Earnings Metrics Research Articles

EBITDA, EBITA, or EBIT?

Over the last thirty years there has been a strong positive trend in the magnitude of amortization charges, due to both economic and accounting changes. This trend has accelerated over the last decade, following the implementation of a revised accounting standard for business combinations. Concurrent with the recent trend, managers and external users of financial statements increasingly discuss operating performance focusing on earnings metrics that exclude amortization but include depreciation. This study compares earnings before interest, taxes and amortization (EBITA) with its two more common alternatives—EBIT and EBITDA. Consistent with the amortization trend, EBITA’s advantage over EBIT in explaining market values has gradually increased over time. However, throughout the sample period, EBITDA performed substantially better than both EBITA and EBIT. In terms of predicting stock returns, the three operating income measures performed well in the 1990s and 2000s, but not over the last decade.

Litigation Risk and Non-GAAP Reporting

The SEC has recently raised renewed concerns about firms’ reporting of adjusted (non-GAAP) earnings metrics. Regulators have significant interest in understanding the factors that help constrain non-GAAP reporting. We first provide evidence on the relation between securities litigation risk and firms’ propensity to report non-GAAP earnings. We then provide evidence on how this relation is moderated by the regulation of non-GAAP disclosure under Reg G. Using a plausibly exogenous litigation shock based on a U.S. circuit court ruling, we find a robust negative relation between litigation risk and non-GAAP reporting prior to the passage of Reg G. This negative relation suggests that, in the absence of rules-based regulation of non-GAAP reporting, litigation risk helps to constrain non-GAAP disclosure. However, our evidence suggests that the subsequent regulation of non-GAAP disclosure has decreased the sensitivity of non-GAAP disclosure to litigation risk. Specifically, we find that differences in non-GAAP reporting across judicial circuits are diminished and the negative association between litigation risk and non-GAAP reporting is significantly attenuated following the implementation of Reg G. Our results are consistent with claims that Reg G has had the unintended consequence of shielding firms’ non-GAAP disclosures from litigation risk by creating a de facto “safe harbor” for non-GAAP disclosure. Finally, we use our quasi-natural-experimental setting to validate a new proxy for circuit-specific litigation risk that future researchers can employ in any setting.

Evolution of financial reporting of life insurers

PurposeThis paper aims to examine the capital market effects and predominance of unregulated embedded value (EV) financial reporting in the life insurance industry in foreign domestic markets, and US markets for foreign firms that cross-list in the USA.Design/methodology/approachRecent empirical archival data are analyzed and evaluated to determine the incremental and relative value relevance of an unregulated valuation metric that is disclosed by life insurers.FindingsThe findings support the proposition that EV is valuable supplemental information in foreign domestic markets, and in US markets for foreign life insurers that cross-list in the USA. Given that International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) are engaged in projects to improve accounting standard for insurance companies, and have faced criticism with the existing drafts on this issue, the two institutions ought to consider the valuation relevance of EV disclosures. Moreover, this analysis strongly suggests that financial analysts in the USA should consider EV in valuing life insurers’ stocks.Practical implicationsThe findings discussed in this paper are of special interest to financial reporting policy makers, financial analysts, firm compensation committees and managers, and academics.Originality/valueThis paper contributes to the extant literature by providing recent evidence that suggests that EV, an unregulated fair value market-driven metric, is more value-relevant than traditional earnings metrics such as earnings and book value. It is the only study that we are cognizant of that critically examines the recent empirical literature on this evolving issue.

Earnings Metrics and Investorss Motivated Reasoning

Earnings Metrics and Investorss Motivated Reasoning

Do Non-GAAP Earnings Adjustments Deliver Comparability Benefits?

This paper examines the comparability of non-GAAP earnings. Recent work on earnings comparability focuses on GAAP earnings despite non-GAAP earnings being widely used by both firms and financial statement users. Using the De Franco et al. (2011) method, we quantify the comparability of a suite of GAAP and non-GAAP earnings metrics. The findings indicate that street earnings are significantly more comparable than GAAP earnings, supporting the benefit of non-GAAP adjustments by analysts. Moreover, the superior comparability of street earnings is likely attributed to the removal of material nonrecurring items and recurring items with considerable measurement errors. In the supplementary analysis, we find that street earnings bring greater comparability improvement for firms that are larger, followed by more analysts, and have more volatile returns.

Has the Regulation of Non-GAAP Disclosures Influenced Managers’ Use of Aggressive Earnings Exclusions?

The frequency of non-GAAP (or “pro forma”) reporting has continued to increase in the United States over the last decade, despite preliminary evidence that regulatory intervention led to a decline in non-GAAP disclosures. In particular, the Sarbanes–Oxley Act of 2002 (SOX) and Regulation G (2003) impose strict requirements related to the reporting of non-GAAP numbers. More recently, the Securities and Exchange Commission (SEC) has renewed its emphasis on non-GAAP reporting and declared it a “fraud risk factor.” Given the SEC’s renewed emphasis on non-GAAP disclosures, we explore the extent to which regulation has curbed potentially misleading disclosures by investigating two measures of aggressive non-GAAP reporting. Consistent with the intent of Congress and the SEC, we find some evidence that managers report adjusted earnings metrics more cautiously in the post-SOX regulatory environment. Specifically, the results suggest that firms reporting non-GAAP earnings in the post-SOX period are less likely to (a) exclude recurring items incremental to those excluded by analysts and (b) use non-GAAP exclusions to meet strategic earnings targets on a non-GAAP basis that they miss based on Institutional Brokers’ Estimate System (I/B/E/S) actual earnings. However, we also find that some firms exclude specific recurring items aggressively. Overall, the results suggest that while regulation has generally reduced aggressive non-GAAP reporting, some firms continue to disclose non-GAAP earnings numbers that could be misleading in the post-SOX regulatory environment.

How do CEO incentives affect corporate tax planning and financial reporting of income taxes?

We examine how different accounting metrics used to evaluate CEO performance for annual bonuses affect the level of corporate tax planning as well as financial reporting for income taxes. We predict and find that firms using cash flow metrics report lower GAAP and cash effective tax rates (ETR) than firms using earnings metrics. We also find that firms using after-tax earnings metrics report lower GAAP ETRs but similar cash ETRs as firms using pre-tax earnings metrics. Further analyses show that firms using after-tax earnings metrics are more likely to designate foreign earnings as permanently reinvested and have lower discretionary reserves for tax uncertainty. Hence, it appears that both types of firms engage in similar levels of tax planning, but firms evaluating CEOs with after tax-earnings metrics incentivize different financial reporting choices.

Earnings Metrics, Information Processing, and Price Efficiency in Laboratory Markets

ABSTRACTAn enduring issue in financial reporting is whether and how salient summary measures of firm performance (“earnings metrics”) affect market price efficiency. In laboratory markets, we test the effects of salient earnings metrics, which vary in how they combine persistent and transitory elements, on investor information search, beliefs about value, offers to trade, and market price efficiency. We find that including transitory elements in salient earnings metrics causes traders to search unnecessarily for further information about these elements and to overestimate their effect on fundamental value relative to a rational benchmark. In contrast, separately displaying persistent elements in earnings increases the accuracy of traders’ value estimates. Prices generally reflect traders’ beliefs about value, and prices are most efficient when transitory elements are excluded from earnings metrics entirely. Our study contributes to research on salience effects in financial reporting by showing that including transitory elements in salient earnings metrics causes inefficient information search and biased beliefs about value that can aggregate to affect market prices. We also contribute to research in experimental markets by showing that redundant disclosure is not always beneficial; redundant disclosure of transitory earnings elements, in particular, appears to have negative consequences for investor behavior and market efficiency.

The Great Unknown: Why Exclude Otherr Items from Non-GAAP Earnings Calculations in the Post-Reg G World?

The underlying motives for non-GAAP earnings disclosures have garnered a great deal of research in the extant literature, which is important given that non-GAAP reporting is at an all-time high. In examining these motives, the non-GAAP literature groups managers’ and analysts’ earnings adjustments into two categories: (1) special item exclusions and (2) other item exclusions. Special item exclusions relate to one-time items and non-GAAP studies find that excluding these items from non-GAAP earnings calculations is largely informative. In contrast, other item exclusions frequently relate to recurring earnings components (e.g., amortization expense), are currently the most common form of non-GAAP adjustment (78% of non-GAAP firms exclude other items), and early studies find that excluding these items is generally opportunistic. More recent studies provide evidence suggesting that SEC regulations have lessened the opportunism in other exclusions, but do not provide insight into which incentives currently motivate these common adjustments, which is the purpose of my study. I find that excluding other items in the current reporting environment is largely informative because these exclusions relate to non-cash items that are heavily discounted by investors when pricing firm performance. In addition, excluding other items creates earnings metrics that are comparable to analysts’ ex ante earnings forecasts, which provides investors with comparable ex ante and ex post assessments of performance. Thus, although I find some evidence that opportunism can still motivate other item exclusions in certain scenarios, the primary motives for these adjustments in the current reporting environment appear to be informative in nature.

The Impact of IFRS Adoption in Romania upon the Earnings Management of the Bucharest Stock Exchange Entities

The adoption of IFRS in Romania affects the performance of the companies which are going to apply them for the first time. While the listed companies have mandatory adopted the International Financial Reporting Standards (IFRS) for consolidated financial statements, the individual financial statements are compulsory to be reported under IFRS only from 2012. A comparison between Romanian Accounting Standards (RAS) and IFRS, in terms of earnings management metrics, was realized upon the entities that are listed on the Bucharest Stock of Exchange (BSE). Significant improvements were observed in the year of adoption when variability of earning management regarding the variability of net income, the variability of cash flows, the correlation between accruals and cash flow and the value toward positive earnings metrics were analyzed.

You Get What You Pay For: How Earnings and Cash Flow Performance Metrics Differentially Affect CEO Behavior

We examine how different accounting metrics used to evaluate CEO performance for annual bonuses affect the level of corporate tax planning as well as financial reporting for income taxes. We predict and find that firms using cash flow metrics report lower GAAP and cash effective tax rates (ETR) than firms using earnings metrics. We also find that firms using after-tax earnings metrics report lower GAAP ETRs but similar cash ETRs as firms using pre-tax earnings metrics. Further analyses show that firms using after-tax earnings metrics are more likely to designate foreign earnings as permanently reinvested and have lower discretionary reserves for tax uncertainty. Hence, it appears that both types of firms engage in similar levels of tax planning, but firms evaluating CEOs with after tax-earnings metrics incentivize different financial reporting choices.

Extracting Sustainable Earnings from Profit Margins

Revenues and expenses are fundamentally proportional to one another, but are likely to be disproportionally affected by transitory items or economic shocks. We build on this observation and propose a new measure of sustainable earnings based on deviations from normal profit margins. While some other sustainable earnings metrics attempt to identify transitory components on a line-by-line basis, our measure, referred to as the intensity of core earnings (ICE), uses ratio analysis to extract the transitory portion of earnings from all line items. We find that the ICE, as measured here, is positively associated with earnings persistence, better earnings predictability, and stronger market reaction to unexpected earnings. We also find that our measure is positively associated with post-earnings announcement excess stock returns. Comparing our measure with an accrual-based measure of earnings quality, we find that, in general, the two metrics provide distinct incremental information relative to one another and in some instances our measure is better than an accrual-based measure in assessing earnings quality.

Has the Regulation of Pro Forma Reporting in the US Changed Investors’ Perceptions of Pro Forma Earnings Disclosures?

Abstract: We explore whether investors’ perceptions of pro forma earnings numbers have changed following the regulation of pro forma reporting imposed by the Sarbanes‐Oxley Act of 2002 (SOX). First, we find that investors appear to pay more attention to pro forma earnings disclosures in the post‐SOX period, consistent with the notion that they perceive that regulation generally renders these disclosures more credible. Second, the results indicate that investors discount aggressive pro forma earnings reports in both periods. However, they appear to discount at least some potentially misleading pro forma earnings disclosures more in the post‐SOX period. Finally, our results imply that the regulation of pro forma reporting has increased the average quality of pro forma earnings disclosures by filtering out those that are most likely to be misleading. These results are consistent with the conclusions that (1) the quality of pro forma reporting has improved following SOX, and (2) investors’ perceptions of pro forma earnings metrics have changed in the post‐SOX regulatory environment.

Earnings Metrics, Motivated Reasoning and Market Efficiency

An enduring issue in financial reporting is whether and how salient summary measures of firm performance (“earnings metrics”) affect market price efficiency. In laboratory markets, we test the effects of salient earnings metrics, which vary in how they combine persistent and transitory elements, on investor information search, beliefs about value, offers to trade, and market price efficiency. We find that including transitory elements in salient earnings metrics causes traders to search unnecessarily for further information about these elements and to overestimate their effect on fundamental value relative to a rational benchmark. In contrast, separately displaying persistent elements in earnings increases the accuracy of traders’ value estimates. Prices generally reflect traders’ beliefs about value, and prices are most efficient when transitory elements are excluded from earnings metrics entirely. Our study contributes to research on salience effects in financial reporting by showing that including transitory elements in salient earnings metrics causes inefficient information search and biased beliefs about value that can aggregate to affect market prices. We also contribute to research in experimental markets by showing that redundant disclosure is not always beneficial; redundant disclosure of transitory earnings elements, in particular, appears to have negative consequences for investor behavior and market efficiency.

Investor Sentiment and Pro Forma Earnings Disclosures

ABSTRACTWe examine the influence of investor sentiment on managers’ discretionary disclosure of “pro forma” (adjusted) earnings metrics in earnings press releases. We find that managers’ propensity to disclose an adjusted earnings metric (especially one that exceeds the GAAP earnings number) increases with the level of investor sentiment. Furthermore, our analyses suggest that, as investor sentiment increases, managers: (1) exclude higher levels of both recurring and nonrecurring expenses in calculating the pro forma earnings number and (2) emphasize the pro forma figure by placing it more prominently within the earnings press release. Additional analyses indicate that the association between investor sentiment and managers’ pro forma disclosure decisions at least partly reflects opportunistic motives. Finally, we find that managers’ own sentiment‐driven expectations also play a role in their pro forma disclosure decisions.

Has the Regulation of Pro Forma Reporting in the U.S. Changed Investors’ Perceptions of Pro Forma Earnings Disclosures?

We explore whether investors’ perceptions of pro forma earnings numbers have changed following the regulation of pro forma reporting imposed by the Sarbanes-Oxley Act of 2002 (SOX). First, we find that investors appear to pay more attention to pro forma earnings disclosures in the post-SOX period, consistent with the notion that they perceive that regulation generally renders these disclosures more credible. Second, the results indicate that investors discount aggressive pro forma earnings reports in both periods. However, they appear to discount at least some potentially misleading pro forma earnings disclosures more in the post-SOX period. Finally, our results imply that the regulation of pro forma reporting has increased the average quality of pro forma earnings disclosures by filtering out those that are most likely to be misleading. These results are consistent with the conclusions that (1) the quality of pro forma reporting has improved following SOX, and (2) investors’ perceptions of pro forma earnings metrics have changed in the post-SOX regulatory environment.

The value relevance of a non‐GAAP performance metric to the capital markets

PurposeThe study is driven by concerns raised by standard setters and others about the usefulness of performance reporting under generally accepted accounting principles (GAAP). Of primary interest is whether explicitly defining what information should be included in earnings results in an earnings measure that is more relevant than operating earnings computed according to current GAAP. The purpose of this paper is to explore whether reducing management discretion in the reporting of performance adds to the value relevance of the performance measures reported to capital markets.Design/methodology/approachThe value relevance of this non‐GAAP earnings measure is examined by estimating market valuation and returns models for 518 US firms included in the Standard & Poor's 500 Index over the time period 2002‐2007.FindingsResults show that the explicitly defined non‐GAAP measure used is significantly associated with equity market values and returns and is significantly more value‐relevant than the GAAP measure.Originality/valueThe paper contributes to accounting literature assessing the relevance of earnings in setting equity market value. More specifically, it provides evidence consistent with prior results that non‐GAAP performance measures are more useful in valuation than GAAP earnings. However, in contrast with prior studies, the more explicit performance measure the paper examines removes some of the classificatory discretion pervasive in other non‐GAAP earnings metrics.

Press Release Disclosure of ‘Pro Forma’ Earnings Metrics by Large German Corporations – Empirical Evidence and Regulatory Recommendations

This paper is set against the background of recent regulatory action and standard-setting activities pertaining to the disclosure of so-called ‘pro forma’ earnings. For a sample of large corporations listed on the Frankfurt stock exchange, I individually analyze quarterly earnings announcements published for the fiscal years 2005 and 2006. Given voiced concern about the potential of pro forma metrics to misrepresent firm performance and thus to potentially mislead investors, research questions pertain to the use, the calculation and the presentation of pro forma earnings, and the impact of recent recommendations issued by European securities commissions. The results indicate that firms make extensive use of so-called ‘EB’ (earnings before) metrics and, more importantly, of pure non-GAAP performance measures, both in terms of frequency and reporting emphasis. The transparency of adjustments to GAAP earnings turns out to be low. Year-to-year analysis suggests that recent recommendations by European securities regulators have had no discernible impact on these disclosure patterns. Taken together, this evidence suggests that regulatory concern may be warranted. At the same time, it points out the need for more research into the determinants and the investor reception of pro forma earnings disclosures in EU jurisdictions.

The effect of governance transparency on earnings response coefficient: evidence from emerging markets

This study examines whether the earnings response coefficient (ERC) is conditional on the transparency of corporate governance (CG) in emerging markets. Using 81 of the top 100 Chinese firms that are listed either in mainland China or in Hong Kong, we find that the level of governance transparency positively interacts with ERC. This finding is generally robust to controls for various firm specifications (size, assets growth, leverage, E/P ratio) and institutional factors (listing place, issuing status, and economic sector). The predicted model is tenable even if we change earnings metrics and window settings. Our refined analysis using five subcategories of governance scores indicates that the interaction of governance transparency on ERC is mostly contributed by information disclosure on shareholders and related parties, two types of governance information that concern investors. The alternative test using governance structural variables further shows that the relation of ERC is not significantly conditional on the CG structure.

The Relative Informativeness of GAAP and Pro Forma Earnings Announcements in France

This study examines the main problem raised by pro forma earnings (or “street” earnings) because investors may have trouble focusing their attention when they are relying on this information to make decisions about investing in French publicly traded securities. This article, based on 116 pro forma earning announcements over the period 1996-2006, aims first at examining why French traded corporations use pro forma reporting in their annual press releases to announce earnings. Interestingly, I find that managers do use pro forma earning measures strategically to report better corporate performance than those based on GAAP earnings metrics. In 79% of the cases I identified, pro forma numbers are higher than GAAP ones, suggesting that managers have significant motives to report a higher profit than the GAAP-based one and the one forecasted by analysts would be. Furthermore, about 82% of pro forma announcements should have disclosed bad news that would have been revealed by releasing GAAP earnings. Finally, I show that those pro forma numbers are much more informative than GAAP earnings.