Quality of earnings
Application of GAAP
How can GAAP help to sustain a bubble?
Earnings management checklist
Problems with Companies’ Application
of GAAP – Levitt Speech (1998)
Big Bath charges
In-Process R&D (IPRND) charges
“Cookie Jar” reserves
Increased disclosure of restructuring charges
(beginning/ending balances and activity)
Increased scrutiny of IPRND
Qualitative as well as quantitative description
New guidance on revenue recognition
Strengthening audits, auditors, and audit
More than EBITDA
Generally, excluding transitory items
(restructuring expenses, etc)
Analysts are increasingly projecting proforma
(“operating” or “core”) earnings and these are
reported in First Call, I/B/E/S and Zachs
“Bad terminology is the enemy of good thinking. When
companies or investment professionals use terms such as
„EBITDA‟ and „pro forma,‟ they want you to unthinkingly
accept concepts that are dangerously flawed. (In golf, my
score is frequently below par on a pro forma basis: I have
firm plans to „restructure‟ my putting stroke and therefore
only count the swings I take before reaching the green.)”—
Berkshire Hathaway annual report
What companies are trying to do is entice analysts into excluding certain charges
and value them only on that basis…Companies are creating their own grading
systems to help ensure that, no matter how their business is doing, they will get
an A or an A+.” WSJ 8/24/99
Examples of things left out in proforma earnings:
1. Restructuring charges
2. Write-downs and impairments
3. R&D expenditures
4. Merger and acquisition costs
5. Goodwill amortization
Bradshaw and Sloan, 2001
Stock prices are becoming more highly correlated
with proforma earnings than with GAAP earnings
There is a growing disparity between proforma
and GAAP earnings
Doyle, Lundholm and Soliman (2003)
Higher levels of exclusions lead to predictably lower future cash flows.
We also find that investors do not fully appreciate the lower cash flow
implications at the time of the earnings announcement. A trading
strategy based on the excluded expenses yields a large positive
abnormal return in the years following the announcement, and
persists after controlling for various risk factors and other anomalies.
Bhattacharya, et. al. (2004)
Our intraday investigation of transactions around pro forma earnings
announcements reveals that small investors’ announcement-period
abnormal trading volume is significantly positively associated with the
earnings surprise based on pro forma earnings. In contrast, we find
that large, sophisticated investors either do not trade on pro forma
information or they take the position opposite to that of small
investors (i.e., while small investors predominantly buy following a
favorable pro forma announcement, large investors generally sell).
Collectively, our results indicate that the segment of the market that
relies on pro forma earnings information is populated predominantly
by small investors.
Watch out for Proforma
Company focus on EBITDA
May help to sustain aggressive borrowing
May hide capitalization issues
• Promotes excess substitution of capital for labor
(can lead to excess capacity)
• Promotes capitalization of costs that should be
Watch for excesses in any area the company
wants to exclude in proforma earnings.
How does GAAP Help to
Sustain a Bubble? Inclusion of
Accounting for passive investments - recognize gains by selling AFS securities
when needed and relegate unrealized losses to OCI
Accounting for sale of put options - Sale proceeds are tax free cash flow, not
income. “Losses” occur when the stock declines, but the share purchase is reported
like a normal share purchase, with no loss reported in I/S
Accounting for convertible securities - if conversion option is not valued
separately, it is not accounted for. Conversion is recorded at book value. The “cost”
is not reflected in earnings, only diluted EPS via share increase.
Accounting for subsidiary IPOs – Gains can be recognized on increases in equity
investment account following sub IPO.
Accounting for Pensions - Net pension obligations reduce when market increases.
Also, pension investment increases affect profit via reduction of pension expense.
Accounting for business combinations - recorded at market value. Non-
amortization of goodwill may encourage overpayment. But, subsequent goodwill
write-offs can reflect either overvalued target company or overvalued parent.
Hard to distinguish between the two.
How does GAAP Help to
Sustain a Bubble (part 2)?
Keeping assets off the balance sheet
results in higher book rates of return
Pooling of interest accounting for acquisitions
Equity method investments
Tale of a 1990s Firm
Lessons from the 1990s
GAAP was assailed in the 1990s bubble for not
recognizing the value of knowledge assets.
Some desired to impute knowledge assets by the
difference between market capitalization and equity book
Some thought that GAAP earnings should be replaced with
“value reporting” (remember clicks and page views?)
Justification for high valuations also came in the
form of suggestions that estimates of the cost of
capital were too high.
“Enron’s collapse, like the dot-com meltdown, is a
reminder that our financial reporting model is out of
date.” Joe Bernardino, CEO of Arthur Andersen and
shortly before its demise
Earnings Management Checklist