Measures that aren’t part of statutory earnings reports – such as the frequently used ‘underlying profit’ – are better indicators for investors of the future performance and value of a company, new research has found.
The research, presented at the International Accounting Standards Board (IASB) annual research forum in Sydney, compares “non-standard” financial information from ASX 500 companies with statutory reporting measures from the same firms over more than a decade.
“The results have turned out to be quite striking,” the lead researcher, Professor of Accounting Stephen Taylor of UTS Business School, says. “They have significantly higher predictive ability for future profitability, for example.”
The findings help inform the current debate about which financial measures should be reported.
Non-standard – or non-GAAP (Generally Accepted Accounting Principles) measures – are used by companies in media releases and other communications to augment the measures they are required to report under accounting standards.
However, these non-standard measures are sometimes eyed with suspicion because they are considered open to manipulation.
On the other hand, the GAAP measures, which companies are legally obliged to produce as part of audited figures for the investment market and regulators, have been criticised because they take a “conservative” or cautious approach to reporting financial information.
“There has been a significant increase in the frequency of Australian firms prominently reporting non-GAAP earnings measures,” says Professor Taylor, who is also a member of the Australian Accounting Standards Board (AASB). “But we didn’t know whether this increase is because the information is helpful to investors or self-serving, or both.”
The research aims to answer this question by comparing for the first time several different properties of non-GAAP earnings measures with their closest accounting standard equivalent.
This involved comparing the statutory information reported by the firms and the non-statutory information provided in their news releases from 2000 to 2014. “It is like running a horse race between two horses, but over many different tracks,” says Professor Taylor.
The results suggest firms choose to report non-standard financial information because of demand from investors for measures of financial performance that are more predictable and that are more closely tied to a firms’ share price.
As well as being a better predictor of future performance and value, the research revealed non-GAAP measures were also smoother and less volatile.
Professor Taylor notes that earnings reports fulfil two functions: providing information to facilitate the “stewardship” of a business by its management, and providing information to inform the decisions of investors.
“Where the statutory measure wins the race is when it comes to getting bad information into earnings in a timely fashion,” Professor Taylor says. “This reflects the ‘stewardship’ or control role of financial reporting.”
Where the non-GAAP measures come out in front is on the investment side.
The IASB is currently reviewing frameworks and standards for the reporting of financial performance.
“Our research is relevant to the debate about whether firms should be encouraged or even required to include non-GAAP financial information in reporting requirements, and/or break the statutory earnings number into more line items,” Professor Taylor says.
“The results suggest a single earnings figure can’t fulfil the role of both stewardship and relevance to investors in relation to valuation and future performance.”
The paper, Non-GAAP Earnings and the Earnings Quality Trade-off, co-authored by Professor Taylor, Dr Andrea Ribeiro and Associate Professor Yaowen Shan, will be published in the journal Abacus in early 2019.
The research was funded through an Australian Research Council grant and the former Centre for International Finance and Regulation (CIFR).