LOS ANGELES--(EON: Enhanced Online News)--Mark Soliman, Arthur Andersen & Co. Alumni Associate Professor of Accounting at the USC Marshall School of Business and the USC Leventhal School of Accounting, and his colleagues, Jeffrey Doyle at the Jon M. Huntsman School of Business at Utah State University and Jared Jennings at the Olin Business School at Washington University in St. Louis, have broken new ground with their article, "Do managers define non-GAAP earnings to meet or beat analyst forecasts?," published in the Journal of Accounting and Economics. Studying 237,617 earnings announcements from 1998-2009, the authors have conducted the first large-scale study which shows a definitive relationship between issuing non-GAAP or pro-forma earnings (which deviate from what are considered generally accepted accounting procedures) and propensity to exceed analyst forecasts.
“One cost of the use of exclusions may be that the market discounts the firm's earnings surprise, suggesting that the market partially understands the opportunistic nature of these exclusions”
Approximately 25.5% of firms in the sample issued non-GAAP earnings. According to Soliman, this pro-forma earnings/non-GAAP reporting allows firms to classify expenses as "one time charges" such as restructuring charges, special one-time, non-recurring, non-cash or non-relevant expenses. These are highly discretionary expenses that firms arbitrarily remove from their financials in order to increase earnings. The authors find that managers tend to do this when other forms of earnings management have already been used and already "maxed out."
The result? Firms who report non-GAAP earnings, the USC study shows, tend to beat analysts' expectations more often than firms who solely report GAAP earnings. Exclusions in these earnings are driving results as non-GAAP reporters meet or beat analysts' expectations 65% percent of the time. In fact, the authors found that the probability of a firm meeting or beating analysts increases 20% when the firm incorporates "other exclusions" into their reporting.
What's the danger? Analysts, the authors conclude, are not entirely unwinding the opportunistic expenses excluded from GAAP (for example when an expense is labeled as 'other' but it is in fact, an ongoing or reoccurring expense). The big danger is that analysts are not able to anticipate all of these exclusions to generate accurate forecasts.
The authors concede however, that the market does a fair job of recognizing what managers are doing as stocks get lower returns than one might expect. The researchers found that the market discounts the firm's earnings surprise by 10 percent to 14 percent when it is associated with the use of income-increasing exclusions. "One cost of the use of exclusions may be that the market discounts the firm's earnings surprise, suggesting that the market partially understands the opportunistic nature of these exclusions," say the authors.
This study is the first to document that these highly discretionary "pro forma" earnings that were first regulated by the SEC in 2003 continue to give managers another "lever" to pull in order to beat analyst forecasts especially when other forms of earnings management are no longer available to them or more costly to employ.
About the USC Marshall School of Business
Consistently ranked among the nation's premier schools, USC Marshall is internationally recognized for its emphasis on entrepreneurship and innovation, social responsibility and path-breaking research. Located in the heart of Los Angeles, one of the world's leading business centers and the U.S. gateway to the Pacific Rim, Marshall offers its 5,700-plus undergraduate and graduate students a unique world view and impressive global experiential opportunities. With an alumni community spanning 90 countries, USC Marshall students join a worldwide community of thought leaders who are redefining the way business works.