0706-16 Stephen Taylor Report (PDF)

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The Institute of Chartered Accountants in AustraliaGAAP-based financial reporting: measurement of business performance

Professor Stephen Taylor, The University of New South Wales, Sydney, Australia

The Institute of Chartered Accountants in Australia

GAAP-based financial reporting: measurement of business performance


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Foreword

About this report

This monograph was written by Professor

Stephen Taylor from the University of New

South Wales in Sydney, Australia.

All materials in this monograph is current as at

July 2006.

In producing this monograph the author

acknowledges the benefit from discussions

with colleagues at the School of Accounting,

University of New South Wales, and particularly

the comments on earlier drafts by Jeff Coulton

(UNSW), Sarah McVay (NYU) and Caitlin

Ruddock (UNSW).

© The Institute of Chartered Accountants in Australia 2006

First published August 2006. First edition.

Published by: The Institute of Chartered Accountants in Australia

Address: 37 York Street, Sydney, New South Wales 2000

Author: Professor Stephen Taylor

ISBN: 1-921245-05-0

ABN 50 084 642 571 The Institute of Chartered Accountants in Australia Incorporated in Australia Members’ Liability Limited. 0706-16

Disclaimer: This monograph presents the opinions and comments of the author and not necessarily those of the Institute of Chartered

Accountants in Australia (the Institute) or its members. The contents are for general information only. They are not intended as professional

advice – for that you should consult a Chartered Accountant or other suitably qualified professional. The Institute expressly disclaims all liability

for any loss or damage arising from reliance upon any information contained in this paper.

The 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.

Neil Faulkner FCAPresident

Institute of Chartered Accountants in Australia

The Institute of Chartered Accountants in Australia 05 >


Contents

Executive summary 06

Introduction 08

1 How ‘useful’ are GAAP metrics for evaluating business performance? 12

1.1 Introduction 12

1.2 Does GAAP produce ‘value relevant’ measures? 14

1.3 How fully do market participants understand accrual accounting? 17

1.4 Direct evidence on the value relevance of GAAP performance measures 19

1.5 Conservatism and GAAP reporting 22

1.6 Summary 25

2 What is the quality of GAAP accounting measures? 26

2.1 Introduction 26

2.2 Measuring earnings quality and earnings management 27

2.3 Examples of earnings management 29

2.4 Incentives to report high quality earnings 32

2.5 Summary 35

3 Evidence on ‘modified GAAP’ reporting 36

3.1 Introduction 36

3.2 Comprehensive income 38

3.3 Street earnings — is this a selective narrowing of GAAP income (and does it improve

earnings as a measure of business performance)? 40

3.4 Pro-forma earnings — telling it like it is or how you want it to be seen? 43

3.5 Summary 46

4 Conclusion 47

Bibliography 48


GAAP-based financial reporting: measurement of business performance06 The Institute of Chartered Accountants in Australia


Executive summary

The report provides an overview ofcurrent knowledge about the state of‘conventional’ financial reporting and themeasurement of business performance.The term ‘conventional’ implies ananalysis of what we know about financialreporting produced by the application ofgenerally accepted accounting principles(GAAP). It is intended to inform thoseinterested in the future of financialreporting by providing a summary of keyevidence about the existing GAAPmodel. In particular, two key questionsare addressed:

> What are the factors underlying thedemand for measurement of businessperformance?

> How successful are existing, GAAP-based methods for the measurement ofbusiness 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

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 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 ‘pro-

forma’ 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.

08 The Institute of Chartered Accountants in Australia


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.



Introduction

This monograph is motivated by concernsthat the existing method of measuringfinancial performance and, by implication,financial position is in need of potentiallysignificant changes. Financial reportingencompasses not only the basic financialstatements (i.e. income statement, balancesheet and cash flow statement), but alsothe plethora of statutory reporting withinthe annual report (e.g. remuneration report)and even the ongoing requirements toensure an informed market via continuousdisclosure 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 GAAP-

based 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

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.



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

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

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. pro-

forma 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.



Figure 1: How useful is the existing GAAP-based reporting model for measuring business performance

Financial reporting quality

Alternative measures of financial performance

(Modified GAAP)

Value relevance Evidence Costly Contracting

Market reactionsCorrelation with share price changesCorrelation with price

Use of accounting numbersModification of accounting

Useful Financial Reporting

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.



1 How ‘useful’ are GAAP metrics for evaluatingbusiness performance?

Key points> Claims that financial reports produced

under extant GAAP are not relevant to theevaluation of business performance have been repeatedly rebutted over thelast 40 years

> GAAP-based measures of financialperformance and position (income, netassets) are related to firms’ marketvaluations, as well as the way in whichthese values change over time

> There is theoretical, as well as empiricalsupport for the role of accountingnumbers produced under GAAP as inputto valuation metrics

> Accrual accounting as applied by GAAPimproves the ability to understand businessperformance over finite horizons

> There are legitimate concerns that capitalmarkets do not completely take account ofthe way in which accrual accounting‘works’ (i.e. the way accruals reverse)

> The usefulness of GAAP accounting is alsohighlighted by the way it has been used todefine and enforce contractual relations

> The contracting role of GAAP potentiallylimits the implications that can be drawnfrom evidence about ‘value relevance’

> Evidence of conservatism in financialreporting highlights the tension betweenthe contracting and value relevanceperspectives on how GAAP financialreporting should evolve.

1.1 IntroductionThis 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.



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).

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



1.2 Does GAAP produce ‘valuerelevant’ 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


relevant if it contains variables used in a

valuation model or helps predict those

variables


relevant if it changes the total mix of

information in the marketplace


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



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).

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

Month relative to annual report announcement date-12 -10 -8 -6 6-4 4-2 20

Variable 3

Variable 2

Variable 1

Figure 2: Abnormal indexes for various portfolios

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 marketparticipants understandaccrual 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



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.

> 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 valuerelevance of GAAPperformance 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



> 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



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).

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.

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


GAAP-based financial reporting: measurement of business performanceThe Institute of Chartered Accountants in Australia 21 >

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.

Francis and Schipper (1999) 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 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’

> The valuation prediction model used

progressively more disaggregated measures

of income in order to establish whether

accruals increase the usefulness of cash-

based 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.

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.

> 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.

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.



1.5 Conservatism and GAAPreporting

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 GAAP-

related) 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

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.



1.6 SummaryCriticism 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.

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.

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.



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 book-

to-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 (debt-

based) 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.

> They examined over 3,700 Australian firm-

years 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)

> 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.



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 qualityand 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,



2 What is the quality of GAAP accounting measures?

Key points> The quality of GAAP financial data is a

critical consideration in whetherperformance metrics drawn from GAAPare likely to be useful measures of periodicbusiness performance

> The definition of accounting quality (or earnings quality) depends on the users’ perspective

> Considerable research demonstratessome evidence of earnings managementwhere incentives to engage in suchmanipulation exist

> The same flexibility within GAAP thatpermits some degree of earningsmanagement also facilitates the ability tosignal future prospects

> Capital markets are frequently alleged toencourage managers to engage inbenchmark beating

> Managers seemingly are more likely toengage in real economic decisions tomanage earnings rather than risk the costsassociated with GAAP violation

> Capital markets appear to rewardaccounting quality

> Managers bear economic consequencesif they engage in serious accountingmanipulation

> Corporate governance mechanisms(auditor, board composition, auditcommittee composition) appear toencourage higher quality accounting.

2.1 IntroductionThe 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 self-

serving, with the result that it reduces the

usefulness of earnings (and related GAAP-

based 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



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.

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 earningsmanagement

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



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.

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.

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.

Whether this is in part attributable to a ‘post-

Enron’ 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 ‘under-

delivering’ earnings results.

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.

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:



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.

Teoh, Wong and Rao (1998)

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 post-

IPO stock returns. This was also consistent

with the stock market failing to efficiently

incorporate information in the measure of

earnings management.

Louis and Robinson (2005)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



low quality earnings measures provide a partial

explanation for the widely-recognised pattern

of negative stock returns following an IPO.

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

‘shift‘ earnings may be an important part of

managers’ tool-bag for communicating

efficiently with investors and others.

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

400

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Operating income deflated by total assets

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0.010.020.030.040.050.060.070.080.090.100.110.120.130.140.150.160.170.180.190.200.210.220.230.24

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Changes in operating income deflated by total assets

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0.010.020.030.040.050.060.070.080.090.100.110.120.130.140.150.160.170.180.190.200.210.220.230.24

Figure 4: Australian benchmark beating – avoiding earnings decline

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 firm-

specific 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.



> 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.

2.4 Incentives to report highquality 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



2.5 SummaryIn 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.

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.



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.

Tucker and Zarowin (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.

> 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.

Klein (2002)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.

> 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.

Desai, Hogan and Wilkins (2006)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.

> 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.



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 GAAP-

based 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.



Key points> ‘Modified GAAP’ equals altered

definitions of what is included in income.This can be additions beyond current netincome (to yield ‘comprehensiveincome’), or exclusions (i.e. above the lineadjustments) to yield either ‘streetearnings’ or ‘pro-forma earnings’

> Comprehensive income is favoured bysome regulatory domains, but there is littleempirical evidence to support therequirement to provide this information inaddition to existing financial statements

> ‘Pro-forma reporting’ is where a selectiveexclusion of income components occurs.This is sometimes termed ‘streetearnings’, corresponding to earningsmeasures found on the major databasesproviding earnings forecasts (e.g. ValueLine, Institutional Brokers EstimationService (IBES) and First Call)

> It is hard to know exactly what ‘street’earnings are, as providers of forecast dataare effectively a ‘black box’ in terms of theprecise adjustments made

> Evidence suggests that pro-forma or streetearnings may be more informative thanearnings measures that conform withGAAP. This is especially true where thedifferences relate to non-recurring items.

3.1 IntroductionThis 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:

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



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).

3 Evidence on ‘modified GAAP’ reporting

‘other owners’ equity changes

transient components

pro-forma earnings

GAAP GAAP

comprehensive income street earnings

Street earnings adjusted in an

ad-hoc way

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.



3.2 Comprehensive incomeOne 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?

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.



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).

Other comprehensive income

Other comprehensive income

Comprehensive income

Net income

Unrealised gains/losses on ‘available for sale’ securities as defined

by SFAS 115

Net losses associated with minimum liability pension

adjustments (SFAS 87)

Foreign currency translation adjustments (SFAS 52)

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).



3.3 Street earnings — is this aselective narrowing of GAAPincome (and does it improveearnings as a measure ofbusiness 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.

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 firm-

quarters. 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.



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 itlike it is or how you want it tobe 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.



Brown and Sivakumar (2003)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.

> 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.

Abarbanell and Lehavy (2005)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 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 firm-

quarters. 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’.



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 pro-

forma reporting, this study examined how

things have changed

> Pro-forma reporting appears to have

become less biased, as evidenced by

a decline in the frequency with which

pro-forma earnings exceeded its GAAP

equivalent. Pro-forma reporting also

appears to have become less frequent.

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.



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.

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).



4 Conclusion

3.5 SummaryThis 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 widely-

used 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.

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.

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 firm-

specific 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 firm-

specific definition of performance is clearly an

issue that broader measures of performance

beyond GAAP will only serve to further test.

Criticisms of measures of businessperformance produced under GAAP (suchas income) have become more widespreadin recent years. These criticisms take anumber of forms, but broadly they fall intothree 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.

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.

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.

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.


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