Core Earnings Research Articles

Dividend Irrelevance and Accounting Models of Value

In accounting models of value dividends typically appear to have a strong positive relationship with value despite theoretical reasons to expect dividend displacement. We show that this result is driven by the relationship between dividends and both core earnings and other information derived from the valuation error in the prior year. Where core earnings can be effectively modelled in a specification including other information dividend displacement is no longer rejected. Under these circumstances dividends exhibit weak incremental predictive power for earnings and earnings expectations and hence have little impact on value. We show that valuation models are sensitive to model specification and should be used with caution when testing the value impact of firm characteristics or accounting numbers.

Management of Core Earnings Using Classification Shifting Around Seasoned Equity Offerings

McVay (2006) shows that managers can raise reported core (pro-forma) earnings by shifting core expenses to special items. While the bulk of the literature (e.g. Teoh, Welch, and Wong, 1998; Cohen and Zarowin, 2010) has exclusively focused on accrual- and real activities-based earnings manipulation methods, we provide the first known evidence of the manipulation of core earnings in the equity issuance context. To the extent that investors focus solely on non-GAAP 'core' earnings, managers have incentive to inflate core earnings rather than bottom-line return on assets (which remains unaffected) through accrual-based earnings management. If successful, this leads to investors misinterpreting the issue prospects and subsequently overvaluing new issues. Using a core earnings expectations model, which builds on the approach of McVay (2006) and extended by Fan, Barua, Cready, and Thomas (2010) with quarterly data, we provide evidence supportive of manipulation in the form of a positive association between income-decreasing special items and unexpected core earnings in the fourth quarter. We also find that issuers’ choices to use classification shifting or accrual earnings management strategies depends on auditor’ characteristics, flexibility and detection probability. Finally, we compare the effect of the two means of manipulation strategies and provide evidence that classification shifting is less likely than accruals management to be associated with post-issue performance declines.

Accounting Restatements and Managerial Legal Liability Coverage

This study investigates how managerial legal liability coverage, as measured by excessive managerial liability coverage, affect earnings restatements. Once managers mitigate their personal legal liability through managerial liability coverage, they may be more willing to misstate reported earnings. We test a sample of listed companies from Taiwan where D&O insurance are publicly available. We find that managers are more likely to misstate company's earnings when they are covered by relatively higher excess managerial liability coverage. Moreover, we find that excessive managerial liability coverage couldn’t mitigate management legal liability concerns about material misrepresentation (e.g., core earnings restatements). In addition, several additional analyses are conducted and the results are robust and remain unchanged.

Earnings Management Using Discontinued Operations

ABSTRACT: This study investigates whether managers use classification shifting to manage earnings when reporting discontinued operations. Using a methodology similar to McVay (2006), we find evidence consistent with the hypothesis that firms shift operating expenses to income-decreasing discontinued operations to increase core earnings. Our findings also indicate that managers use classification shifting to meet or beat analysts’ forecasts. Finally, we find that, since the introduction of SFAS No. 144, the reporting frequency of discontinued operations has increased; however, the magnitude of classification shifting has decreased. We provide potential explanations for this finding.

EMPIRICAL INVESTIGATION OF ORGANIC GROWTH, EVIDENCE FROM INDONESIAN PUBLIC LISTED COMPANIES

The main objective of this research is to examine Indonesian public listed companies with earnings generated organically rather than through earnings management, income manipulation, financial engineering, or through mergers and acquisitions. 70 samples were taken from Kompas 100 Stock Index from the period of 2004 to 2007 excluding banks, financial institutions, REITs and insurance companies. The authors applied the model of Organic Growth Index (OGI), developed by Hess (2007). The OGI model designed to illuminate value-creating companies that have consistently outperformed industry competition through organic growth. The test begins by selecting the best Economic Value Added and high growth companies. The result of our study shows that there are 10 percent of Indonesian public listed companies identified as OGI winners. These companies passed the core earnings test, income manipulation test and cash realization test, and thus indicated that those Indonesian public companies have a low level of earnings manipulation and low engagement in non-core earnings such as hedging activities.

Managing Earnings Using Classification Shifting: Evidence from Quarterly Special Items

ABSTRACT: McVay (2006) concludes that managers opportunistically shift core expenses to special items to inflate current core earnings, resulting in a positive relation between unexpected core earnings and income-decreasing special items. However, she further notes that this relation disappears when contemporaneous accruals are dropped from the core earnings expectations model. McVay (2006) calls for research to improve the core earnings expectations model and to provide additional cross-sectional tests of classification shifting. Using a core earnings expectations model that is not dependent on accrual special items, we show that classification shifting is more likely in the fourth quarter than in interim quarters. We also find more evidence of classification shifting when the ability of managers to manipulate accruals appears to be constrained and in meeting a range of earnings benchmarks. Overall, our evidence provides broad support for McVay’s (2006) conclusion that managers engage in classification shifting. Our study also sheds new understanding of the conditions under which managers are more likely to employ classification shifting.

US Managers' Use of ‘Pro Forma’ Adjustments to Meet Strategic Earnings Targets

Abstract: The practice of reporting manager‐adjusted ‘pro forma’ earnings numbers in quarterly earnings press releases has attracted considerable attention in recent years in the United States. Prior research suggests that while some managers report these adjusted numbers to better reflect core earnings, others may use these earnings adjustments to meet strategic earnings targets on a pro forma basis when they fall short based on GAAP reporting standards. Assuming the latter motivation could potentially mislead investors, the difficulty lies in distinguishing the ‘good guys’ from the ‘bad guys.’ Using hand‐collected pro forma earnings data, we investigate the extent to which different types of earnings adjustments affect the spread between pro forma earnings and GAAP earnings from continuing operations. Moreover, we investigate which types of adjustments managers use to meet strategic earnings targets. In addition to the exclusion of one‐time items like restructuring charges, the results indicate that managers often exclude recurring expenses such as depreciation, research and development, and stock‐based compensation to meet these strategic targets. The exclusion of recurring items is especially indicative of aggressive pro forma reporting. Finally, we find that firms that report adjusted earnings numbers only sporadically are more likely than firms that adjust earnings figures on a regular basis to use pro forma reporting to achieve strategic earnings targets by excluding recurring items.

Are special items informative about future profit margins?

Most proponents of using profit margins in forecasting models suggest that unusual items be removed from income to create a core profit margin. We investigate the appropriateness of this assumption over short and long horizons. Specifically, we explore the association between profit margins and special items over windows of increasing length, from one to five years. We find that the association between past special items and future profit margins differs markedly between firms with low and high core profitability. For low profitability firms, past special items have no association with future profit margins, even over windows of five years. In sharp contrast, for high profitability firms, negative special items are associated with lower future profit margins. This suggests that some firms maintain high core profitability by becoming serial chargers and special items differ from core earnings only to the extent that the allocation process induces timing errors in reported earnings.

Earnings management or forecast guidance to meet analyst expectations?

We examine whether UK firms engage in earnings management or forecast guidance to ensure that their reported earnings meet analyst earnings expectations. We explore two earnings management mechanisms: (a) positive abnormal working capital accruals; and (b) classification shifting of core expenses to non‐recurring items. We find no evidence of a positive association between income‐increasing, abnormal working capital accruals and the probability of meeting analyst forecasts. Instead we find evidence consistent with a subset of larger firms shifting small core expenses to other non‐recurring items to just hit analyst expectations with core earnings. We also find that the probability of meeting analyst expectations increases with downward‐guided forecasts. Overall our results suggest that UK firms are more likely to engage in earnings forecast guidance or, for a subset of larger firms, in classification shifting rather than in accruals management to avoid negative earnings surprises.

Earnings Management Using Discontinued Operations

This paper investigates whether managers use classification shifting to manage earnings when reporting discontinued operations. Using a methodology similar to McVay (2006), we find evidence consistent with our hypothesis that firms shift operating expenses to income-decreasing discontinued operations to increase core earnings. Our findings also indicate that managers use classification shifting to meet or beat analysts’ forecasts. Finally, we find that since the introduction of SFAS 144, the reporting frequency of discontinued operations has increased; however, the magnitude of classification shifting has decreased. We provide potential explanations for this finding.

An Examination of SFAS 146 Restructuring Charges*

This study examines whether earnings management using restructuring charges has changed subsequent to the implementation of SFAS 146. My empirical results indicate a significant decrease in the magnitude of abnormal restructurings and a lower association between abnormal restructurings and big bath reporting behavior after the standard. These findings suggest that the reliability of restructurings has improved under SFAS 146. Furthermore, I investigate how the effect of abnormal restructurings on future earnings growth has changed after the FASB action. My results reveal that the association between abnormal restructurings and growth in next year's core earnings is more positive in the post-SFAS 146 regime. This suggests that more reliable abnormal restructurings reported under SFAS 146 are accompanied by a greater improvement in future operating performance than prior to the standard. Finally, my stock returns tests show that abnormal restructurings are negatively and strongly associated with subsequent returns in the pre-SFAS 146 period, while such negative association is weaker in the post-SFAS 146 period. Thus, investors' perceptions of the implications of abnormal restructurings for future earnings growth may have improved following the standard.

What Triggers Top Management Turnovers in China?

Studies on management turnover in Chinese companies typically find that turnover decisions are associated with companies' accounting performance. Using a sample of Chinese company turnovers during 2000–2003, we disaggregate their net-earnings into core, recurring non-core, and other non-recurring components. Analyzing these earnings components, we show that turnover decisions for government firms are related negatively only to recurring earnings which consist of operating, administrative and financial expenses. Leverage also plays a significant role suggesting the concern that high debt levels may reduce the impacts of the Chinese SOE reforms. However, turnovers in private firms are associated with poor core earnings, a result similar with profit-maximizing firms in developed economies.

What Roles Can Nonrecurring Items Play?

Prior research on accounting conservatism suggests two distinct roles that nonrecurring items can play for firms with a high level of intangibles. One is for market participants to assess the value of operating activities and the other is to provide incentives for managers. For the valuation role, I find convincing evidence that special items and discontinued operations contain useful information about unrecorded intangibles. Discontinued operations signal a downward adjustment of the value of intangibles and special items signal an upward adjustment. In contrast, for the incentive role, I find only weak evidence of a relationship between the use of market-based compensation and the ability of nonrecurring items to explain goodwill. My findings have important implications for standard setters and accounting researchers because they indicate that even when core earnings cannot convey adequate information about important intangible projects, investors can assess the value of intangibles and related managerial decisions from reports of special items and discontinued operations. They also indicate that reliability is an important attribute for incentive relevance, and suggest the presence of a tradeoff between value relevance and reliability of special items and discounted operations in a compensation contracting.

Classification Shifting and Special Items: Evidence of Earnings Management or a Research Design Consequence?

McVay (2006, 2008) report compelling evidence that firms reclassify ordinary expense items as special item in order to boost benchmark core earnings numbers. We show that another far more innocuous explanation exists for this evidence. The effects that McVay attributes to classification shifting activities can arise as an artifact of the approaches used in deriving expected core earnings values. This can happen because expected core earnings and expected change in core earnings values are determined, in part, by special item accruals. When we focus on either subsamples where this special item accrual effect on the expected core earnings values is a priori expected to be small or incorporate controls for it into the analysis, there is no reliable evidence of widespread classification shifting activities by managers.

Classification Shifting or Model Bias‘ A Reply to Barua and Cready (2008)

In McVay (2006), I present evidence of managers classifying core operating expenses as special, in the year of the special item, to increase core earnings (which is the focus of both investors and analysts). The analysis requires a model of expected core earnings, and I discuss the limitations of this model at length in the original paper. Barua and Cready (2008) build upon these stated limitations and claim that the evidence of classification shifting is a byproduct of the expectations model. In this reply, I argue against this claim. I first present evidence of classification shifting for a subset of firms without using a model of expected core earnings. I next critique each of the authors' empirical tests, and then replicate their main analysis and show that their results are not consistent with model bias. I conclude my reply by summarizing the improvements to the classification shifting model made by subsequent researchers.

Managers' Use of 'Pro Forma' Adjustments to Meet Strategic Earnings Benchmarks

The practice of reporting manager-adjusted 'pro forma' earnings numbers in quarterly earnings press releases has attracted considerable attention in recent years. Prior research suggests that while some managers report these adjusted numbers to better reflect core earnings, others may use these earnings adjustments to meet strategic earnings benchmarks on a pro forma basis when they fall short based on GAAP reporting standards. The difficulty lies in distinguishing the 'good guys' from the 'bad guys.' Using hand-collected pro forma earnings data, we investigate the extent to which different types of earnings adjustments affect the spread between pro forma earnings and GAAP earnings from continuing operations. Moreover, we investigate which types of adjustments managers use to meet strategic earnings benchmarks. In addition to the exclusion of one-time items like restructuring charges, the results indicate that managers often exclude recurring expenses such as research and development, depreciation, and stock-based compensation to meet these strategic benchmarks. The exclusion of recurring items is especially indicative of manager opportunism in pro forma reporting.

Stock Market Sensitivity to U.K. Firms' Pension Discounting Assumptions

AbstractNew U.K. pension accounting regulations significantly increase the exposure of the balance sheets of U.K. firms to volatilities in pension fund valuations. We examine whether the abnormal returns of firms that voluntarily used market‐based pension discount rates are significantly different from the abnormal returns of industry‐matched pair samples of firms that retained traditional cost‐based valuation assumptions during the period surrounding the release of the related exposure draft. We also examine the interest rate sensitivity of stock price returns over the 4‐year period before and after the announcement date. Consistent with our hypotheses, U.K. stock price returns incorporate the effect of unexpected interest rate changes on sources of pension earnings for firms that voluntarily switched to market‐based assumptions but do not incorporate these effects for firms that did not switch. These results suggest that unexpected changes in interest rates have a differential effect on a firm's sources of pension, financial, and core earnings.

Who Trades on Pro Forma Earnings Information?

In recent years, many companies have emphasized adjusted-GAAP earnings numbers in their quarterly press releases. While managers use different names to describe these nonstandard earnings metrics, the financial press frequently refers to them as “pro forma” earnings. Managers and other advocates of pro forma reporting argue that these disclosures provide a clearer picture of companies' core earnings. On the other hand, regulators, policymakers, and the financial press often allege that managers' pro forma earnings disclosures are opportunistic attempts to mislead investors. Recent evidence suggests that while many pro forma earnings disclosures are altruistically motivated, some may represent managers' attempts to portray overly optimistic financial performance. If this is the case, then less wealthy, less sophisticated, individual investors are arguably the most at risk of being misled. Consequently, this study investigates who trades on pro forma earnings information. Our intraday investigation of transactions around earnings announcements containing pro forma earnings information reveals that less sophisticated investors' announcement-period abnormal trading is significantly positively associated with the magnitude and direction of the earnings surprise based on pro forma earnings. In contrast, we find no association between sophisticated investors' trading and manager-reported pro forma information. Overall, our analyses and numerous robustness tests suggest that the segment of the market that relies on pro forma earnings information is populated predominantly by less sophisticated individual investors. This evidence is particularly relevant to standard-setters and regulators given that Section 401(b) of the Sarbanes-Oxley Act of 2002 and subsequent SEC regulations are specifically designed to protect ordinary investors from misleading pro forma information.

The Persistence of Special Items

Prior research shows that negative special items are less persistent than core earnings. However, the allocation of special items to periodic earnings entails significant measurement error which may induce the observed lower persistence. In this paper, we control for this measurement error by aggregating core earnings and special items over periods of one to five years, and testing whether the differential persistence is robust to longer aggregation periods. We find lower persistence of special items only for firms with low core (pre-special items) profitability. For these firms, negative special items have no association with future bottom line earnings for all aggregation periods. In contrast, for high core profitability firms, negative special items exhibit significant persistence, and the persistence increases with the aggregation period. In particular, when earnings are aggregated over five years, we find no difference in the persistence of negative special items and core earnings.

Earnings Components, Accounting Bias and Equity Valuation

In this paper we address three issues in accounting-based equity valuation: (i) How are valuation parameters related to earnings persistence and accounting conservatism when earnings components aggregate, or “add up”, in valuation? (ii) What does aggregation of earnings components in valuation imply for abnormal earnings dynamics? and (iii) When is an earnings component “irrelevant” and “core”␣earnings the relevant construct for valuation? Assuming linear valuation, no-arbitrage, dividend irrelevance and clean surplus accounting, we show that when earnings components aggregate, valuation expressions and abnormal earnings dynamics are generalizations of the Ohlson (1995) model, incorporating simple adjustments for accounting conservatism. When “core” earnings are the relevant earnings construct, valuation expressions closely resemble the aggregation case, but core (abnormal) earnings replaces clean surplus (abnormal) earnings. We demonstrate that an earnings component can be irrelevant in valuation even when it is predictable.