-based pay have
been able to select appropriate measures on
which to define the relationship and measure
compliance. As contracts have evolved with
changing business circumstances, so has the
demand for accounting as a technology for use
in contracting. Contracting parties are not
bound necessarily by the rules that determine
GAAP reporting as produced in external
financial reports. However, there is likely to be a
strong overlap between accounting used within
firms and that which is used externally.
Proponents of various extensions to the current
GAAP-based model of financial reporting must
surely be obliged to explain why measures that
they favour have not been used voluntarily
where it is (at least implicitly) alleged that more
efficient financial contracting would result. Put
simply, if there is really a ‘better’ measure for
performance evaluation, why is it not used in
settings other than statutory external reporting?
The ‘economic Darwinism’ reflected above
should not be interpreted as a claim that the
existing financial reporting model is not capable
of improvement. At no stage in this review is it
claimed that the existing GAAP-based model of
financial reporting cannot be improved as a
measure of business performance. It is one
thing, however, to agree that change may be
desirable, but another entirely to agree on what
those changes should be. Concepts such as
triple bottom line, sustainability reporting,
intellectual capital measurement and
environmental reporting all have their
proponents. For the most part though,
arguments in favour of what may be quite
fundamental changes (or at least extensions) to
GAAP-based financial reporting rarely
commence by carefully considering what we
currently have as the financial reporting model,
and why we have it.
In many senses, what follows is comparable
to the first stage of planning a trip. We cannot
hope to plan how to get to our destination if
we do not know where we are commencing
the journey. In a similar vein, it is hard to
rigorously evaluate recommendations for
change unless we have a solid grounding in
where we are currently. This monograph
attempts to provide such a roadmap of the
existing financial reporting landscape, not
saying where we should go, but rather
showing where we are currently. It is worth
considering why the existing financial
reporting model works the way it does and
why it takes the form that it does. Figure 1
summarises the structure of this review.
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
GAAP-based financial reporting: measurement of business performance
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
09 >
Figure 1: How useful is the existing GAAP-based reporting model for measuring business performance
Useful Financial
Reporting
Value relevance
Evidence
Market reactions
Correlation with share
price changes
Correlation with price
Costly Contracting
Use of accounting
numbers
Modification
of accounting
Financial reporting
quality
Alternative measures of
financial performance
(Modified GAAP)
An example serves to illustrate the approach.
The method is to draw selectively on key
research papers to highlight what may be
viewed as ‘evidence’ about the current state of
the financial reporting model. In section 1,
evidence on the functionality of the existing
model is reviewed. This section commences by
considering capital markets research intended
to highlight how useful GAAP accounting is, at
least to equity investors. This research,
commencing from the path-breaking study by
Ball and Brown (1968), is a cornerstone of
modern thinking about how to define a
measure of the ‘usefulness’ of financial
reporting. However, an immediate dilemma
arises. Is a ‘good’ result necessarily a high
degree of correlation between changes in
market values and periodic accounting
performance? This ‘value relevance’
perspective is increasingly adopted to support
arguments in favour of market values as the
preferred method of measurement within the
10
existing GAAP model (Barth 2005). Yet even a
casual inspection of 500 or more years of
accounting history suggests that the
measurement of market values (and hence
‘value relevance’) has not been the primary
concern underlying the economic demand for
periodic financial reporting (Watts 2005).
Why is this? The most likely explanation, as
section 1 also highlights, is that the stewardship
role of accounting underlies the early economic
demand for business reporting, and the
susceptibility of market value accounting to
manipulation meant that historic costs are often
a preferred measurement basis in terms of the
reliability of financial reporting. This is especially
true of arm’s-length contracts (such as debt
contracts) that rely on well-understood,
relatively ‘reliable’ accounting rules and
conventions (i.e. GAAP) to form measures that
can be readily monitored (e.g. liquidity, leverage
and interest coverage). So section 1 highlights
an important concern, namely that the move
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
towards ‘mark-to-market’ accounting may be
viewed as at least partially inconsistent with the
underlying economic demand for financial
reporting. In this sense, standard-setters may
be ‘getting ahead’ of where the basis of
measurement for financial reporting should be.
In section 2, current knowledge as to the
‘quality’ of current GAAP reporting is reviewed.
The first dilemma here is to adequately define
just what we mean by ‘high quality’
accounting. The lead of recent research is
followed recognising that it is likely that
accounting quality has several different
dimensions. For example, predictability, value
relevance and conservatism may all be possible
measures of the quality of periodic accounts,
especially key summary measures such as net
income. Having recognised that accounting
quality is a complex concept, a review of
evidence consistent with accounting quality
being rewarded is given — that is, evidence
consistent with an economic demand for
accounting quality. Once again, an important
inference is that the current GAAP model has
been shaped by a variety of economic forces.
The extent of any link between the quality of
accounting and corporate governance is also
considered. Some argue that better corporate
governance is required to ensure better
financial reporting. However, these claims
frequently ignore the existing body of evidence
exploring such linkages.
Proposed changes to the existing financial
reporting model can be viewed as reflecting
one of two types — either the provision of
information beyond that provided under the
existing GAAP reporting model, or similar
information using rather different measurement
rules. Examples of the former include very
substantial deviations from the existing GAAP
model to include broader forms of stakeholder
reporting such as environmental reporting,
triple bottom line and the like, as well as less
dramatic recommendations such as the
reporting of comprehensive income. An
example of the latter would be the seemingly
inexorable shift towards mark-to-market
accounting, especially as reflected in current
and proposed standards produced under the
auspices of the International Accounting
Standards Board (IASB).
Section 3 extends the approach underlying
sections 1 and 2 to consider evidence on some
‘alternatives’ to GAAP. It is hard to scientifically
examine potential extensions to the existing
financial reporting model without actual
examples, so the focus of section 3 is on the
limited evidence to date of
extensions/modifications to GAAP reporting.
This includes those popularised by consulting
firms such as Stern Stewart’s Economic Value
Added (EVA), and the ad-hoc modification of
GAAP by reporting firms themselves to
produce measures such as pro-forma income.
The purpose here is to evaluate the usefulness
of such measures relative to GAAP, as well as
the scope for opportunistic manipulation by
those the financial reports are intended to
monitor. If, for example, managers are able to
choose the exact definition of income (i.e. proforma income) that they wish to highlight, is
this likely to lead to less informative and/or
lower quality reporting?
Some conclusions are briefly summarised in
section 4. For the most part, however, this
monograph is not about conclusions per se.
It is an overview of the evidence. In short, it is
intended to be a relief map of where we are
now. It is therefore a necessary, but not
sufficient, condition for deciding how we get to
our target destination. A wide variety of interest
groups, including preparers, investors,
employees, regulators, auditors, politicians and
academics will no doubt continue to have
much to say about where a search for better
financial reporting will take us. However, that
search inevitably is informed better by an
adequate understanding of where we are now.
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GAAP-based financial reporting: measurement of business performance
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1 How ‘useful’ are GAAP metrics for evaluating
business performance?
Key points
1.1 Introduction
> Claims that financial reports produced
under extant GAAP are not relevant to the
evaluation of business performance
have been repeatedly rebutted over the
last 40 years
> GAAP-based measures of financial
performance and position (income, net
assets) are related to firms’ market
valuations, as well as the way in which
these values change over time
> There is theoretical, as well as empirical
support for the role of accounting
numbers produced under GAAP as input
to valuation metrics
> Accrual accounting as applied by GAAP
improves the ability to understand business
performance over finite horizons
> There are legitimate concerns that capital
markets do not completely take account of
the way in which accrual accounting
‘works’ (i.e. the way accruals reverse)
> The usefulness of GAAP accounting is also
highlighted by the way it has been used to
define and enforce contractual relations
> The contracting role of GAAP potentially
limits the implications that can be drawn
from evidence about ‘value relevance’
> Evidence of conservatism in financial
reporting highlights the tension between
the contracting and value relevance
perspectives on how GAAP financial
reporting should evolve.
This section reviews evidence addressing the
question ‘does GAAP accounting produce
measures that are useful for evaluating
business performance?’ Such a question is
fundamental to any consideration of how
GAAP reporting may be improved, either
incrementally via changes in certain
measurement rules or much more
fundamentally via substantially altered
performance measurement systems (e.g.
sustainability measures). As advocates of
allegedly improved or ‘better’ systems of
measuring business performance speak up, or
as entirely new concepts for measuring and
assessing business performance are offered,
the same underlying theme is inevitably present
— namely the alleged deficiencies (or even
failure) of GAAP accounting to produce metrics
which are useful. Of course, this in turn requires
us to identify what we mean as ‘useful’. To a
certain extent, the subject of this review helps
in that respect. If we are interested in the
measurement of business performance, then
presumably we are interested ultimately in
business valuation. Hence, one appropriate
benchmark against which to assess the
usefulness of extant GAAP measures is a
measure of value. This insight has been a
fundamental tenet of accounting research for
the last 40 years, dating from the pioneer study
of Ball and Brown (1968). In section 1.2, the role
of value relevance as a criterion for evaluating
GAAP financial reporting as a measure of
business performance is explained more fully,
along with a description of several important
research studies.
The use of value relevance as a criterion for
evaluating the performance of GAAP financial
statements also invokes some very important
assumptions. In several forms of value
relevance research, an important assumption is
that financial markets, especially markets in
which share prices are established, are
relatively efficient. The ‘efficient markets
hypothesis’, while a useful paradigm in which
to understand the process by which
information is impounded into the valuation
process, has come under increasing question.
Indeed, research that challenges the ability of
share market participants to understand
relatively basic properties of accrual accounting
(on which GAAP financial reporting is based)
has become more widespread in recent years
(Sloan 1996). In section 1.3 these
developments are briefly reviewed and their
significance to any evaluation of GAAP financial
reporting is considered. This analysis to recent
theoretical and empirical research addressing
‘value relevance’ of GAAP financial reporting is
extended further in section 1.4.
However, a more fundamental concern
expressed about the ‘value relevance’
construct is that it is not the only way to
examine the usefulness of GAAP financial
statements data as a measure of periodic
business performance. Indeed, it is possible
that if the value relevance criterion is the
dominant means of assessing the performance
of GAAP as a measure of periodic business
performance, then a clear implication is that
GAAP accounting should measure equity
value. This has implications for the choice of
measurement rules within GAAP, and possibly
underlies the move towards increasing use of
‘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.
Apart from providing input into a valuation role,
there are several other functions that GAAP
financial reporting is asked to perform, and
which historically underlie the gradual
development of GAAP rules and conventions.
The most obvious of these roles is the
contracting role whereby financial reporting
serves as inputs in establishing and enforcing
contractual relations that make up the modern
firm. Obvious examples include debt contracts
and compensation contracts for employees,
but there are also many other ways in which
GAAP numbers may be implicitly incorporated
into decision making that affects the firm. An
obvious example here would be various forms
of regulatory action that rely on GAAP
numbers as input (e.g. profitability analysis in
rate regulation).4
An extensive literature has evolved over the
last 25 years examining the contracting role
of accounting, commencing from the
pioneering work of Watts and Zimmerman
(1978; 1979). Detailed reviews of this
literature are available, and direct evidence
on the contracting role of accounting is not
reviewed here. Rather, in section 1.5 one
specific attribute of GAAP accounting is
looked at that may impact on its use as a
measure of periodic business performance
and which is attributable to contracting
considerations. This attribute is
conservatism. How the demand for
conservatism in GAAP potentially conflicts
with suggestions that measurement rules
within GAAP should give more weight to
market values (i.e. mark-to-market
accounting) is also considered.
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).
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GAAP-based financial reporting: measurement of business performance
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
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1.2 Does GAAP produce ‘value
relevant’ measures?
The concept of ‘value relevance’ is not one that
is explicitly recognised by those charged with
setting the standards that underlie GAAP. Most
conceptual framework-type projects
undertaken by standard setting agencies
recognise concepts such as ‘relevance’ and
‘reliability’, but not the term ‘value relevance’.
Nevertheless, the relation between accounting
information produced under GAAP rules and
the level and/or changes in value would seem
to be an intuitively reasonable way for
accounting researchers to operationalise these
criteria. GAAP accounting information is
unlikely to be either relevant or reliable if it does
not reflect information that is impounded into
the firms’ share price (Barth et al. 2001).
There are a number of ways that the value
relevance concept has been operationalised by
accounting researchers. Four primary
approaches outlined by Francis and Schipper
(1999) are:
1. Financial statement information is value
relevant if the accounting information leads
prices by capturing intrinsic values which
share prices then approach
2. Financial statement information is value
relevant if it contains variables used in a
valuation model or helps predict those
variables
3. Financial statement information is value
relevant if it changes the total mix of
information in the marketplace
4. Financial statement information is value
relevant if it is correlated with ‘other’
information used by investors.
Of course, it is possible that GAAP financial
statement data may be value relevant but not
‘decision relevant’, if the information contained
in GAAP financial statements is not especially
timely. To the extent that GAAP provides a
measure of periodic performance, and this
performance reflects factors that are
themselves observable over time via a large
number of other sources, then it would not be
surprising if GAAP financial statements were
not a very timely source of ‘new’ information for
investment decision-making purposes. In other
words, while periodic financial statements
produced under GAAP may be, on average,
strongly correlated with the underlying periodic
economic performance of the business, these
reports may have relatively little impact at the
time of their release due to the correlation
between performance measurement under
GAAP and other metrics which are observable
to market participants during the course of the
financial period.
Although Barth et al. (2001) argue that the term
‘value relevance’ does not appear to have been
used in accounting research prior to the early
1990s, the foundations of this approach date
back to the pioneering work of Ball and Brown
(1968). Prior to this time accounting research
was either purely descriptive or of a normative
nature directed at identifying what might be
argued to be ‘best’ accounting practices.
A prime example of this approach can be found
in Chambers (1966), who argued eloquently
and passionately for the introduction of a
system of accounting measurement known as
continuously contemporary accounting
(CoCoA). Of course, fundamental to such work
was the criticism, explicit or implicit, that
existing accounting practice was of little value
to users for tasks such as assessing business
performance. However, with the development
of modern finance theory (particularly the
efficient markets hypothesis) and the
concurrent availability of computerised
databases of accounting and share price
information, it is not surprising (at least with
hindsight) that the claims that periodic financial
statements produced under GAAP were ‘not
informative’ would be subject to empirical
testing. This is exactly what the pioneering Ball
and Brown study did, by examining the
association between accounting performance
measurements produced under GAAP (e.g. net
income, EPS) and share price changes over the
same period as captured by the financial
statements.5 This approach typified what came
to be known as ‘information content’ research.
Ball and Brown (1968)
The study by Ball and Brown is widely
recognised as a ‘revolution’ in accounting
research, and the key points are
summarised below.
> The study is widely recognised as having
pioneered research in terms of
understanding whether accounting numbers
produced under GAAP have ‘information
content’. The principal test for which Ball and
Brown is best known was mapping the
relation between annual earnings changes
(i.e. a proxy for earnings surprises) and firms’
contemporaneous annual stock returns,
adjusted for the effect of market movements.
They examined annual earnings data for US
firms between 1957 and 1965 for a sample in
excess of 2,500 firm-years
> Ball and Brown showed that most of the
association between the sign of the earnings
change and contemporaneous annual stock
returns occurs prior to the release of the
earnings number. Hence, earnings measured
under the prevailing GAAP rules and
principles was seen to be an informative
metric in terms of explaining changes in
value, but it is not especially timely as a
source of new information
> The results reported by Ball and Brown were
consistent with the existence of numerous
other sources of information that are
correlated with earnings performance. These
observable signals result in much of the total
information in earnings being incorporated
into prices before the actual announcement
of the earnings result
> The most widely cited aspect of Ball
and Brown is their diagram illustrating the
correlation between three measures
of annual earnings changes and
contemporaneous stock returns.
This is reproduced below.6
Figure 2: Abnormal indexes for various portfolios
1.12
1.10
1.08
1.06
1.04
1.02
1.00
0.98
0.96
0.94
0.92
0.90
0.88
-12
-2
0
2
-8
-6
-4
4
-10
Month relative to annual report announcement date
6
Variable 1
Variable 2
Variable 3
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
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15 >
What ensued following Ball and Brown (1968)?
Empirical research directed towards the
information content of accounting rapidly
expanded. Chief among researchers’ concerns
was the development of better measurements
of the ‘impact’ that release of accounting
information had on share prices. This involved
identifying shorter and shorter ‘windows’ in
which to measure price changes around
information releases, as well as better
measures of the associated earnings surprise,
such as measures based on analysts’ forecasts
rather than the time series behaviour of
earnings. A further extension involved
examining the determinants of the differences
in how prices changed in response to news
contained in GAAP financial statements (i.e.
determinants of earnings response
coefficients). These developments are
comprehensively reviewed by Kothari (2001).7
Although the Ball and Brown (1968) study and
those that followed suggest that information
contained in GAAP accounting reports is useful
for assessing periodic business performance
(and, ultimately, valuation), this research does
not necessarily address what specific
properties of GAAP are fundamental to the
result. Most simply, GAAP financial statements
reflect the combination of two components,
namely cash flows and accrual adjustments.
Indeed, GAAP accounting is really just the
accrual accounting technology applied (via a
set of rules and conventions) to what would
otherwise simply be cash flow reports. This
raises an obvious question — does accrual
accounting do what it is supposed to do?
Dechow (1994)
Dechow is a widely cited study that directly
addresses the question of whether accruals
generated under GAAP ‘do the job’. She
recognises that if earnings are to be a useful
summary measure of business performance
(relative to cash flow), then that is likely to occur
via two important principles which underlie
GAAP accruals, namely the revenue
recognition principle and the matching
principle. These can be summarised as follows:
> Revenue recognition principle — recognise
revenue when a firm has performed all or
substantially all of the services to be
performed (or provided goods) and the
receipt of cash is reasonably certain
> Matching principle — outlays that are directly
associated with revenue recognised during
the period must be expensed in that period
before income for the period can
be determined.
These two principles are fundamental to
GAAP accounting providing periodic
performance measures that more closely
reflect business performance.
The revenue recognition principle and the
matching principle are fundamental reasons
why accrual accounting is expected to yield
more informative periodic performance
measures than simply relying on a cash-based
measure of periodic performance. It is the
accrual process, on the other hand, that is also
widely viewed as being most subject to
manipulation, thereby possibly reducing the
ability of GAAP measures such as income to
serve as a useful measure of business
performance.8 Indeed, a widely held view in
texts used to teach finance courses is ‘only
trust cash flow’, or ‘cash is king’. Dechow’s
(1994) study is therefore important in
providing a relatively straightforward method
for understanding why, and how, accrual
accounting measures produced via GAAP are
better measures of business performance
over finite periods. The key results are
summarised below.
> This study examined the circumstances
under which accruals improve the ability of
earnings to measure firm performance. This
was assessed by reference to the ability of
earnings to explain contemporaneous
market-adjusted stock returns. Several
different earnings periods were examined,
beginning with quarterly earnings, through
7 Additional background on the development of Ball and Brown and its subsequent implications is discussed by Brown (1989).
8 This issue is considered more fully in Section 2, which addresses concerns about the ‘quality’ of GAAP financial reporting measures.
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GAAP-based financial reporting: measurement of business performance
annual earnings and, finally, a four-year
aggregate measure of earnings. Over
27,000 US firm-years were examined for
the period 1960–1989
> As the length of the performance
measurement interval was increased, the
relative advantage of GAAP earnings over
cash flow (i.e. the contribution of accruals)
declined. Over very short intervals (e.g.
quarterly measurement), GAAP earnings was
far more informative than cash flow. This
result is primarily attributable to operating
accruals (i.e. changes in working capital)
> Accruals were relatively more important in
measuring periodic performance with the
length of the firm’s operating cycle
> Accruals were relatively more important in
measuring periodic performance as the
volatility of the firm’s working capital
requirements increased
> In effect, Dechow demonstrated that
accruals create a measure of periodic
performance that results in better matching
than a simple cash-flow based measure
would provide. This result contrasts with the
view that accruals somehow ‘scramble’ the
message provided by periodic cash flow
> Dechow’s conclusions were premised on the
assumption that contemporaneous stock
returns are an appropriate benchmark — that
is, stock returns reflect all ‘new’ information
that becomes available during the period.
In summary, Dechow (1994) is representative
of a shift in accounting researchers’ approach
to evaluating GAAP financial reporting. Instead
of focusing on the extent to which the release
of the information impacts on market
participants’ expectations (via changes in share
prices), she considers the correlation between
market and accounting-based performance
measures. In doing so, Dechow demonstrates
that periodic performance measures produced
via GAAP rules and principles achieve precisely
what the accrual accounting process is
designed to accomplish, namely better
revenue recognition and matching processes
than would arise if periodic financial reporting
simply tracked cash flows.
1.3 How fully do market
participants understand
accrual accounting?
As mentioned in the context of explaining the
origination of capital markets-based accounting
research, efficient capital markets (EMH) are an
important assumption where share prices, or
changes therein, are relied on to assess the
performance, or value relevance, of periodic
financial reporting under GAAP. For example, it
is a necessary assumption in Dechow’s (1994)
study that all value-relevant information is
reflected in share prices — in effect that
markets are informationally efficient. While this
has been a fundamental tenet of capital
markets research in accounting since Ball and
Brown (1968), the assumption has come under
an increasing amount of challenge.
Sloan (1996)
Of particular interest to those wanting to
understand the usefulness of GAAP measures
in explaining business performance is the
evidence in Sloan. He directly examines the
extent to which the very basic distinction within
GAAP accounting (i.e. cash flow versus
accruals) appears to be understood.
Specifically, Sloan points to the differing
persistence in the cash flow and accrual
components of earnings. Operating accruals
are relatively transient, whereas cash flow tends
to be more persistent. Indeed, the idea that
accruals reverse is fundamental to why accrual
accounting achieves better ‘matching’ of
revenues and associated expenses, as
discussed above. Sloan identifies several
important implications that follow from this
most basic appreciation of how accrual
accounting ‘works’.
> He examined how efficiently stock prices
reflect information about future earnings that
is readily available from current earnings. He
pointed to the differing persistence of the
accrual and cash flow components of
earnings. Cash flows are more persistent
than accruals, which follows from the
manner in which most (operating) accruals
reverse relatively quickly. Sloan examined
annual earnings data for US firms between
1962 and 1991, with over 40,000 firm-years
included in the analysis
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GAAP-based financial reporting: measurement of business performance
17 >
> Using a simple model of annual earnings
prediction, Sloan showed that the accrual
component of earnings was significantly less
persistent than the cash flow component
> Sloan then showed that size-adjusted stock
returns (a measure of ‘abnormal’ returns) can
be explained by differences between the
actual persistence of cash flows and accruals
and the implied persistence from a model
explaining size-adjusted returns. This result
implied that the market puts too much
weight on earnings changes that are driven
by accruals, and insufficient weight on
earnings changes that are caused by cash
flow changes. Put simply, the result
suggested that investors fail to anticipate
fully the fact that accruals are less persistent
than cash flows
> Sloan also demonstrated that a trading
strategy based on this apparent market
inefficiency would have yielded larger than
expected returns. These returns were
clustered around subsequent earnings
announcements for up to three years after
the earnings result of interest. This was
consistent with investors ‘slowly’ realising
the error in their weighting of information in
cash flows and accruals respectively. In
literature that has followed Sloan’s study,
the basic result has come to be known as
the ‘accrual anomaly’.
Although Sloan’s conclusions have been
controversial, they also appear to have been
relatively robust. Several studies addressing
possible methodological explanations have
been conducted, but there is not always
agreement among researchers on the
appropriateness of various ‘adjustments’ which
have been shown to possibly affect the results.9
LaFond (2005)
Extensions to other countries, such as the
evidence in LaFond, reveals similar evidence
of the accrual anomaly. However, what is
puzzling is that the most obvious explanations
for such an anomaly do not appear to have
any ability to explain systematic variation in
the extent of this evidence.
> LaFond (2005) examined the extent to which
the ‘accrual anomaly’ of Sloan (1996) is
evident internationally. He examined data
from 17 countries over the period 1989–2003
to provide evidence on whether there was
systematic variation across and within
countries. Within countries, the study
examined the role of managerial discretion
(proxied by income smoothing),
informational environment (proxied by
analyst following) and ownership structure
> LaFond was unable to detect systematic
relations between the accrual anomaly
and any of the three ‘causal’ factors
suggested above
> LaFond also examined whether the returns
associated with the accrual anomaly were
correlated across countries. If they were, this
would suggest that perhaps some part of the
accrual anomaly was really a reflection of
systematic risk factors prevalent in
internationally integrated stock markets.
However, there was no evidence to this effect.
Given the results of Sloan (1996) and
subsequent studies such as LaFond (2005),
does that leave a serious concern that a study
of the usefulness of accruals that underlie
GAAP accounting such as Dechow (1994) is
on shaky ground, relying as it does on market
prices rationally reflecting value-relevant
information? A resolution of this apparent
conflict is to be found in a recent study by
Dechow, Richardson and Sloan.
Dechow, Richardson and Sloan (2005)
> This study provided a more careful
examination of why the cash component of
earnings is more persistent than the accrual
component (a fundamental part of the
accrual anomaly). They decomposed the
cash component of earnings into three
components; first, cash retained by the firm;
second, cash applied to debt financing; and
third, cash applied to equity financing. Earlier
evidence on the so-called accrual anomaly
treated all of the cash components of
earnings as a single measure
> Dechow et al. examine in excess of 150,000
US firm-years covering the period
1950–2003. They find that the higher
persistence of cash flows relative to accruals
is entirely due to the high persistence of cash
applied to the amount of equity financing
> Stock prices act as if investors correctly
anticipate the lower persistence of cash
applied to debt financing, but overestimate
the persistence of cash that is applied to the
firm’s cash balance (i.e. cash retained within
the firm)
> One interpretation of the results was that
investors overestimated the persistence of
earnings that were held within the firm.
Hence, the so-called accrual anomaly would
appear to be a reflection of hubris regarding
the future value of new investment
opportunities, as accruals and retained cash
flow both were associated with higher
future investment outlays, as well as lower
stock returns.
These results are still of concern if we expect
that markets rationally and efficiently process
available information. However, what they
contribute that is important to the issue at hand
is that it is not a misunderstanding of the
properties of GAAP accruals per se that appears
to somewhat mislead investors. Rather, a more
general hubris is evident in terms of how
retained cash is viewed. In this sense, the
original conclusion from Dechow (1994) that
accruals ‘do what they are supposed to do’
appears reasonable.
1.4 Direct evidence on the value
relevance of GAAP
performance measures
As noted above, there has been a shift in
researchers’ priorities away from examining
how the release of periodic accounting reports
impacts market participants to what has
become popularly termed ‘value relevance’
tests. These studies typically examine the
relation between periodic accounting measures
and share prices, or the ability of such
measures to identify firms where the share
price differs from what would be predicted.
Central to this research is a theory linking
accounting measures to value. Ohlson (1995)
frequently is credited with providing the
underlying theory to support this approach.
Ohlson outlines the role of periodic accounting
measures in explaining (or predicting) value,
using what is commonly known as the residual
income model (RIM). Although the RIM is not
attributed to Ohlson (i.e. it has existed for a
much longer period of time), the contribution
made by Ohlson was to highlight how, under
certain assumptions, the RIM and discounted
cash flow (DCF) methods should yield the
same result. The key inputs to the residual
income model from the system generating
periodic accounting reports are the current
measure of worth (i.e. book value) and the
expectation of future earnings relative to the
required accounting return on equity (i.e.
accounting return on equity (ROE)). Value, as
measured from periodic accounting data, is the
current book value plus the present value of
abnormal earnings.10
In effect, where there is no reasonable basis on
which to project accounting earnings that differ
from the required rate of return, then market
value and book value should be the same (i.e.
the market-to-book ratio would be one.) Where
expected earnings differ from the required rate
of return, then the necessary horizon over
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
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GAAP-based financial reporting: measurement of business performance
19 >
which forecasting must occur is the period
over which the difference between actual
accounting ROE and required accounting ROE
is expected to persist. Importantly, competitive
forces as well as the accrual accounting
process itself mean that expected abnormal
earnings are unlikely to persist over a large
number of periods. This has the advantage of
creating a finite forecasting horizon, in contrast
to the DCF (and related) approaches to
estimating value.
The existence of a formal model providing
a theoretical link between periodic GAAP
accounting results and value is an important
consideration in examining the ‘usefulness’
of the existing system of periodic reporting
for measuring business performance.
Some evidence in support of the practical
advantages evident from the RIM approach is
provided by Penman and Sougiannis. This
evidence is reviewed below.
Penman and Sougiannis (1998)
> Penman and Sougiannis investigated the
practical advantage of accounting-based
valuation multiples (including a RIM) relative
to cash flow techniques (i.e. dividend
discount model and DCF). In theory, all
methods reflect the same assumptions, and
should yield the same valuation estimates.
However, this is dependent on the use of
differential forecasting horizons appropriate
to each model
> Using a sample of US data averaging over
4,000 firm-years each year between 1973
and 1990, the authors compared prediction
errors for each technique based on different
forecasting horizons
> The results showed that the practical
advantage of accrual accounting-based
valuation methods, particularly the RIM, was
due to the greater efficiency in forecasting.
DCF and dividend discounting models
require longer forecasting horizons to yield
similar prediction errors
> One interpretation of the results was that
accrual accounting assists in bringing
expected outcomes into the reporting
process more quickly than would occur
using a cash-based system.
20
Following the theoretical work of Ohlson
(1995) and others, it has become common
for researchers examining the linkage between
accounting measures and share price levels to
cite the RIM as justification for this approach.
Most commonly, the method is to regress a
measure of market value (share price) on
current earnings and book value. The relative
weight attached to each of these two summary
measures should reflect the relevant
characteristics of the firms (and financial
period) used for this estimation. Although the
linkage between the RIM and this approach
(to either explain or predict equity values) is
not without some dispute (Ohlson 1998),
researchers have adopted this approach to
address a number of claims that fall under
the broad notion of ‘value relevance’. In the
summary below three examples of the
questions addressed are highlighted:
1. Have GAAP financial statements become
less value relevant over time? Many critics
have argued that GAAP financial reporting is
unable to adequately reflect the performance
drivers of the modern corporation. This
criticism became especially popular during
the so-called ‘tech boom’ of the late 1990s.
Francis and Schipper (1999) is one of the first
studies to systematically address this claim,
and demonstrate that, contrary to populist
and anecdotal evidence, GAAP financial
reporting has continued to demonstrate a
strong association with market pricing
2. Are there ‘obvious’ measures that GAAP
reporting excludes, but which are important
to determining the value of modern
businesses? The answer to many may be a
self-evident ‘yes’, but it is difficult to subject
potential improvements to empirical analysis
unless the data is otherwise available.
One example is the value of brands, which
in many cases reflect the overall importance
of what are often termed ‘intangible’
assets. Barth et al. (1998) examine the
additional information contained in a
proprietary measure of brand values which
GAAP excludes from measurement.
They find that these brand values are ‘value
relevant’ over and above the information
contained in periodic GAAP-based financial
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GAAP-based financial reporting: measurement of business performance
reports. However, as the authors themselves
recognise, this does not automatically mean
that GAAP reporting should be modified to
explicitly measure brand values
3. How do accruals improve the value relevance
of GAAP financial statements? Barth et al.
(2004) use the RIM approach to predict
equity values, and find that separating out
the accrual component of expected income
improves the predictive power of the
valuation model. This research extends the
inferences made from Dechow (1994) to a
somewhat broader notion of value relevance.
These three studies are summarised below.
> The valuation prediction model used
progressively more disaggregated measures
of income in order to establish whether
accruals increase the usefulness of cashbased earnings for measuring value
> The results indicated that prediction errors
were reduced when the accrual component
of income is included separately in the
valuation model.
Francis and Schipper (1999)
> They examined over 1,200 brand valuations
for 595 US firm-year observations covering
the period 1992–1997
> To test the value relevance of brands, Barth
et al. regressed share price on book value,
earnings and the brand valuation, which is
not recognised within GAAP financial
statements. They also examined the
association between changes in brand value
and contemporaneous stock returns. In both
cases, they also included several additional
controls, and their results were robust to
these additional controls, as well as a
simultaneous equations approach to control
for the possibility that brand values reflect
share prices (i.e. causality may go in the
opposite direction to the hypothesis)
> Barth et al. found that brand valuations not
recognised in GAAP financial statements
were value relevant. They also found that
brand valuations were positively associated
with advertising expense, brand operating
margin and brand market share. However,
the brand valuations were not significantly
related to sales growth.
Francis and Schipper considered the extent
to which GAAP financial statements may have
progressively lost value relevance over time.
> They operationalised value relevance in two
ways; first, a measure of what investors
could have earned based on foreknowledge
of the financial statements; and second, the
ability of earnings to explain
contemporaneous stock returns, and the
combined ability of earnings and book value
to explain stock prices
> The authors examined data from US firms
over the period 1952–1994
> Although the authors found some decline
in the value relevance of earnings, they also
documented a corresponding increase in the
value relevance of balance sheet information
(e.g. measures of book value)
> When the analysis is confined to ‘high-tech’
firms, the authors found little evidence of
systematic changes over time.
Barth, Beaver, Hand and Landsman (2004)
This study examined the usefulness of accruals
for predicting equity values.
Barth, Clement, Foster and Kasznik (1998)
Barth, Clement, Foster and Kasznik considered
whether a commercial estimate of brand values
had incremental value relevance over and
above financial statement data.
> Barth et al. examined over 17,000 US
firm-years between 1987 and 2001
> They examined the prediction errors for
a model of equity value (i.e. share price)
prediction based on the insights of Ohlson
(1995) that equity value is a weighted
multiple of book value, earnings and
‘other information’
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GAAP-based financial reporting | Measurement of business performance
21 >
1.5 Conservatism and GAAP
reporting
The use of a value relevance criterion for
considering the usefulness of the existing
GAAP-based system of periodic financial
reporting (and possible extensions/
modifications thereto) ignores the many other
ways in which business performance is
measured (or monitored) for purposes other
than valuation per se. For example,
measurement of business performance is an
integral part of executive compensation
contracts, which specify GAAP (or GAAPrelated) performance measures as part of the
set of criteria against which executive
performance is assessed and rewarded.
Similarly, the provision of debt financing
typically entails some commitments on behalf
of the borrowing entity which are defined and
monitored using variables derived from the
GAAP financial statements.
The use of GAAP-based measures in various
types of contracting creates a demand for
certain properties within GAAP-based
accounting. These properties may be at odds
with a pure ‘value relevance’ perspective. One
such example is the demand for conservatism.
What is conservatism in financial reporting?
Fundamentally there are two types of
conservatism (Watts 2003a; 2003b). First,
there is what can be termed unconditional
conservatism. This simply reflects a preference
for accounting methods that result in lower (or
the lowest possible) value of assets and hence
owners’ equity. This is a systematic bias in
accounting, and as such can be readily
adjusted. It is hard to see how such a
systematic bias would improve periodic
financial reporting. While it does not assist in
achieving greater value relevance, it also is
unlikely to be of value in facilitating more
efficient contracting arrangements between the
various parties of which the firm is comprised.
In contrast, conditional conservatism arises
where financial reporting requires a higher
standard of verification for the reporting of
good news as compared to bad. This reflects
a perspective similar to that of ‘anticipate no
22
gains, but anticipate all losses’. In effect,
this results in an asymmetrical timeliness —
periodic financial reporting reflects bad
economic news more quickly than good.
A simple example provided by Basu (1997)
illustrates the asymmetrical treatment of good
versus bad economic news. Imagine a machine
for which the estimated useful life changes
part-way through the period over which it is
depreciated. Typically, if the estimated useful
life is now shorter, there will be an immediate
adjustment to ‘catch up’ the accumulated
depreciation to an amount appropriate to the
shorter expected life. On the other hand, if the
estimated life is now longer, the only
adjustment is normally to depreciate the
remaining balance over the (now) longer
estimated economic life. Prior depreciation
expense is not reversed. Clearly, the ‘bad’
economic news of a shorter than expected
useful life is recognised in full through the
income statement in the period in which that
news occurs. However, the ‘good’ economic
news that the expected useful life is longer only
works its way into income progressively over
the remaining expected life of the machine, via
lower than previously charged annual
depreciation expense.
Timely loss recognition of this type means that
the extent to which periodic financial
statements prepared in accordance with GAAP
are able to reflect economic circumstances is
dependent on the type of economic
circumstance. However, there are several
reasons why such an asymmetry may be
desirable. First, it may improve the governance
role of financial reporting. Managers who
know that selection of negative net present
value (NPV) investments will show up relatively
quickly in reported income are less likely to do
so, even if there are benefits to them from
doing so (Ball & Shivakumar 2005). Second,
the efficiency of debt contracts that utilise
financial statement variables is likely to be
enhanced, as loan covenants are likely to be
triggered more quickly.
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GAAP-based financial reporting: measurement of business performance
It is also seems pertinent to note that the
overwhelming number of criticisms about the
‘timeliness’ of GAAP earnings put forward by
regulators, politicians and investor groups
refers to a failure to reflect bad economic news
on a timely basis. It is extremely rare to find a
firm’s financial statements criticised for failing
to reflect good economic news quickly enough!
This extends to criticisms about the effect of
corporate governance mechanisms such as
audit quality on the quality of financial reporting
(Ruddock et al. 2006).
The essential insight gained from the above is
that timely loss recognition (conditional
conservatism) is likely to be valued as an
attribute of periodic financial reporting, even
if it means that such measures are less timely
under certain circumstances (i.e. good
economic news) than they might otherwise be.
Researchers have contributed to an
understanding of this phenomenon in a
number of ways. First, they have documented
systematic evidence of timely loss recognition
as an attribute clearly evident in GAAP financial
statements (Basu 1997). Second, they have
shown circumstances where timely loss
recognition is more likely to be valued, and
hence apparent (Ball & Shivakumar 2005; Ball
et al. 2005). Third, they have reconciled timely
economic loss recognition with the audit
process and notions of audit quality (Ruddock
et al. 2006). Finally, they have identified timely
recognition of economic losses as a
component of the surprisingly high frequency
with which publicly-traded firms report losses,
and the persistence of such losses (Balkrishna
et al. 2006). Each of these studies is briefly
reviewed below.
Basu (1997)
In this study, Basu tested for the extent to
which earnings reported by US firms displayed
evidence of reflecting bad news more quickly
than good news (i.e. conditional conservatism).
> He examined in excess of 43,000 firm-years
drawn from the period 1963–1990
> Two primary tests were used to identify
conditional conservatism. First, earnings
were regressed on contemporaneous stock
returns, including a dummy variable and
interaction effect which identified cases
where stock returns were negative (a proxy
for bad news). A second test regressed the
current earnings change on the previous
earnings change, with a dummy variable and
interaction effect identifying cases where the
prior earnings change was negative
> Both tests suggested that annual earnings
reported by US firms are conditionally
conservative. Bad economic news is
reflected in earnings much more quickly, and
negative earnings changes are much more
likely to reverse than positive earnings
changes, consistent with bad news being
reflected more quickly.
Ball and Shivakumar (2005)
A study by Ball and Shivakumar examined the
extent of conditional conservatism in a large
sample of private and public UK firms.
> They hypothesised that conservatism would
be less prevalent in private firms, as market
demands for conservative reporting is less
likely to be prevalent among firms that are
not publicly traded
> They examined data for the period
1989–1999, with over 54,000 firm-years for
publicly-traded UK firms and over 140,000
firm-years for UK firms that did not have a
stock exchange listing (i.e. ‘private firms’)
> Ball and Shivakumar used two methods for
measuring conservatism. Like Basu (1997),
they examined the time series behaviour of
earnings changes, and second, they
examined the extent to which the relation
between accruals and operating cash flows
varies depending on the sign of operating
cash flow
> The finding that private firms’ earnings
were significantly less conservative than
those of publicly-traded firms was robust
to controls for differences between the two
groups such as leverage, size, industry and
fiscal year. The result also cannot be
explained by risk or tax differences.
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
23 >
Ball, Robin and Sadka (2005)
This study by Ball, Robin and Sadka
compared the role of contracting-based
explanations versus ‘value relevance theories’
in explaining the role of GAAP reporting and
hence certain attributes of published GAAP
financial statements.
> They examined the extent of conditional and
unconditional conservatism across 22
different countries, and their relation to the
varying importance of debt and equity
markets in those countries (measured as the
size of debt or equity markets relative to GDP)
> They measured conditional conservatism
using a regression of annual earnings on
contemporaneous stock returns (Basu 1997),
and measured unconditional conservatism
from the intercept of the conditional
conservatism regression, as well as bookto-market ratios
> They found that conditional conservatism
increased with the importance of debt
markets, but is not related to the importance
of equity markets. On the other hand,
measures of unconditional conservatism
were unrelated to either debt or equity
market size
> Ball et al. interpreted these results as
supporting the contracting–based (debtbased) explanation of GAAP accounting,
but not consistent with an equity market, or
‘value relevance’ explanation.
Ruddock, Taylor and Taylor (2006)
This study examined the extent of conditional
conservatism in Australian GAAP financial
reporting, and its relation to indicators of
audit quality.
> Conditional conservatism was evident in
Australian GAAP, and was not reduced where
auditors provided relatively high levels of
non-audit services (NAS). In general, firms
audited by Big N auditors reported annual
earnings which displayed a higher degree of
conditional conservatism.
Balkrishna, Coulton and Taylor (2006)
Balkrishna, Coulton and Taylor examined the
frequency of losses reported by publicly-traded
firms in Australia over the period 1993–2003.
> They found that losses were surprisingly
frequent (over 35 per cent of all firm-years
were losses)
> Losses were also surprisingly persistent, and
the probability of loss reversal declined as the
history of losses extends
> Conditional conservatism was more evident
among firm-years that represented reported
losses, consistent with the argument that the
high frequency of losses over the last 15 or
so years was, at least partly, a reflection of
conservatism in Australian GAAP.
In summary, it is apparent that the timely
recognition of economic losses is an important
property of GAAP financial statements, and that
such ‘conditional conservatism’ is evident in
many different systems of GAAP around the
world. This highlights the need to interpret
evidence of value relevance somewhat
carefully, especially when it is used to argue for
extensions to the GAAP model, or even
modifications to existing measurement/
valuation practices under GAAP.
> They examined over 3,700 Australian firmyears drawn from the period 1993–2000
> Conditional conservatism was measured
using a regression of annual earnings on
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
GAAP-based financial reporting: measurement of business performance
1.6 Summary
Criticism of periodic financial statements
produced in accordance with GAAP is nothing
new. Some have long argued for different
measurement or recognition rules within the
basic GAAP framework, such as a move
towards increased use of ‘mark-to-market’
accounting. On the other hand, some have
argued that certain financial measures that are
excluded from GAAP leave out important
dimensions of business performance
(e.g. the absence of brand valuations for
intangible assets). Finally, there are those who
argue for a wholesale change in the business
reporting model, either to broaden the notion
of business performance itself and/or to expand
the stakeholder group to whom the existing
GAAP-based reporting model is directed.
The claim that the existing GAAP-based model
is not ‘useful’ has been repeatedly subject to
empirical testing. In a variety of contexts,
across a large number of national GAAP
frameworks, GAAP-based periodic
performance measures have been shown
to have value relevance and hence to be
useful to investors and others interested in
understanding and/or estimating the value of
the firm. Such evidence provides a baseline
against which suggested improvements or
even wholesale changes to the GAAP model
can be considered, although, if a suggested
performance metric is not widely available, it is
hard to either confirm or rebut the claim that it
would represent an improvement on the
existing model of periodic financial reporting.
It is evident, and of equal importance, that
periodic measurement of business
performance is also critical to the definition and
enforcement of many types of contractual
relationships that are central to the creation and
operation of a business entity. It is hardly
surprising then that many properties of financial
reporting have evolved over a lengthy period of
time, even where they may seem to be at least
partially at odds with a pure value relevance
perspective. One such example is the timely
recognition of economic losses (i.e. conditional
conservatism). Evidence of such properties in
GAAP financial reporting also serves as a
warning to those who would change the GAAP
model so substantially that these properties
would be lost. Such changes are unlikely to
improve the overall efficiency of the financial
reporting model.
Broadly speaking, it appears as though accrual
accounting, as applied by GAAP, provides a
significantly better measure of periodic
business performance than a cash- based
system of measurement. It is also evident that
accounting numbers are an equally credible
basis (compared to cash flows) on which to
estimate business value.
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
25 >
2 What is the quality of GAAP accounting measures?
Key points
2.1 Introduction
> The quality of GAAP financial data is a
critical consideration in whether
performance metrics drawn from GAAP
are likely to be useful measures of periodic
business performance
> The definition of accounting quality
(or earnings quality) depends on the
users’ perspective
> Considerable research demonstrates
some evidence of earnings management
where incentives to engage in such
manipulation exist
> The same flexibility within GAAP that
permits some degree of earnings
management also facilitates the ability to
signal future prospects
> Capital markets are frequently alleged to
encourage managers to engage in
benchmark beating
> Managers seemingly are more likely to
engage in real economic decisions to
manage earnings rather than risk the costs
associated with GAAP violation
> Capital markets appear to reward
accounting quality
> Managers bear economic consequences
if they engage in serious accounting
manipulation
> Corporate governance mechanisms
(auditor, board composition, audit
committee composition) appear to
encourage higher quality accounting.
The evidence summarised in section 1
highlights how existing GAAP-based measures
of business performance are useful in a variety
of contexts. However, this evidence does not
speak to the question of the ‘quality’ of
measures of business performance produced
by GAAP. This section addresses that concern.
What do we mean by the ‘quality’ of measures
of business performance? For the most part,
this section focuses on measures of earnings
quality. Earnings is a pre-eminent measure of
periodic business performance, and is also not
independent of balance sheet-based measures
of financial position. Hence, for the most part
this section reviews concepts of earnings
quality. In section 2.2, alternative ways of
measuring earnings quality are reviewed briefly.
The most important point to recognise is that
the concept of earnings quality is likely to be
contingent on the specific users’ requirements.
For example, an analyst may be particularly
concerned with the ability to extrapolate from
current earnings to generate forecasts of future
earnings (Dechow & Schrand 2005). On the
other hand, actions that managers may take to
try and improve earnings predictability may
have the effect of adding noise (or a systematic
bias) to the ability of earnings to measure
current business performance. It is therefore
not surprising that researchers interested in
measuring earnings quality (and subsequently,
the determinants of earnings quality) have used
a variety of measures. These are also
summarised in section 2.2.
Much of the interest in earnings quality stems
from widespread anecdotal evidence of
managerial manipulation of reported earnings.
Such manipulation is often alleged to be selfserving, with the result that it reduces the
usefulness of earnings (and related GAAPbased metrics) as measures of periodic
performance. This not only reduces the ‘value
relevance’ of GAAP accounting reports, but
also its usefulness for a variety of other
contracting mechanisms, such as a measure
around which performance-based bonuses can
be calculated. However, the extent to which
GAAP-based earnings can be manipulated may
also serve to facilitate the ability of managers to
signal their expectations. GAAP rules, in certain
cases, may serve to reduce the ability of
periodic financial statements to provide an
unbiased measure of business performance,
both current and expected. In section 2.3,
examples of research that show some evidence
of both opportunistic manipulation, as well as
managerial signaling are reviewed, along with
evidence of so-called benchmark-beating,
whereby managers of listed firms have been
argued to place undue emphasis on meeting or
beating well-established market benchmarks,
such as avoiding a loss, beating last period’s
earnings, or beating analysts’ forecasts.
In section 2.4, the incentives that exist for high
quality financial reporting are reviewed. In
particular, evidence that shows that markets
reward firms that report high quality earnings
(and other GAAP measures) or, conversely, that
low quality financial reporting is penalised are
considered. The most generalisable form of this
evidence is to show that the quality of financial
reporting is inversely related to firms’ cost of
capital, and this is the focus of the research
studies reviewed on this point. The role of
corporate governance in influencing the quality
of financial reporting is also considered,
although it is somewhat unclear as to whether
so-called ‘better’ governance causes higher
quality financial reporting, or whether higher
quality financial reporting leads to better
governance. The section concludes with
some observations about the extent to which
evidence on the quality of GAAP financial
reporting (especially earnings quality) is
pertinent to the assessment of how
successfully GAAP-based financial reporting
meets the needs of a variety of uses for
assessing periodic business performance.
2.2 Measuring earnings quality
and earnings management
Although there is simply no single,
unambiguous, all-encompassing definition of
earnings quality available, the term ‘earnings
quality’ is widely used. Schipper and Vincent
(2003) suggest that definitions of earnings
quality fall into three broad categories:
1. Decision usefulness. This is a contextual
definition, in that it depends on both the user
and the contemplated use of earnings. As
already outlined in Section 1, there are a
variety of users for whom the ‘ideal’
attributes of earnings differ (contrast the
‘value relevance’ perspective with the
reasons suggested as to why conservatism
may be an important attribute of periodic
earnings). Users of GAAP earnings include
shareholders, bondholders, management,
regulators and government
2. Economic earnings constructs. Under this
approach to assessing earnings quality,
assessment is made on the basis of the
extent to which reported earnings represents
(unobservable) Hicksian (or economic)
income. Not surprisingly, uncertainty about
whether economic income corresponds to
changes in market value mean that this
construct in not empirically tractable, and
has not been explored
3. Stewardship. The stewardship perspective
suggests that constructs such as verifiability
(and hence conservatism) are potentially
important attributes of high quality earnings.
Research addressing the broader notion of
earnings quality has often focused on the
extent of earnings management. Earnings
management refers to the deliberate
intervention by management in the financial
reporting process to ‘push’ earnings in a
particular direction. High profile scandals are
usually portrayed as examples of earnings
management.11 Of course, these are invariably
examples of alleged earnings overstatement,
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
GAAP-based financial reporting: measurement of business performance
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
27 >
whereas earnings management can be either
upward or downward. Indeed, a vocal critic of
alleged earnings management in a broader
context (Levitt 1998) has explicitly identified
the downwards management of earnings to
create ‘cookie jar’ reserves as a practice of
some concern.
Whether this is in part attributable to a ‘postEnron’ environmental change is hard to
determine. Put simply, Graham et al. find that
most financial executives are willing to make
small or moderate economic sacrifices in
economic value in order to avoid ‘underdelivering’ earnings results.
But how do we measure the extent of earnings
management? Researchers have given
considerable attention to this issue. Over the
last 20 or so years, it has become common to
focus on the accrual component of earnings as
the source of any manipulation. This
presumably reflects a view that manipulation
via the accrual process (especially where this
entails ‘judgement’ that cannot be shown to be
outside GAAP) is less costly than making actual
economic decisions that have direct cash
flow consequences and hence earnings
consequences as well. However, recent
evidence calls into question the validity
of this assumption.
The implications of the Graham et al. survey are
troubling for attempts to document and
measure earnings management. Any ‘outsider’,
including researchers, is going to have great
difficulty in observing and quantifying earnings
management of the type that Graham et al.
suggest is most prevalent. This is an inherent
limitation in interpreting much of the research
that follows in this section.
Although earnings management via accruals
continues to be the focus of regulatory concern
and is pre-eminent in empirical research, there
are costs associated with attempted earnings
management via accruals. Obviously where the
attempt goes beyond what is probably
acceptable under GAAP, it is to be expected
that the auditor will challenge managers’
preferences, with the possible threat of a
modified audit report. Similarly, there is the risk
of regulatory intervention and discipline. On the
other hand, it is much more difficult for auditors
and regulatory agencies to challenge economic
decisions taken by management, where the
effect on reported income occurs via cash
flows rather than an accrual adjustment.
Graham, Harvey and Rajgopal (2005) surveyed
a large number of US financial executives (over
400) to get a better insight into management’s
thinking about earnings management. Their
results contradict much of what researchers
have assumed about the higher likelihood of
earnings management via accruals (rather than
cash flows). So-called ‘real’ earnings
management appears to be preferable to
managers, on the basis that even within-GAAP
‘adjustments’ are likely to be controversial.
28
Researchers have had considerable success
in measuring accruals-based earnings
management. Following the insight contained
in Jones (1991), the most common practice is
to estimate the expected value of the accrual
component of periodic earnings by modelling
the observed total accrual as a function of sales
changes and the extent of depreciable (and
amortisable) assets. Extensions to this
approach have included adjusting sales
changes for the change in receivables (Dechow,
Sloan & Sweeny 1995), including lagged
performance (Dechow, Richardson & Tuna
2003) and performance matching (Kothari,
Leone & Wasley 2005). The result is a measure
of ‘unexpected accruals’. One interpretation of
an unexpected accrual closer to zero is that
earnings are higher quality.
As noted above, however, there are many
different ways of thinking about earnings
quality, depending on what the use of earnings
is intended to be. Indeed, studies that attempt
to measure the overall quality of earnings (as
distinct from just ‘earnings management’) have
increasingly used a combination of proxy
variables to capture earnings quality (Francis,
LaFond, Olsson & Schipper 2004; 2005).
Although the Francis et al. studies are outlined
in more detail in section 2.4, it is useful to have
an understanding of the different ways in which
earnings quality might be assessed:
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
Possible indicators of earnings quality
> Accrual quality. This could entail simple
measurement of accruals, or unexpected
accruals, or some estimation of how
successfully current (i.e. operating) accruals
map into current, lagged and lead cash flows
(Dechow & Dichev 2002)12
> Persistence. Persistent earnings are often
seen as desirable because they represent
earnings that recur. Analysts often focus on
measures of ‘sustainable earnings’ (also see
the discussion in section 3)
> Predictability. Predictability is often valued by
financial analysts. It is also an important
consideration in valuation, which requires
prediction of future results
> Smoothness. While the practice of
smoothing earnings has been condemned
(Levitt 1998), benefits have also been
identified, such as increased informativeness
about future earnings (Tucker & Zarowin 2006)
> Value relevance. This is discussed extensively
in section 1. It is based on the premise that
GAAP financial reporting should track
changes in market values
> Timeliness. Timely earnings (i.e. revealing
economic news quickly) are desirable
where other timely sources of information
are not available
> Conservatism. This is also discussed in detail
in section 1. It reflects a demand that the
verification standards for good economic
news be higher than the corresponding
standards for bad economic news.
The message from this summary is that the
quality of earnings (and associated financial
statement measures) is likely to reflect several
dimensions. No single measure is likely to
capture the ability of say, earnings, to provide a
‘high quality’ measure of periodic business
performance. Equally, it is dangerous to
conclude that just because there is evidence of
concern on one of these dimensions, then
earnings is therefore a low quality measure of
business performance. Indeed, caution is even
warranted in interpreting any one so-called
indicator as evidence of low versus high quality
earnings. This is highlighted in the following
section with respect to the most widely-used
measure of earnings management, namely
unexpected accruals.
2.3 Examples of earnings
management
As noted above, the common assumption is
that earnings management is ‘bad’. Much of
the empirical research addressing factors
associated with earnings management (i.e. the
incentives to engage in earnings management)
reflects this view. It is also possible, however,
that the divergence of the accrual component
of earnings from what is expected may be
indicative of more informative, rather than less
informative earnings. The first two studies
described below highlight this tension. On the
one hand, the study by Teoh et al. (1998) of
earnings management (and its consequences)
by firms making initial public offerings (IPOs) is
a widely-cited example of apparent
opportunistic management of earnings, in a
setting where earnings information is likely an
especially important measure to investors (i.e.
there is limited information available). Not only
is there strong evidence of IPO firms engaging
in a ‘ramping up’ of their earnings at the time of
the IPO, but this manipulation also appears to
result in an artificially high share price in the
period immediately following the IPO. To the
extent that this is the ‘average’ behaviour, then
12 The Dechow and Dichev (2002) measure of accrual quality is not without critics (Wysocki, 2005). It is possible that it captures income
smoothing, which may be earnings management to either help or hinder accurate assessment of current period business performance.
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
29 >
Figure 4: Australian benchmark beating – avoiding earnings decline
‘shift‘ earnings may be an important part of
managers’ tool-bag for communicating
efficiently with investors and others.
On the other hand, the study by Louis and
Robinson (2005) highlights the dangers in
simply interpreting unexpected accruals
(especially positive unexpected accruals) as
evidence of self-serving manipulation of
periodic income. The danger is that earnings
may be dismissed too easily as a useful
measure of periodic performance. In the case
of Louis and Robinson, they show that firms
make positive unexpected accruals in earnings
released immediately prior to stock splits, and
the market sees that as evidence of better
prospects in the future. Post stock-split stock
returns reinforce the view that, in this case, the
market is not being misled by the upwards
earnings management. In short, the ability to
Finally, the Coulton et al. (2005) evidence
confirms (for Australian firms) widespread
‘street folklore’ that firms attempt to avoid
‘just missing’ pertinent benchmarks.
Reproduced below are two figures from that
study. In this case, a simple picture would
appear very informative. However, it needs to
be borne in mind that the future performance
by benchmark beaters is no worse than those
that just miss reporting a profit and/or an
increase in earnings. If anything, it is better,
consistent with benchmark beating reflecting
a method of signalling information about
future prospects rather than obscuring the
underlying performance.
Figure 3: Australian benchmark beating – avoiding a loss
N
400
350
300
250
200
150
100
50
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0.
19
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0.
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23
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24
0
Operating income deflated by total assets
30
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
N
600
500
400
300
200
100
0
-0
.2
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24
low quality earnings measures provide a partial
explanation for the widely-recognised pattern
of negative stock returns following an IPO.
Changes in operating income deflated by total assets
Teoh, Wong and Rao (1998)
Louis and Robinson (2005)
This study documented the extent of earnings
management by US IPOs, and whether such
earnings management could help explain the
poor post-listing returns that are a common
feature of IPO pricing.
> They examined around 1,700 US IPOs
between 1980 and 1990
> Teoh et al. used the ‘standard’ measure of
unexpected accruals as their primary measure
of earnings management. They also
attempted to control for differences in
performance unique to IPO firms by adjusting
this measure relative to the unexpected
accrual of a similar sized, non-IPO firm
> The time series behaviour of unexpected
accruals was strongly consistent with the
idea that IPO firms attempted to inflate
earnings either just prior to, or just following
the IPO
> Earnings management measures estimated
in the year of the IPO forecast the long-term
decline in post-issue earnings performance.
This was consistent with opportunistic
earnings management
> Earnings management measures also had
predictive power for the sign and size of postIPO stock returns. This was also consistent
with the stock market failing to efficiently
incorporate information in the measure of
earnings management.
Louis and Robinson considered the extent
to which unexpected accruals reflected
managerial optimism rather than managerial
opportunism.
> They examined the link between unexpected
accruals (a measure of earnings
management) and stock splits, a phenomena
often interpreted as a method of signalling
managers’ optimism about the future. Their
sample comprised over 2,200 stock splits by
US firms between 1990 and 2002
> Louis and Robinson found that the quarterly
earnings results immediately prior to the
stock split were managed upwards. This
result was robust to the exact method of
estimating unexpected accruals
> They also find that stock splits were, as
expected, accompanied by a positive market
reaction to the announcement (i.e. a positive
abnormal return)
> The abnormal return at the stock split
announcement was significantly positively
associated with the measure of earnings
management. This effect appeared to be
immediate, as future returns were not
systematically associated with the extent of
upwards earnings management prior to the
stock split
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
31 >
> Louis and Robinson interpreted these results
as showing that the market viewed upwards
earnings management prior to the stock split
as a signal of management optimism, rather
than a measure of managerial opportunism.
Coulton, Taylor and Taylor (2005)
The extent to which Australian firms reported
small profits and/or small increases in earnings
(i.e. the extent to which Australian firms
engage in benchmark beating) was the
subject of this study.
> They examined annual results for over
6,000 Australian firm-years between
1993 and 2002
> Coulton et al. showed that there was a
significantly larger number of Australian
firms that reported very small earnings (and
earnings increases) than reported very small
losses (or small declines in earnings). This is
prima facie evidence of benchmark beating
by Australian firms with respect to widely
claimed benchmarks of interest to capital
market participants
> However, Coulton et al. also showed that
unexpected accruals (a popular measure of
earnings management) were similar for the
groups that just beat and just missed the
relevant benchmark. This result calls into
question the extent to which benchmark
beating is evidence of earnings management
> Coulton et al. also found no evidence that
benchmark beaters do worse in terms of
future earnings performance. If accruals
were used as a temporary means of
‘getting over the line’, then this would be
expected to result in a subsequent decline
in earnings performance.
32
2.4 Incentives to report high
quality earnings
It has already been noted that a large body of
empirical evidence documents various contexts
in which managers face incentives to engage in
earnings management and where, on average,
there is some evidence of this behaviour.
Broadly speaking, these incentives stem from
either the use of accounting numbers in
defining and enforcing contractual relationships
(e.g. debt contracts, compensation contracts)
or share market incentives such as the sale of
equity (Fields et al., 2001). However, it is also
important to recognise an increasing amount
of evidence that suggests there are strong
incentives to report under GAAP rules and
conventions in such a way as to produce ‘high
quality’ earnings (and balance sheets).
The most fundamental incentive, broadly
speaking, is the achievement of a higher share
price, which in turn implies a lower cost of
equity. A similar incentive exists with respect to
the costs of debt. Francis, LaFond, Olsson and
Schipper (2004; 2005) provide evidence that
accounting quality is rewarded. Moreover, they
show that to the extent accounting quality is
innate rather than being the result of
managerial discretion, then this is also priced
by market participants. An advantage of these
studies is that they are not ‘context specific’.
Rather, they provide relatively generalised
evidence that accounting quality is priced
(and rewarded) by capital markets.
Of course, for managers, directors and auditors
(at a minimum) there are also likely to be direct
effects on human capital value when
employees are associated with the provision
of low quality accounting. Actual convictions
for fraudulent accounting are relatively rare,
and represent only the most egregious cases
of accounting manipulation. However, in lesser
(albeit still serious) cases, some direct effects
may be felt by those involved. Desai, Hogan
and Wilkins (2006) provide evidence consistent
with this hypothesis by showing that managers
responsible for the restatement of previously
reported earnings suffer in the form of a greater
than expected chance of termination, and
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
relatively poor future employment prospects.
Although cases of earnings restatements are
still relatively extreme cases of possible
accounting manipulation, these results suggest
that market forces also act to constrain
attempts at accounting manipulation.
Corporate governance also has a potentially
important role to play in ensuring high quality
accounting and hence the usefulness of
measures such as reported income as
indicators of business performance. Klein
(2002) provides evidence of reduced earnings
management where the board of directors,
and especially the audit committee, is
controlled by outside directors who are less
likely to be controlled by the CEO. However,
showing a relation between governance
mechanisms such as these and higher quality
accounting does not rule out the possibility that
causality runs the other way, namely that firms
with high quality accounting are more able to
attract good directors. This is a topic which,
along with the influence of other forms of
corporate governance on accounting quality,
is likely to be the subject of future research.
Finally, it is also worth noting that the difficulties
in adequately defining what we mean by high
quality accounting should serve as a cautionary
note to those who would dismiss GAAP
earnings (and related measures) as subject to
excessive manipulation. For example, former
SEC chairman Arthur Levitt strongly criticised
practices that amounted to income smoothing
(Levitt 1998). However, evidence provided by
Tucker and Zarowin (2006) shows that the
component of accruals that is most likely to
represent income smoothing is associated with
a better understanding by market participants
of future earnings. In effect, it appears as
though income smoothing can be informative.
Taken in conjunction with evidence (Wysocki
2005) that the measure of accrual quality relied
on in a number of empirical studies (Dechow &
Dichev 2002) may simply capture income
smoothing, the evidence provided by Tucker
and Zarowin is an important reminder of the
difficulties associated with unambiguously
identifying the exercise of managerial discretion
within GAAP accounting as implying that
accounting is low quality.
Francis, LaFond, Olsson
and Schipper (2004)
This study investigated the link between
earnings attributes and the cost of equity.
> They examined the seven attributes listed
in section 2.3 above (accrual quality,
persistence, predictability, smoothness, value
relevance, timeliness and conservatism) and
several alternative methods for estimating
the cost of equity capital, including an ex ante
estimate based on future dividend forecasts.
Their sample covered the period 1975–2001,
with an average of over 1,400 US firmspecific observations each year
> Firms with the least favourable measures of
each attribute, considered individually,
typically had a significantly higher cost of
equity capital
> The largest cost of equity effects were for the
accounting-based attributes (compared to
market based attributes such as value
relevance or timeliness). Using a measure of
accrual quality based on the relation between
accruals and lagged, lead and
contemporaneous cash flows, Francis et al.
reported a 260 basis point spread between
the best and worst accrual quality deciles
> The primary results reported by Francis et al.
were robust to including a series of controls
for ‘innate‘ accounting quality. By innate
accounting quality, the authors meant the
extent to which firm and industry specific
factors explained accounting quality.
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
33 >
Francis, LaFond, Olsson
and Schipper (2005)
Francis, LaFond, Olsson and Schipper
examined the relationship between accrual
quality and the cost of debt and equity.
> They examined over 90,000 US firm-year
observations over the period 1970–2001.
Accrual quality reflected the ability of lead,
lagged and current cash flows to explain
operating accruals
> Firms with poorer accrual quality had higher
costs of debt. They had higher ratios of
interest expense to interest bearing debt and
lower debt ratings than firms classified as
having high accruals quality
> Firms with lower accrual quality had
significantly lower price–earnings ratios,
consistent with a higher cost of equity
> The cost of capital effect of a unit of
discretionary accrual quality was less than
the effect of a unit of innate accrual quality.
Klein (2002)
2.5 Summary
Klein’s study examined the relation between
audit committee and board characteristics
and the extent of earnings management,
as measured by the magnitude of
unexpected accruals.
In section 1 evidence was presented showing
that, contrary to what might be termed
‘populist criticism’, measures of business
performance produced as part of GAAP (e.g.
income) are useful as measures of business
performance. However, this ‘on average’
conclusion must compete against high profile
anecdotes of relatively egregious manipulation
of accounting to produce measures that clearly
have borne no relationship to the underlying
economic circumstances of the businesses
concerned. Consequently, the evidence
reviewed in this section on the extent of
possible accounting manipulation, the factors
that give rise to such behaviour, and the
potential constraints on such behaviour
are of equal importance to the evidence
reviewed in section 1.
> A sample of 692 US firm-years drawn from
1992 and 1993 was used
> The results suggested that firms with
relatively audit committees comprised
predominantly of outside directors engaged
in less earnings management
> The results also extended to the
composition of the entire board, as firms
with boards dominated by outside
directors were also less likely to engage
in earnings management.
The overall conclusion was that boards
structured to be more independent of the CEO
are more effective in monitoring the corporate
financial reporting process.
Tucker and Zarowin (2006)
Desai, Hogan and Wilkins (2006)
This recent study examined whether income
smoothing (defined as the negative correlation
between a firm’s unexpected accruals and its
‘pre-managed’ earnings) garbled earnings
information or improved its informativeness.
This recent study examined whether aggressive
accounting by US firms (as captured by
earnings restatements) resulted in tangible
reputation penalties for managers of firms
announcing restatements.
> Using US data from 1988–2000, Tucker and
Zarowin found that annual stock returns
more closely reflected future earnings
results when current period income was
relatively ‘smoothed’. This result extended to
the extent to which information about future
cash flows was impounded into current
stock prices
> The results reported by Tucker and Zarowin
support the view that managers use their
reporting discretion (in this case, smoothing
of reported income) to increase the
informativeness of reported earnings.
> They examined 146 US firms announcing an
earnings restatement during 1997 or 1998
> They found that 60 per cent of restating firms
experienced a turnover of at least one top
manager in the two years following the
restatement. The ratio for a control group of
firms was only 35 per cent
> Subsequent employment prospects of the
displaced managers were shown to be
poorer than those of displaced managers
from the control firms
> The overall conclusion was that private
penalties for GAAP violations are severe
and may serve as a partial substitute for
public enforcement.
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GAAP-based financial reporting: measurement of business performance
There is no doubt that research over the last
30 years, commencing with Watts and
Zimmerman (1978), has shown that certain
contractual and capital market considerations
are associated with some degree of accounting
manipulation. Just as importantly, however,
recent research provides at least three
cautionary notes. First, it is apparent that
suppliers of finance (i.e. debt markets and
equity markets) reward high quality accounting.
Second, there are disciplinary and governance
mechanisms that further discourage and/or
restrict managers’ ability to engage in
accounting manipulation. Finally, it is simply
not always obvious whether managerial
intervention within the boundaries allowed by
GAAP is necessarily an attempt to obscure the
underlying performance of the firm. Rather,
there is a legitimate expectation that the
discretion allowed managers within GAAP
may serve to facilitate more effective
communication about current and future
performance. In this respect, managerial
‘manipulation’ is a means of increasing the
usefulness of GAAP metrics as a measure of
periodic business performance rather than a
means of obscuring it.
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GAAP-based financial reporting: measurement of business performance
35 >
3 Evidence on ‘modified GAAP’ reporting
Key points
3.1 Introduction
> ‘Modified GAAP’ equals altered
definitions of what is included in income.
This can be additions beyond current net
income (to yield ‘comprehensive
income’), or exclusions (i.e. above the line
adjustments) to yield either ‘street
earnings’ or ‘pro-forma earnings’
> Comprehensive income is favoured by
some regulatory domains, but there is little
empirical evidence to support the
requirement to provide this information in
addition to existing financial statements
> ‘Pro-forma reporting’ is where a selective
exclusion of income components occurs.
This is sometimes termed ‘street
earnings’, corresponding to earnings
measures found on the major databases
providing earnings forecasts (e.g. Value
Line, Institutional Brokers Estimation
Service (IBES) and First Call)
> It is hard to know exactly what ‘street’
earnings are, as providers of forecast data
are effectively a ‘black box’ in terms of the
precise adjustments made
> Evidence suggests that pro-forma or street
earnings may be more informative than
earnings measures that conform with
GAAP. This is especially true where the
differences relate to non-recurring items.
This section reviews evidence on the use
of what can be termed ‘modified GAAP’
reporting of business performance. There are
fundamentally four types of modification
to GAAP-based measures of periodic
performance, where the modifications
nevertheless retain the fundamental properties
that underlie the production of GAAP income.
These modifications are all directed at altering
what would otherwise be a definition of
periodic income that is fully compliant with
GAAP, such as operating income or net income.
The four fundamental forms of modification are
as follows:
GAAP
GAAP
‘other owners’
equity changes
transient
components
comprehensive
income
street earnings
1. Selective modification of GAAP earnings by
the reporting firms themselves, resulting in
these firms reporting what are usually
termed ‘pro-forma’ earnings
2. In a more systematic fashion than (1), the
use of so-called ‘street’ earnings numbers.
These are the numbers which analysts
typically are asked to forecast and which are
then aggregated and reported, subject to
possible adjustments, by commercial
providers of forecast data such as IBES,
Zacks and others
3. In the opposite direction to the ‘typical’
exclusion of selected income components to
arrive at either pro-forma or ‘street’ earnings,
there is support for the reporting of so-called
‘comprehensive income’. This is a measure
that extends the current bottom line to
include various other movements within
owners’ equity, and is effectively a
reconciliation of the change in consecutive
balance sheets
Street earnings
adjusted in an
ad-hoc way
pro-forma
earnings
4. There are a wide variety of business
performance measurement metrics
advertised by consulting firms, all of which
have at least some common ground with
GAAP earnings. Some of these measures
are also touted as superior measures of
business performance for the use of external
investors. One such example is the
Economic Value Added (EVA) measure
promoted by Stern Stewart.13
The first three forms of modification to
GAAP reporting are concentrated on
in what follows. As the focus is on external
measurement and evaluation of business
performance, the fourth type of modified
GAAP (i.e. measures of business performance
promoted by individual consulting firms) has
been excluded because these appear to have
as their primary aim the provision of useful
measures for internal performance
evaluation and capital budgeting/rationing.
Where they have been promoted as a
measure useful for external users, this is
seemingly of secondary importance.
It is not surprising that preparers and users of
periodic financial reports should show interest
in modifying periodic performance measures,
as even standard-setters themselves have done
so over time. For example, the definition of
what constitutes operating income, as distinct
from items that are separately recognised as
‘extraordinary’, has changed substantially.
Standard-setters around the world have
progressively tightened the definition of
extraordinary items, and more recently
Australian GAAP has seen the complete
elimination of the separate recognition of what
were termed ‘abnormal’ items. Earlier attempts
at tightening the regulations on what constitute
extraordinary items were met, at least in part,
by the increased highlighting of certain items as
‘abnormal’, a category that has now been
eliminated from the terminology of Australian
GAAP financial reporting.14
Why has there been this progressive
tightening of what is excluded from a GAAPbased measure of operating performance?
Almost inevitably, this reflects concerns that
flexibility in determining what constitutes
operating income results in the opportunistic
shifting of various items between
extraordinary and operating components of
reported income. However, while anecdotal
evidence may appear to support this view, it is
still ultimately an empirical question as to
whether ad-hoc adjustments made by firms
themselves (i.e. pro-forma reporting) or by
security analysts and providers of such data
(i.e. street earnings) result in earnings
measures which are more or less useful than
the corresponding GAAP number.
However, the three forms of modification
reviewed below represent differing degrees of
departure from GAAP. In the case of pro-forma
earnings and street earnings, there is
sometimes a considerable degree of departure
from GAAP, especially in terms of removing
what may be described as ‘non-recurring’
components of income. On the other hand,
comprehensive income represents a shift in the
opposite direction, whereby everything within
GAAP income is retained, but the definition of
income is extended to incorporate any changes
that affect differences between opening and
closing book value. In this sense, both forms of
modification reflect different perspectives on
what constitutes high quality earnings. One
reason often advanced in support of street
earnings or pro-forma earnings is that such
earnings numbers are more predictable. On the
other hand, comprehensive income has been
advocated on the basis that it is closer to an
‘economic’ definition of earnings, namely the
change in net assets over the period of
measurement. In the remainder of this section
selected evidence on the attributes of each type
of modified GAAP reporting is highlighted.
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
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GAAP-based financial reporting: measurement of business performance
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
37 >
3.2 Comprehensive income
One way in which the ‘standard’ output of the
GAAP financial reporting model has already
been extended is via the requirement
implemented by the Financial Accounting
Standards Board (FASB) for US firms to report
‘comprehensive income’ (CI). In contrast to
less-regulated attempts to adjust GAAP income
to exclude certain components via pro-forma or
street earnings, CI extends net income to
include other changes in owners’ equity that
represent non-capital items taken directly to the
balance sheet. Under SFAS 130, Reporting
Comprehensive Income, CI is comprised of net
income plus ‘other comprehensive income’.
This is summarised in Figure 5 below:
Figure 5: What is comprehensive income?
Net income
Other comprehensive
income
Comprehensive
income
Clearly, the definition of CI under SFAS 130 is
relatively restricted, addressing areas where
gains and losses have been recognised as
direct movements in owners’ equity, rather
than passing through the income statement.
In effect, CI provides a measure of income that
is closer to the clean surplus concept (Ohlson
1995) reviewed in section 1. However,
although CI may be viewed as a relatively
narrow extension of existing GAAP income
measures, the introduction of a requirement to
report CI as defined in SFAS 130 has yielded an
opportunity to test at least one narrow
extension of the standard measure of earnings
from the GAAP model.
With no reference to empirical research, the
Chartered Financial Analysts (CFA) Institute
(2005) has advocated the adoption of a
measure of CI in other reporting regimes,
stating that ‘all changes in net assets must be
recorded in a single financial statement, the
Statement of Changes in Net Assets Available
to Common Shareholders’. This call for reform
(in this case, extension) of GAAP is typical of
how debate can occur in the absence of any
review of empirical evidence. While CI
measured in compliance with SFAS 130 does
not exactly match the recommendation made
by the CFA Institute, it is sufficiently close to
further highlight the value in reviewing extant
empirical research.
Unrealised gains/losses
on ‘available for sale’
securities as defined
by SFAS 115
Net losses associated with
minimum liability pension
adjustments (SFAS 87)
Dhaliwal, Subramanyam
and Trezevant (1999)
Dhaliwal et al. examined data for over 11,000
US firm-years drawn from the years 1994
and 1995.
> Although this period preceded the
introduction of mandatory CI, the items of
which CI is comprised were all readily
observable as part of balance sheet-related
disclosures. Hence, Dhaliwal et al.
reconstructed a measure of CI consistent
with the requirements subsequently
introduced via SFAS 130
> Dhaliwal et al. conducted two types of
analysis. First, they compared the ability of
GAAP income (net income) and CI to explain
contemporaneous annual stock returns, as
well as their respective contributions to
models focusing on explaining variation in
price. These results do not support the claim
that CI is a ‘better’ measure of periodic
performance than GAAP income. A possible
caveat to these results is that one of the
components of ‘other comprehensive
income’, namely gains/losses on marketable
securities, does have some incremental
explanatory power beyond GAAP income
> Dhaliwal et al. conducted a second set of
tests to compare the ability of CI and GAAP
net income to predict future earnings and
cash flows. A key application of financial data
for the analyst community is to serve as input
to prediction models, so this type of evidence
is a useful supplement to direct tests of ‘value
relevance’. However, once again, the authors
found no evidence to support claims that CI
is a better measure of periodic performance
than GAAP net income.
What are the lessons to be drawn? While CI
represents only a modest extension to the
conventional net income measure, the results
suggest that relatively more ‘comprehensive’
measures of performance add little, if anything,
to a measure of performance that is more
narrowly focused on operations. Moreover, it is
worth asking whether the evidence provided by
Dhaliwal et al. even addresses broader notions
of usefulness. For example, is there any
evidence that various contracting applications
of net income (or similar) are in any way
‘modified’ to look more like a measure of
comprehensive income? If such applications
are also likely to focus on operating
performance and implications for future
operating performance, it is hardly surprising
that no evidence can be found of voluntary
modifications to net (or operating) income to
extend these measures beyond capturing
(more narrowly) operating performance.
In short, what evidence we have available
suggests that stock market participants prefer
measures of periodic performance that are
‘focused’ on operating performance, while the
absence of any evidence showing that broader
measures of performance (such as CI) are used
in contractual arrangements, such as in debt
and compensation contracts, serves to reinforce
the conclusion that there is little, if any, evidence
at this point to support the statutory
requirement to provide a measure of CI.
Foreign currency translation
adjustments (SFAS 52)
Other comprehensive
income
38
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
15 See the critique offered by Abarbanell and Lehavy (2005). Examples of the ‘confusion’ between what exactly ‘pro-forma’ earnings really
means include Doyle et al. (2003) and Brown and Sivakumar (2003).
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GAAP-based financial reporting: measurement of business performance
39 >
3.3 Street earnings — is this a
selective narrowing of GAAP
income (and does it improve
earnings as a measure of
business performance)?
The debate about street versus GAAP
earnings (and the role within that debate
about pro-forma earnings) is a relatively
recent phenomenon. For most of the last
40 years, researchers have been focused
on understanding the properties of GAAP
accounting, resulting in research of the type
described in sections 1 and 2. More recently,
however, it has been alleged frequently that
there has been a rise in the frequency with
which firms attempt to prompt analysts and
others to focus on measures of earnings
that exclude at least some components
(typically expenses) that are claimed to
be ‘non-recurring’.
It is important to understand that, strictly
speaking, street earnings and pro-forma
earnings are not the same, despite the fact that
in several cases researchers have used these
terms interchangeably.15 Street earnings is
specifically an ‘adjusted’ earnings per share
number captured by commercial data service
providers, such as IBES, First Call and Value
Line. On the other hand, pro-forma earnings is
the number reported in actual firm press
releases, typically in preference to the regular,
GAAP-conforming number. While in some
cases pro-forma and street earnings may be the
same, street earnings are more likely to reflect
relatively systematic modification to GAAP
rules, simply because they are the product of a
commercial data provider who must attempt to
‘standardise’ as much of their product as
possible. These services provide a tracking of
firms’ performance over time, so even though
their output is inevitably a ‘black box’ to
external users, some degree of consistency
could reasonably be assumed. On the other
hand, pro-forma reporting is the product of
individual firms themselves. In the research
summary below, the focus is on street earnings.
Evidence on pro-forma earnings is reviewed in
section 3.4 below.
40
Bradshaw and Sloan (2002)
This study examined the differences between
GAAP and IBES measures of quarterly earnings
for US firms over the period 1986–1997.
> Their sample size exceeded 100,000 firmquarters. IBES coverage of US listed firms is
nowhere near as extensive prior to this time,
so the analysis effectively covered the ‘life’
of IBES as a supplier of street earnings
estimates up to 1997
> IBES earnings demonstrate increasing
divergence from GAAP earnings over the
period examined by Bradshaw and Sloan.
They note that this divergence appears to
have occurred from approximately 1990
onwards, but do not provide any explicit
statistical test of this hypothesis
> IBES earnings showed a statistically stronger
association with contemporaneous quarterly
stock returns than was the case for GAAP
quarterly earnings, at least for periods
following 1992, where the divergence
between GAAP and street measures of
quarterly earnings was greatest
> IBES appeared to have filtered from
operating profit what in US terms are known
as ‘special items’. These special items have
become more frequent over the period
studied by Bradshaw and Sloan, and are
more likely to be negative than positive.
However, it was not possible to separately
identify the extent to which increasing
differences between GAAP and street
earnings (using IBES) were caused by
changes in the definition of street earnings
versus increased identification of special
items that (typically) reflect non-recurring
expenses and were therefore eliminated from
the definition of street earnings. This was
because the process applied by IBES (or any
other provider of such data) is effectively a
‘black box’ to external users
> There was also some evidence identified by
Bradshaw and Sloan of managers making
increasing reference to street earnings
numbers in press releases discussing
quarterly earnings results.
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GAAP-based financial reporting: measurement of business performance
The results reported by Bradshaw and Sloan
(2002) have two possible explanations (as
recognised by the authors). First, an increased
emphasis on street earnings may represent
an effective strategy by managers (and
possibly analysts as well) to achieve higher
valuations by reporting and/or emphasising
(usually) higher street earnings numbers. This
explanation is hard to reconcile with the idea
of a relatively efficient capital market, but it is
consistent with allegations made by critics of
financial reporting, such as Levitt (1998).
However, a second explanation is simply that
increased emphasis by market participants on
street earnings reflects a rational attempt to
adjust GAAP earnings for non-recurring items
(i.e. transitory components) so as to create a
superior measure for determining future cash
flows and, ultimately, value. Of course, the
two explanations are not mutually exclusive,
but it is noteworthy that the former is largely
consistent with the opportunistic
manipulation of the GAAP reporting model,
while the latter is reflective of an efficient
search for the ‘best’ measure that can be
obtained from ‘adjusted GAAP’.
Some further evidence on the usefulness of
street versus GAAP earnings numbers
reinforces the results, but does not necessarily
resolve the underlying dilemma as to why street
earnings appear more strongly correlated with
market-based measures such as
contemporaneous stock returns. These papers
are as follows:
Doyle, Lundholm and Soliman (2003)
Although Doyle et al. (2003) refer to ‘pro-forma
earnings’, their paper was in fact an analysis of
earnings components relating IBES (i.e. street
earnings) with those reported under GAAP.
Their focus is on the difference between these
two figures, whether such differences are
useful in predicting future cash flows (a test of
‘usefulness’) and to what extent such
potentially useful information excluded from
street earnings is also ignored by investors.
> Doyle et al. examined quarterly earnings
data for US firms between 1988 and 1999,
with a total sample size in excess of
140,000 firm-quarters
> Doyle et al. found that one dollar of excluded
expenses (i.e. expenses recognised within
GAAP quarterly income but excluded from
the street figure) predicted $3.33 fewer
dollars of cash flow over the next three years.
This is more than 40 of the predictive value of
street earnings. This result was driven by the
exclusion of items other than those which are
labeled ‘special items’, such as the
elimination of goodwill amortisation. This
suggests that these expenses do in fact recur
and consume future cash flow
> Although Doyle et al. found that stock
returns around earnings announcements
were declining in the amount of GAAP
expenses that were excluded from street
earnings, the adjustment did not appear
sufficient, as stock returns for the
following three years were significantly
decreasing in the amount of the
exclusions from GAAP income
> While Doyle et al.’s results appear to support
the ‘opportunistic’ view of street earnings
(relative to GAAP), at least two concerns
arise. First, why is the focus on incrementally
explaining the following three years of
aggregate cash flow? If the answer reflects
the role of future cash flow in the valuation
process, then why not just examine the
ability of the different measures to explain
price (i.e. value)? Second, in tests such as
those of Doyle et al., it is almost inevitable
that additional disaggregating of a periodic
result will have incremental explanatory
power (Easton, 2003).
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
41 >
Brown and Sivakumar (2003)
Abarbanell and Lehavy (2005)
Like Doyle et al., Brown and Sivakumar
referred to ‘pro-forma’ earnings but actually
compared street earnings (i.e. earnings
reported by IBES) with GAAP.
Abarbanell and Lehavy’s study identified a
number of dangers in attempting to make an
evaluation of street earnings versus GAAP
earnings numbers.
> They examined quarterly earnings for US
firms between 1989 and 1997. Three types of
tests were performed, each of which directly
compared GAAP and street measures of
quarterly income
> The predictive ability of GAAP and street
earnings was tested by comparing the
accuracy of each measure as a predictor of
the corresponding quarterly result one year
later. Street earnings is a significantly better
predictor than GAAP earnings
> The valuation relevance of each measure was
tested by examining their respective
associations with stock prices. Street
earnings were shown to have a significantly
higher association with stock price than
GAAP earnings
> Information content was measured as the
correlation between each measure of
quarterly income and either the three-day
stock return surrounding the earnings
announcement (i.e. earnings surprise tests)
or the stock return for the corresponding
quarter. The results supported the conclusion
that street earnings have greater information
content than GAAP earnings
> If one assumes capital markets are relatively
efficient, then the results suggested that
street earnings more successfully eliminate
transitory components from GAAP income.
These transitory components provide little
additional information to investors. To the
extent a commercial service such as IBES
simply reflects what security analysts ‘do’,
then the results are also consistent with
analysts trying to provide the market with
earnings measures that are more informative
about future performance and, hence,
current value, than is the case from earnings
that are entirely in accord with GAAP.
> They examined quarterly earnings as
reported by IBES (i.e. street earnings) and
Compustat (i.e. GAAP earning) for 8,000
US firms between 1985 and 1998. In total,
they examined in excess of 150,000 firmquarters. There were three specific types
of difference between street earnings and
GAAP earnings highlighted
> First, there was a higher frequency of cases
where street earnings exceeded GAAP
earnings by extreme amounts compared to
instances where GAAP earnings exceeded
street earnings by extreme amounts. This
suggested that street earnings tend to
more frequently exclude extreme items
that are income decreasing than are
income increasing
> Second, there appeared to be a permanent
shift in the average difference between street
and GAAP earnings in the early 1990s. It is
likely that this reflected changes in
procedures by services collecting analysts’
forecasts of earnings (the commercial
providers such as IBES), as well as certain
GAAP accounting changes that have
permanently altered the relation between
street and GAAP earnings
> Third, there was a very high incidence (over
50 per cent of all observations) where GAAP
earnings and street earnings were identical
> The inference from these results was that the
extent to which street and GAAP earnings
differ may be overstated, especially when
driven by anecdotal examples of differences
> It was also apparent that at least some of
the apparent advantage of street earnings
documented in earlier studies may have
been driven by a relatively small number of
extreme differences between GAAP and
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
GAAP-based financial reporting: measurement of business performance
The review of evidence comparing street versus
GAAP earnings provided above is in some
respects inconclusive. On the one hand, there
does appear to be an increase in investors’ and
analysts’ emphasis on street earnings.
However, this is consistent with analysts and
investors being concerned with obtaining a
‘better’ measure of sustainable earnings than
current GAAP rules allow for, although it is also
apparent that differences between GAAP and
street earnings may not be as widespread as
anecdotal evidence would have us believe.
Nevertheless, it would appear that analysts
prefer a measure of earnings that is focused
more on earnings that are sustainable, or
‘continuing earnings’.
It is also possible that street earnings reflect a
deliberate attempt by firms to take advantage of
this preference, by selectively excluding certain
components of GAAP income that are actually
informative about future earnings, cash flows
and, ultimately, value. Unfortunately, the
inability to ‘see inside the box’ and know
exactly how to undo differences between street
and GAAP earnings (due to the proprietary
nature of the data collection process by
commercial providers such as IBES) means
that we cannot devise a strong test of this
explanation, at least with respect to street
earnings. However, if one takes a strict
definition of pro-forma earnings, that is, that
pro-forma earnings is an ad-hoc adjusted result
that is firm-specific, then research examining
the properties of pro-forma earnings releases
(and associated disclosures) may be very
relevant in helping us to understand the
extent to which GAAP earnings is ‘usefully’
modified versus the extent to which it may
be opportunistically manipulated. The next
section reviews this evidence.
3.4 Pro-forma earnings — telling it
like it is or how you want it to
be seen?
Just as street earnings (measures collected and
collated by commercial data services such as
IBES) represent a modified form of GAAP
reporting, so too does the use of pro-forma
reporting. The key difference, however, is that
whereas there is inevitably some degree of
standardisation within the approach applied by
a commercial service such as IBES to eliminate
transient components of reported GAAP
income, pro-forma reporting in its strict
definition simply refers to firm-specific
decisions to modify GAAP income in ways that
may be quite idiosyncratic. While the growth in
significance in street earnings has been noted
above, the rise (but most recently a possible fall)
in the use of pro-forma reporting has been
more controversial. Most likely, the distrust of
pro-forma reporting reflects the fact that the
‘rules’ are simply whatever the reporting firm
determines them to be.
Distrust of firms making their own ad-hoc
adjustments to GAAP reporting is widespread.
For example, the former Chief Accountant of
the Securities and Exchange Commission in the
US, Lyn Turner, christened this practice ‘EBS —
Earnings before Bad Stuff’. Such labels clearly
imply the assertion that reporting of pro-forma
earnings is a way of attempting to make firms’
performance look better than it really was. The
high profile anecdotal example described in
Figure 6 captures this type of concern.
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
43 >
Figure 6: Enron and pro-forma earnings
16 October 2001: Enron Press release — items
were reported in the order shown.
1 Recurring third quarter earnings of $0.43 per
diluted share, an increase of 26 per cent over
the corresponding quarter in 2000
2 ‘Recurring earnings’ estimates of $1.80 per
share for 2001 and $2.15 for 2002
3 GAAP loss for the quarter of $0.84 per
share, compared to GAAP profit a year
earlier of $0.34
4 Differences between GAAP profit and
‘recurring earnings’ are due to non-recurring
charges which have ‘clouded the
performance and earnings potential of the
core energy business’.
Six weeks after the press release summarised
above, Enron sought bankruptcy protection
under US law!
Not surprisingly, there have been several
studies directed at comparing the usefulness
of GAAP versus pro-forma earnings
measures. These studies inevitably rely on the
identification of firms who have released
some form of pro-forma earnings result, and
are therefore usually reliant on some degree
of manual data identification. As a result,
sample sizes and time period covered tend to
be much smaller than comparable studies
which compare GAAP and street earnings
numbers. Some examples of this evidence are
reviewed below.
44
Bhattacharaya, Black, Christenson
and Larson (2003)
This study identified a sample of over 1,100
press releases of quarterly pro-forma earnings
for the period 1998–2000.
> They considered the extent to which
pro-forma earnings reported by the firms
concerned differed from either GAAP or
street earnings, whether market
participants perceived pro-forma earnings
to be more informative than either GAAP
or street earnings and, finally, whether
market participants viewed pro-forma
earnings to be a more permanent
measure of firm profitability than either
street or GAAP earnings
> Pro-forma earnings releases identified by
Bhattacharaya et al. tended to be made by
firms reporting GAAP losses for the
corresponding quarter. Pro-forma
announcers were concentrated in the service
and high-tech industry groups. In around 25
per cent of cases, the pro-forma earnings
numbers was actually lower than GAAP
earnings, yet was still reported first in the
press release. It is hard to reconcile such
behaviour with the idea that pro-forma
earnings is simply the opportunistic
overstatement of performance
> The short term (i.e. three-day window) stock
returns around pro-forma earnings
announcements indicated that the market
placed greater weight on these numbers
than GAAP earnings
> Analysts forecast revisions around the release
of pro-forma earnings were consistent with
analysts viewing this as a better measure of
permanent earnings (i.e. less affected by
transient earnings components).
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
Johnson and Schwartz (2005)
The Johnson and Schwartz study examined
press releases highlighting pro-forma earnings
announcements by US firms for the period
June through August 2000.
> This period corresponded with what many
market commentators characterised as the
start of the so called ‘market bubble’
bursting. In contrast to Bhattacharya et al.
(2003), this study compared attributes of
firms which reported pro-forma earnings
with those that did not. In effect, it was
based on comparing pro-forma disclosers
with non-disclosers, rather than using a
within-sample approach
> Initial evidence based on pricing multiples
suggested that firms reporting pro-forma
earnings may be priced at a higher multiple
than other firms. However, the difference in
pricing multiples cannot be explained by the
pro-forma earnings numbers themselves
> At the announcement of quarterly earnings,
there was no evidence that firms announcing
pro-forma earnings were priced at a
premium. It therefore appeared that investors
did not focus ‘exclusively’ on pro-forma
earnings in a way that would be consistent
with a naive reaction to such information.
Entwhistle, Feltham and Mbagwu (2006)
This study examined whether US firms’
reporting of pro-forma earnings has changed
with the introduction of regulation.
> They examined data gathered from earnings
releases by S&P 500 firms over the period
2001–2004. Whereas academic evidence of
the type summarised above pre-dates the
regulatory reaction in the US towards proforma 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.
The evidence summarised above yields a
number of conclusions. First, large scale
empirical studies do not support the anecdotal
evidence that pro-forma reporting is simply an
attempt to mislead market participants. Of
course, examples such as Enron (as shown in
Figure 5) raise serious concerns that allowing
firms to selectively modify GAAP reporting
rules is a licence for exploitation. On the other
hand, the empirical evidence does not seem to
support the contention that the Enron example
is ‘typical’ of all pro-forma reporting. Rather, it
appears as though many of the modifications to
GAAP that are reflected in pro-forma reporting
have the effect of eliminating transient earnings
components. It has long been accepted (and
shown empirically) that transient components
of earnings are less relevant to the valuation
process, as evidenced by the relation between
earnings and either stock returns or stock
prices. This result is also apparent when
examining market reaction to pro-forma
earnings news, as well as the role of pro-forma
earnings in the valuation process. It is also
apparent when looking at the way analysts
react to the release of pro-forma earnings.
Whether the regulation of pro-forma reporting
serves to increase or decrease its usefulness is
an open question. It is apparent that since the
heady days of the dot-com boom (and
subsequent bust) that the introduction of new
regulations (such as the Sarbanes-Oxley
legislation in the US) may have been associated
with a reduction in the frequency with which
relatively extreme differences occur between
GAAP earnings and the figures reported under
the generic label ‘pro-forma earnings’. This is
still an open question, and one on which
research can be expected in the near future.
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
45 >
4 Conclusion
3.5 Summary
This section takes a somewhat different
perspective to the evidence and argument
reviewed in sections 1 and 2. Whereas those
sections focused exclusively on documenting
evidence on the properties of GAAP
accounting, this section has reviewed
evidence on extensions/modifications to
GAAP. In particular, it has considered the use
of two alternative metrics, namely ‘street
earnings’, as reported by commercial
providers of analyst forecast data (e.g. IBES,
First Call and Value Line), and the firm-specific
‘creation’ of earnings metrics under the label
‘pro-forma earnings’.
This evidence is significant for at least two
reasons. First, it provides us with some
appreciation of whether extensions to widelyused GAAP-based metrics, such as earnings,
are of themselves useful. The answer to this
question is, on balance, yes. Measures
portrayed as street or pro-forma earnings are,
for the most part, measures of periodic
performance that exclude relatively transient
components of GAAP earnings. While many
of these items (such as write-offs) may be
informative of themselves, they are not as
informative as other GAAP income
components about future earnings and cash
flows. It is not surprising that the exclusion of
transitory components of GAAP earnings might
increase the innovativeness of periodic
performance measures.
Is it possible that pro-forma reporting illustrates
that regulation (such as those that underlie
GAAP) actually limits the usefulness of financial
reporting for the measurement of business
performance? Possibly, but we simply do not
have sufficient evidence at this time to say
whether external financial reporting is better
served by a degree of firm-specific innovation
or not. Contracting theory (as reviewed in
section 1) provides strong economic grounds
for the significance of verifiability within the
financial reporting model, and greater firmspecific innovation would seemingly make
such verification more difficult. However, it is
apparent that much of the firm-specific
innovation evident in pro-forma reporting is
informative for the reporting firm in question.
Whether there is an appropriate trade-off
between extant regulation and allowing firmspecific definition of performance is clearly an
issue that broader measures of performance
beyond GAAP will only serve to further test.
A second reason for a review of extensions
to conventional GAAP-based measures of
performance is that it provides insight into
the (much) broader debate about whether
we can significantly improve on extant GAAP
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
GAAP-based financial reporting: measurement of business performance
Criticisms of measures of business
performance produced under GAAP (such
as income) have become more widespread
in recent years. These criticisms take a
number of forms, but broadly they fall into
three categories.
First, there are the accusations that as business
models have changed (e.g. the move towards
service industries) the GAAP model of
performance measurement has failed to keep
up. Implications drawn from this criticism range
from possible extensions/modifications to
GAAP-based performance measures, through
alternative measurement methods within
existing GAAP principles, to completely new
performance metrics measured and reported
entirely outside the existing GAAP model.
It is also apparent from extant research studies
that extensions/modifications to GAAP may
add to the informativeness of measures such
as income for assessing business performance.
While concerns may be legitimately held about
allowing managers to ‘choose’ a definition of
earnings most likely to paint the best possible
picture, it is apparent that the type of
modifications to GAAP income made by
analysts and investment services are aimed at
getting a more representative picture of
repeating, or sustainable, earnings. However,
it is also important to note that such measures
maintain the fundamental characteristics of
GAAP-based income measures, such as the
revenue recognition principles and rules and
the associated matching convention.
Second, there is the accusation that existing
GAAP allows sufficient flexibility to result in
measures of performance that are
compromised by managerial manipulation.
However, where this accusation is used as a
justification for fundamentally different forms
of business reporting (e.g. sustainability, triple
bottom line, etc.), it may be equally fair to ask
whether the measures proposed are just as
likely, if not more likely, to be subject to
opportunistic manipulation. Evidence of the
type reviewed in section 2 suggests that there
are market, governance and disciplinary factors
that encourage high quality financial reporting.
However, even establishing exactly what the
term ‘high quality’ means is subject to the exact
purpose for which the accounting measures
are used. For example, what constitutes high
quality financial reporting to a lender may
involve far more conservatism than a
shareholder might consider optimal.
Progress is to be expected in any endeavour,
and so suggestions for improvements to
systems for measuring business performance
are not surprising. However, it is also easy to
get carried away and ignore the achievements
of the existing model for measuring business
performance. GAAP accounting measures have
proven to be a relatively robust way of
assessing performance, and at a minimum
critics and proponents of change need to
identify how their preferred solution is not
subject to many of the same criticisms directed
at the existing reporting model. The
fundamental tenets of existing GAAP have had
a long development period, and are relatively
well understood by various users. While GAAP
can inevitably be improved and extended, it is
simply not correct to conclude that measures
based on GAAP are unsuitable for measuring
business performance.
The Institute of Chartered Accountants in Australia
GAAP-based financial reporting: measurement of business performance
47 >
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Melbourne VIC 3001
Ph: 03 9641 7400
Fax: 03 9670 3143
Email: ca_vic@icaa.org.au
Western Australia
Ground Floor BGC Centre
28 The Esplanade
Perth WA 6000
PO Box Z5385
St Georges Terrace
Perth WA 6831
Ph: 08 9420 0400
Fax: 08 9321 5141
Email: ca_wa@icaa.org.au