The Hindu Business Line : GAAP vs non-GAAP, media vs managers

The practice of reporting earnings measures that deviate from generally accepted accounting principles (GAAP) has received negative attention in the media. Regulators naturally argue in favour of reporting GAAP earnings measures, and utter their concerns that investors may be misled by the use of non-GAAP measures.

In this period of increased regulatory concern for these reporting practices, Miriam Koning, Gerard Mertens and Peter Roosenboom of the Erasmus University, Rotterdam explored whether there has been a shift away from the use of non-GAAP metrics.

“We analyse a sample of earnings press releases in the period 1999-2004 from companies listed at Euronext Amsterdam. Our findings indicate that reporting non-GAAP measures is a common practice and that the frequency of reporting non-GAAP earnings measures has increased despite the concerns voiced by regulators,” the authors noted.

On the other hand, investors seem to have become more hesitant towards the use of alternative earnings measures for their decision-making. The research’s findings (https://ep.eur.nl) suggest that investors find non-GAAP measures informative for periods before 2003, but they turn away from these measures in the following years, and depend on GAAP earnings metrics instead. Together, these findings suggest that the negative media attention for non-GAAP measures has influenced the perception of investors, but not of managers.

Guess, we will have to wait and see whether who dares wins or not!

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Rubber-stamp approval

While Indian IPO market has been relatively unscathed by accounting scandals, the Wall Street has had its fair share.

During stock market bubble of the late 1990s, the US witnessed many tech companies tapping the market through initial public offers. Within the next 2-3 years, a lot of them restated the very financials — which earlier formed the basis of investor judgment during the paper sale. The trend was allegedly reported in companies funded by venture capitalists and the reputation of underwriters who wrote the IPOs was in question. Do underwriters and venture capitalists (VC) help often play a monitoring role in financial reporting around IPOs?

The results of a research conducted by Tommy Cooper of Culverhouse ( www.tomcooper.net ) College of Commerce and Business Administration (University of Alabama) suggest that VCs might have a hand. In all, underwriter and VC characteristics in a sample of 146 firms that went public during 1995-2005 and announced restatements within three years of their IPOs were carefully studied.

“Using matched-pairs logistic regressions, I try to distinguish between several competing hypotheses about underwriter and VC influence on the financial-reporting quality of IPO firms,” Cooper notes.

For the full sample, he found weak evidence to support the underwriter revenue-generation hypothesis. In securities underwriting, a syndicate of banks, usually the lead-managers, underwrite the transaction. This means that they take upon themselves the risk of distributing the securities. Underwriters make their income from the price difference, or underwriting spread, between the prices they pay the issuer and what they collect from investors who buy portions of the offering.

Financial restatements often provide direct evidence of misreporting because they are admissions by management that financial statements were materially misstated. Venture capitalists provide seed fund to start-ups in exchange for significant stake and usually exit the company after selling those stakes in the IPO.

“During the dot-com era, even reputable underwriters seemed to provide rubber-stamp approval to suspect issuers, and the reported business practices of some VCs were inconsistent with their role as monitors,” the author concludes in the paper.

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Numbers or words?

Financial statements must be clear and understandable. They are based on accounting policies that vary from enterprise to enterprise, both within a single country and among countries. The jury is still out on whether companies should reveal as much as they should or as much they could (under existing laws).

An investigation into the relationship between companies’ disclosure of their accounting policies in the annual report, and its association with analysts’ earnings forecasts throws up interesting conclusions. Findings of Ole-Kristian Hope of Joseph L. Rotman School of Management (University of Toronto), posted on SSRN (Social Science Research Network), suggest that accounting policy disclosures reduce uncertainty about forecasted earnings.

“I find univariate but not multivariate support for the hypothesis that accounting policy disclosures are especially helpful to analysts in environments where firms can choose among a larger set of accounting methods,” he concludes.

Accounting standard setters contend that in order to understand and interpret financial statements, users should be aware of the main assumptions on which the reports are based. Hope’s analyses based on one dependent variable suggest that accounting policy disclosures are more important in settings that permit managers relatively more flexibility in choosing among accounting methods.

Impact of legal systems

In common law legal systems, the law is created or refined by judges, if required. Naturally, a decision in a case that is currently pending depends on decisions in previous cases and also affects the law to be applied in future cases as well. On the other hand, civil law starts with abstract rules, which judges must then apply to the various cases before them. It is commonly perceived that common law countries have stronger investor protection laws and more developed financial markets than civil law countries.

In their research, Jere R. Francis, Inder K. Khurana and Raynolde Pereira of University of Missouri-Columbia (College of Business) document that national accounting standards are more timely (accrual-based) and transparent in common law countries.

While covering 31 countries, the authors found that the presence of these accounting standards was consistent with a greater role played by the public disclosure of accrual-based accounting information in corporate governance in countries following common law systems.

“There is also greater demand for auditing as an enforcement mechanism when accounting is more timely and transparent. We also examine if causality could run from high-quality accounting and auditing to the development of financial markets,” the authors said.

Specifically, they examined if those civil law countries that have more timely and transparent accounting, and more auditing, also have more developed financial markets relative to other civil law countries.

The results of the study (http://papers.ssrn.com) were not surprising. “We find little support that this is the case, which raises questions about the rationale for the international harmonisation of accounting and the work of the International Accounting Standards Committee, absent fundamental changes in investor protection laws of civil law countries,” they concluded.

This startling revelation begets another question. Whether there is a need for further research investigating the economic benefits of implementing costly accrual-based financial reporting systems in countries that have weak investor protection laws? Fortunately, India follows common law system.

D. MURALI

JAGAT GURU

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