Earnings Metrics Research Articles

Value Relevance of Fair Value Measurement on Investment Property: Malaysian Evidence

Objective - This research investigates the disclosure practices for fair value measurement of investment property and examines the value relevance of fair value information reported by Malaysian public listed companies. Methodology/Technique - The study focuses on annual reports from 2018 of companies listed on the Main Market of Bursa Malaysia, excluding firms in the financial and unit trust sectors. The sample includes 71 companies that reported fair value gains on investment property. Findings - Findings reveal that none of the companies used Level 1 inputs, 51% used Level 2 inputs, 39% used Level 3 inputs, and 10% used a combination of Level 2 and 3 inputs. The regression analysis indicates that fair value gains are not significantly related to stock returns, suggesting that Malaysian investors do not find this information useful. However, net income before fair value gains is significantly related to share returns, highlighting the importance of traditional earnings metrics. Novelty - This study contributes to the literature by providing empirical evidence from Malaysia, revealing a gap in the perceived usefulness of fair value disclosures and underscoring the continued relevance of traditional financial metrics for investors. Type of Paper: Empirical JEL Classification: M41, M49. Keywords: Fair Value Gain, Investment Property, Value Relevance, Disclosure Reference to this paper should be referred to as follows: Shaari, H. (2024). Value Relevance of Fair Value Measurement on Investment Property: Malaysian Evidence, Acc. Fin. Review, 9(1), 42 – 53. https://doi.org/10.35609/afr.2024.9.1(2)

The joint effects of litigation risk and regulation on non‐GAAP reporting

AbstractWe examine the joint effects of litigation risk and regulation in shaping firms’ financial reporting decisions. Specifically, we investigate how these disciplining mechanisms influence firms’ disclosure of non‐GAAP earnings metrics, which have been at the forefront of the SEC's regulatory concerns in recent years. We employ a plausibly exogenous shock to litigation risk based on a US circuit court ruling to explore how litigation risk influences firms’ non‐GAAP earnings disclosures. We find a robust negative relation between litigation risk and both the likelihood and aggressiveness of non‐GAAP reporting. However, we find a significant attenuation in the sensitivity of non‐GAAP disclosure to litigation risk after the implementation of Regulation G (Reg G), despite evidence that aggressive non‐GAAP reporting persists in the post‐Reg G environment. Additional analyses indicate that this attenuation is actually the net result of two unique effects. First, we find that Reg G created a de facto “safe harbor” for non‐GAAP reporting among firms in circuits with higher litigation risk and a “curtailment effect” among firms in the circuit with the lowest litigation risk. Overall, Reg G led to a convergence in non‐GAAP reporting practices irrespective of firms’ circuit‐specific litigation risk. We posit that this net attenuation of litigation risk's influence on non‐GAAP reporting is likely an unintended consequence of Reg G.

Experience with Non-GAAP Earnings and Investors’ Pricing of Exclusions

ABSTRACT Although the increase in non-GAAP earnings metrics has drawn unfavorable attention from regulators and standard setters, it can provide valuable experience for investors. We investigate whether experience with non-GAAP earnings metrics influences investors’ pricing of non-GAAP exclusions. We measure experience as the frequency with which managers or analysts provide non-GAAP earnings over the prior eight quarters and find that experience aids in the pricing of non-GAAP exclusions. Absent prior experience with non-GAAP earnings metrics, investors appear to overestimate the persistence of exclusions at the earnings announcement, which corrects in the following months. Cross-sectional tests suggest that experience facilitates investors’ pricing of non-GAAP exclusions by reducing their information processing costs. JEL Classifications: M40.

IS THERE EARNINGS DISCONTINUITY AFTER THE IMPLEMENTATION OF IFRS IN NIGERIA?

Earnings metrics are major financial indicators which capital market participants and investors focus on for informed decisions. Because reporting earnings increase may enhance firms’ stock price, many managers are motivated to avoid reporting earnings decreases, but prefer to consistently report increase earnings greater than its previous valuation. There is evidence that such practice has led to a situation of conspicuous upward shift in frequency of observations, starting from the left of identified earnings benchmark to the right. Recent studies have shown that a change in accounting regulation may have effects on the shape of the firm-year distribution of earnings. This paper examines the discontinuity evidence for Nigeria, in relation to the adoption of the international financial reporting standard. The aim is to establish whether discontinuity in earnings, represented by the asset-scaled net profits, as well the discontinuity in earnings-change, has reduced following the adoption. According to literature, the study employs three methods – empirical histogram, standardise differences tests and the permutation tests – to validate the aims. The findings suppose evidence for increase in discontinuity, indicating increased in small profits’ earnings management, after the adoption. Contrary, the evidence is not sufficient to conclude that the discontinuity has increase for the earnings-change. It can be argued that the adoption has not achieve much in ensuring firms are monitored against earnings management to avoid losses. The study has limitation, since it considers only the distributions of earnings and earnings-changes. The distribution of forecast errors is not investigated because such is influence by forecast management. Future studies may consider this for improvement.

Adjusted versus unadjusted earnings: An empirical analysis of pro forma adjustments in large German public companies

AbstractThis article analyzes non‐GAAP, pro forma earnings metrics of large German publicly traded companies to better understand their usage and relevance in practice. We base our analysis on a hand collected data set compiled from annual reports. Almost all companies in our data set use pro forma earnings. Typically, legal, restructuring, acquisition and accounting related costs get adjusted. EBIT, EBITDA, EPS and Net income are the most frequently adjusted earnings metrics. In almost all observed cases, pro forma earnings are higher than their underlying GAAP earnings. Our study addresses the challenge of investors to understand a company's “true” operating performance. Only when one understands the historically observable financial performance, one can make better predictions of its recurring, future financial performance. The article adds to the existing literature by analyzing in which part of the annual report pro forma earnings are typically disclosed, how transparent they are presented and reconciled, and what impact adjustments have compared to the unadjusted GAAP earnings.

The Effect of Investor Inattention on non-GAAP Disclosure

We examine whether investor inattention influences managers’ non-GAAP earnings disclosures. Hirshleifer and Teoh’s (2003) theoretical model predicts that managers are more likely to disclose upwardly-biased non-GAAP metrics when investors are inattentive. Employing a measure that captures exogenous variation in institutional investor inattention, we find that managers are more likely to provide non-GAAP disclosures, particularly those where non-GAAP earnings are greater than GAAP earnings, when inattention is high. Moreover, inattention is positively associated with the magnitude of non-GAAP exclusions, which suggests managers present better non-GAAP performance to inattentive investors. Consistent with managers exploiting investors’ limited attention, we find that stock prices respond more strongly to non-GAAP exclusions when investors are inattentive and that managers are more likely to respond to inattention with income increasing non-GAAP disclosures if they sell shares following the disclosure. Taken together, these findings suggest that managers respond opportunistically to inattentive institutions by disclosing aggressive non-GAAP earnings metrics.

Board Committee Overlap and the Use of Earnings in CEO Compensation Contracts

Using proxy statement data describing the terms of compensation contracts, we examine how overlapping membership between compensation and audit committees influences the use of earnings metrics in compensation. Although research predicts that such overlap could either increase or decrease the reliance on earnings, we find that firms with overlapping directors rely less on earnings-based performance measures in incentive contracts without altering the overall level of performance-contingent cash bonuses. In addition, we provide evidence that firms substitute earnings measures with measures less subject to earnings management. Our findings are robust to potential alternative explanations, extend to an implicit relation between earnings and compensation for a larger sample, and are not driven by the tendency toward an overlapping committee structure more broadly. This paper was accepted by Suraj Srinivasan, accounting.

An Analytical Model Of Audits In Disclosure Of Pro Forma Earnings

Firms have discretion on financial reporting under Generally Accepted Accounting Principles or GAAP. The proliferation in recent years of earnings metrics that deviate from GAAP figures confounds investors' ability to compare firm financial performance. Non-GAAP (or pro forma) figures usually do not include certain balance sheet or income statement items that are required under GAAP. Regulators and accounting standard-setting body are concerned that pro forma financial measures have been used by management to mislead investors by overstating or smoothing earnings or to meet Wall Street earnings expectations. On the other hand, management asserts that by excluding certain nonrecurring and noncash items, pro forma earnings are more relevant in measuring firm performance. Indeed, prior empirical studies provide evidence that certain pro forma measures may have incremental information content over GAAP earnings. Pro forma earnings are typically unaudited and the quality of disclosures accompanying such measures varies across firms. This paper develops an analytical (mathematical) model to examine whether firms will exhibit higher credibility through auditor selection when disclosing pro forma earnings. This study extends prior empirical literature by providing an analytical perspective on the importance of attestation performed by auditors regarding pro forma earnings. The model in this study suggests that managers who possess superior information than shareholders in an asymmetric information setting and expect high future earnings are more likely to engage large auditors when disclosing pro forma earnings. As such, the model may explain the voluntary disclosure of accounting information by managers in capital markets.

Non-GAAP earnings quality in firms with data breach incident

PurposeAfter the massive data breach incident in 2017, Equifax voluntarily disclosed non-GAAP earnings that beat earnings targets by eliminating breach-related charges and used non-GAAP metrics to determine its executives' compensations. However, it is unclear whether its non-GAAP earnings exclusions and the use of non-GAAP earnings in compensation plans are justified. The purpose of this study is to examine non-GAAP earnings quality in firms with data breach incidents.Design/methodology/approachThe authors identified data breach firms from incidents reported in Privacy Rights Clearinghouse (privacyrights.org) during the period 2004–2017. The authors separate the victim firms into six groups based on financial status and non-GAAP earnings disclosure. Quarterly manager non-GAAP earnings per share data is retrieved from the database created by Bentley et al. (2018). Ordinary linear regression models are used in this study to test the authors’ hypothesis.FindingsThe authors find that, in general, the informativeness of non-GAAP earnings is higher than that of GAAP earnings in data breach firms. However, non-GAAP earnings quality vary in data breach firms with different financial health status. The quality of non-GAAP earnings in loss firms with data breach is higher than those in profit firms. Loss converters (i.e. data breach firms with negative GAAP earnings but positive non-GAAP earnings) disclose low quality non-GAAP earnings, which is different from the findings in prior studies.Practical implicationsThe findings are particularly useful to analysts who want to make accurate earnings forecasts of data breach firms by incorporating managers' non-GAAP earnings disclosures.Originality/valueThe authors are among the first to comprehensively analyze the quality of non-GAAP earnings in firms with data breaches. The findings in this study address the analysts' concern that data breach firms use non-GAAP earnings metrics to determine executives' compensation after the massive data breach incidents. Next, the authors provide evidence that the financial status of data breach firms affects the quality of non-GAAP earnings.

Non‐GAAP Earnings: A Consistency and Comparability Crisis?*

ABSTRACTWe use a novel data set to examine the across‐time consistency and across‐firm comparability of firms' non‐GAAP earnings disclosures. Given widespread concern about non‐GAAP reporting among regulators, standard setters, the investor community, and academics, our investigation provides timely evidence on how managers' deviations from their own non‐GAAP disclosure history, or the reporting of industry peers, affects how well earnings inform on firm performance. We begin by identifying firms that change their non‐GAAP earnings definition from one year to the next. These deviations are uncommon, but when managers change the items they exclude in calculating non‐GAAP earnings, the changes generally enhance the information in earnings about firms' core performance. We also examine whether non‐GAAP earnings are more comparable than GAAP earnings and find that firms' non‐GAAP adjustments result in greater earnings comparability. Finally, we examine instances in which firms deviate from common sector‐wide definitions of non‐GAAP earnings. We find that these deviations also result in earnings metrics that better represent firms' core operations. Overall, our results suggest that when managers vary their non‐GAAP calculations, either across time or across firms, the resulting non‐GAAP metrics generally enhance the information in earnings about firms' ongoing performance. Thus, our analysis helps mitigate concerns about why managers might vary their non‐GAAP reporting calculations.

Qualitative characteristics of non-GAAP disclosures and non-GAAP earnings quality

We examine how the qualitative characteristics of a non-GAAP earnings disclosure reveal the quality of the non-GAAP performance metric itself. We measure the qualitative aspects of the non-GAAP disclosure using an index of 12 hand-coded characteristics and presentation choices that provide context to non-GAAP disclosures. We find that more transparent qualitative information in non-GAAP disclosures is associated with more transitory non-GAAP exclusions and a lower likelihood that managers will aggressively exclude expenses in calculating non-GAAP earnings to meet or beat analysts’ forecasts. We also find that the association between non-GAAP exclusions and earnings announcement period returns is less negative for firms with more transparent qualitative information accompanying their non-GAAP disclosures. Overall, these results suggest that qualitative characteristics of non-GAAP disclosures convey useful information about the quality of non-GAAP earnings metrics.

Street versus GAAP: Which Effective Tax Rate Is More Informative?*

ABSTRACTThis study investigates how sophisticated market participants use tax‐based information by examining whether analysts' street effective tax rates (ETRs) are informative. When assessing firm performance, analysts exclude items they believe do not reflect current performance, resulting in “street” metrics such as street ETR. However, evidence on the properties of the components of street earnings is limited. Examining the informativeness of street ETRs is important because taxes are a significant component of earnings, and the extent to which analysts understand taxes and incorporate them into their analyses is not clear. Using a hand‐collected sample of analyst reports, we find that while approximately 35% of street ETRs have at least one tax‐specific exclusion, over 90% reflect the tax effects of pre‐tax exclusions. Further, both tax‐specific exclusions and the tax effects of pre‐tax exclusions significantly contribute to differences between GAAP and street ETRs. Consistent with analysts' understanding of the implications of tax and nontax exclusions, our results suggest that street tax metrics exhibit greater predictive ability about future tax outcomes and provide more information to investors than GAAP tax metrics. We also find that ETR exclusions are of higher quality when the magnitude of the potentially excluded item is greater and when managers disclose pro forma earnings. Collectively, our findings suggest that analysts understand taxes, but selectively exert effort to incorporate tax‐based information into their assessment of firm performance. Our study should be informative to regulators and users of financial information because it provides evidence regarding the usefulness of street earnings metrics.

Does the use of non‐GAAP earnings in compensation contracts lead to excessive CEO compensation? Efficient contracting versus managerial power

AbstractWe examine whether the recent trend of firms’ using non‐GAAP earnings metrics in compensation contracts is consistent with the efficient contracting hypothesis or the managerial power hypothesis. We extract non‐GAAP performance metrics from compensation contracts in proxy statements of S&P 500 firms from 2006 to 2013. We find that the adoption of non‐GAAP earnings in CEOs’ compensation contracts is positively associated with CEOs’ cash compensation. However, the increase in CEOs’ compensation is primarily evident among firms with superior CEO talent. In addition, we find that the cash pay‐performance sensitivity (PPS) increases after the adoption of non‐GAAP performance measures, suggesting that boards use non‐GAAP performance measures to enhance CEOs’ performance‐improving incentives, rather than granting excessive compensation. Overall, our evidence suggests that, on average, the use of non‐GAAP performance metrics in executive compensation contracts reflects boards’ efforts to retain talented CEOs and mitigate agency problems, which is consistent with the efficient contracting hypothesis.

The effect of analysts’ GAAP earnings forecasts on managers’ classification shifting

Prior research on classification shifting finds that managers opportunistically shift core operating expenses down the income statement into the non-recurring expenses category to improve earnings metrics that are not based on Generally Accepted Accounting Principles (GAAP) without changing the GAAP net income. By using a difference-in-differences design based on the availability of analysts’ GAAP earnings forecasts following the enactment of the Sarbanes-Oxley Act (SOX), we find that the introduction of analysts’ GAAP forecasts significantly attenuates the positive association between unexpected core earnings and non-GAAP exclusions for firms with GAAP forecasts. This association strengthens for control firms for which analysts do not issue GAAP forecasts. Our results indicate that classification shifting, which commonly results in a simultaneous inflation of core earnings and non-GAAP exclusions, has been effectively mitigated consequent to the transparency on forecasted non-GAAP exclusions brought about by the growth of analysts’ GAAP forecasts. Our study contributes to the literature by identifying a new mechanism for effectively constraining classification shifting after SOX. Moreover, our findings have important implications for standard setters and regulators advocating for greater transparency in financial information, and emphasize the value of the analyst as an effective information intermediary to capital markets.

Compensation and Taxes: Evidence from Relative Performance Evaluation

ABSTRACT Relative performance evaluation (RPE) is a common practice in compensation contracting, essentially conditioning management compensation on the achievement of certain performance goals relative to a benchmark. In this paper, we examine the incentive effects of RPE usage on tax outcomes. We predict and find that low-tax peers in RPE contracts influence focal firm tax outcomes. Specifically, we find that a greater proportion of low-tax RPE peers embedded in RPE compensation contracts is associated with lower book and cash effective tax rates, and we find evidence that this effect is not confined to RPE peers within the same industry. Moreover, we also find that the tax outcomes incentivized through low-tax RPE peers occur through RPE grants conditional on achieving after-tax earnings metrics. Overall, our results reveal that RPE provides a meaningful influence on corporate tax outcomes. Data Availability: All data used in this study were obtained from publicly available sources.

The value of using early-career earnings data in the College Scorecard to guide college choices

Policymakers are increasingly including early-career earnings data in consumer-facing college search tools to help students and families make more informed postsecondary education decisions. We offer new evidence on the degree to which existing college-specific earnings data equip consumers with useful information by documenting the level of selection bias in the earnings metrics reported in the U.S. Department of Education's College Scorecard. Given growing interest in reporting earnings by college and major, we focus on the degree to which earnings differences across four-year colleges and universities can be explained by differences in major composition across institutions. We estimate that more than 70% of the variation in median earnings across institutions is explained by observable factors, and accounting for differences in major composition explains 20–30% of the variation in earnings over and above institutional selectivity and student composition. We also identify large variations in the distribution of earnings within colleges; as a result, comparisons of early-career earnings can be extremely sensitive to whether the median, 25th, or 75th percentiles are presented. Taken together, our findings indicate that consumers can easily draw misleading conclusions about institutional quality when using publicly available earnings data to compare institutions.

Board committee overlap and the use of earnings in CEO compensation contracts

Using proxy statement data describing the terms of compensation contracts, we examine how overlapping membership between compensation and audit committees influences the use of earnings metrics in compensation. While research predicts that such overlap could either increase or decrease the reliance on earnings, we find that firms with overlapping directors rely less on earnings-based performance measures in incentive contracts without altering the overall level of performance-contingent cash bonuses. In addition, we provide evidence that firms substitute earnings measures with measures less subject to earnings management. Our findings are robust to potential alternative explanations, extend to an implicit relation between earnings and compensation for a larger sample, and are not driven by the tendency towards an overlapping committee structure more broadly.

Street vs. GAAP: Which Effective Tax Rate Is More Informative?

This study investigates how sophisticated market participants use tax-based information by examining whether analysts’ street effective tax rates (ETRs) are informative. When assessing firm performance, analysts exclude items they believe do not reflect current performance, resulting in “street” metrics such as street ETR. However, evidence on the properties of the components of street earnings is limited. Examining the informativeness of street ETRs is important because taxes are a significant component of earnings, and the extent to which analysts understand and incorporate taxes into their analyses is not clear. Using a hand-collected sample of analyst reports, we find that while approximately 35 percent of street ETRs have at least one tax-specific exclusion, over 90 percent reflect the tax effects of pre-tax exclusions. Further, both tax-specific exclusions and the tax effects of pre-tax exclusions significantly contribute to differences between GAAP and street ETRs. Consistent with analysts understanding the implications of tax and non-tax exclusions, our results suggest that street tax metrics exhibit greater predictive ability about future tax outcomes and provide more information to investors than GAAP tax metrics. We also find that ETR exclusions are of higher quality when the magnitude of the potentially excluded item is greater and when managers disclose pro forma earnings. Collectively, our findings suggest that analysts understand taxes, but selectively exert effort to incorporate tax-based information into their assessment of firm performance. Our study should be informative to regulators and users of financial information because it provides evidence regarding the usefulness of street earnings metrics.

The Value of Using Early-Career Earnings Data in the College Scorecard to Guide College Choices

Policymakers are increasingly including early-career earnings data in consumer-facing college search tools to help students and families make more informed postsecondary education decisions. We offer new evidence on the degree to which existing college-specific earnings data equips consumers with useful information by documenting the level of selection bias in the earnings metrics reported in the U.S. Department of Education’s College Scorecard. Given growing interest in reporting earnings by college and major, we focus on the degree to which earnings differences across four-year colleges and universities can be explained by differences in major composition across institutions. We estimate that more than three-quarters of the variation in median earnings across institutions is explained by observable factors, and accounting for differences in major composition explains over 30 percent of the residual variation in earnings after controlling for institutional selectivity, student composition, and local cost of living differences. We also identify large variations in the distribution of earnings within colleges; as a result, comparisons of early-career earnings can be extremely sensitive to whether the median, 25th or 75th percentiles are presented. Taken together, our findings indicate that consumers can easily draw misleading conclusions about institutional quality when using publicly available earnings data to compare institutions.

Pro Forma Disclosure and Investor Sophistication: External Validation of Experimental Evidence Using Archival Data

Insights on how ordinary, less-sophisticated investors interpret and process management-issued pro forma earnings numbers are useful to regulators because of concerns that pro forma disclosures are misleading to ordinary investors. Two recent experimental studies (Frederickson and Miller, 2004 and Elliott, 2006) find that the existence of a pro forma number in the earnings press release as well as the relative placement of the pro forma and GAAP earnings figures within the press release affect the judgments of less-sophisticated investors but not those of more-sophisticated investors. Experimental and archival methodologies complement one another and results that persist in both settings are likely to be robust to both internal and external validity concerns. Therefore, we complement experimental evidence using trade-size-based proxies constructed from intraday transactions data to distinguish the trading activities of less-sophisticated investors from more-sophisticated investors. Our results suggest that less-sophisticated investors rely significantly more on quarterly earnings press releases that include a pro forma number than on those that do not, while more-sophisticated investors exhibit the opposite behavior. This result is consistent with Frederickson and Miller's experimental evidence. Further, consistent with Elliott's results, we find that less-sophisticated investors rely more on the pro forma figure when it is placed before the GAAP earnings number in the press release, while more-sophisticated investors' trading behavior is unaffected by the relative placement of the two earnings metrics. We conclude that the existence of a pro forma number as well as its strategic placement in the press release generally affect the judgments of less-sophisticated (but not more-sophisticated) investors and these inferences are robust because they persist in both experimental and archival settings.