Ebook Voluntary Disclosure of Adjusted Earnings Per Share Numbers
Financial Reporting Standard No.3: Reporting Financial Performance (FRS 3) permits UK firms to report supplementary earnings per share (eps) numbers on the face of their income statement alongside the figure produced according to generally accepted accounting principles (GAAP). The rationale for allowing management to report such numbers is to help communicate a more complete picture of firm performance and value by highlighting potentially important earnings streams (e.g., sustainable earnings). Critics, on the other hand, claim that management often use such disclosures to opportunistically divert investor attention away from poor underlying performance. The objective of this study is to examine the motives for voluntarily adjusted eps reporting and to present evidence on the properties of the resulting disclosures.
Recent interest in non-GAAP earnings disclosures has increased following the decision of some US firms to report supplementary earnings metrics (e.g., ‘pro forma’ earnings) alongside GAAP net income in their quarterly press releases (Bradshaw and Sloan, 2002; Doyle et al., 2003; Bhattacharya et al., 2004 and 2003; Gu and Chen, 2004; Johnson and Schwartz, 2003; Lougee and Marquardt, 2004). Adjusted eps reporting in the UK differs from US non-GAAP earnings reporting in a number of important respects. First, non-GAAP eps disclosures are considerably more pervasive in the UK. Over 70% of non-financial firms currently report adjusted eps. In contrast, prior studies show that only a very small fraction of US non-financial firms report non-GAAP earnings data in their quarterly earnings releases (Bhattacharya et al., 2003; Johnson and Schwartz, 2003). Second, adjusted eps data form part of UK firms’ audited financial statements and must be accompanied by a full reconciliation to the bottom-line (FRS 3) figure, thereby rendering attempts to opportunistically exclude certain income components more transparent than has traditionally been the case in the US.
Accordingly, adjusted eps disclosures in the UK are less likely to be driven by strategic reporting considerations such as meeting or beating analysts’ forecasts. Third, the role of non-GAAP eps as a signal of sustainable earnings is potentially more pronounced in the UK because of a more restrictive definition of GAAP eps. Most notably, while SFAS 128 excludes extraordinary items from bottom-line eps and requires firms to disclose eps from continuing operations, FRS 3 requires only bottom-line eps, computed inclusive of extraordinary items and discontinued operations, to be disclosed.
We predict that management has incentives to voluntarily disclose adjusted eps alongside FRS 3 eps when the latter is relatively uninformative about sustainable earnings performance. We use the earnings definition from I/B/E/S as our proxy for sustainable eps. Empirical tests are based on a large hand-collected sample of adjusted eps disclosures made following the introduction of FRS 3 in June 1993 through 2001. We examine all adjusted eps definitions, thereby addressing Bradshaw’s (2003: 334) criticism that US samples selected on the basis of one particular non-GAAP nomenclature (i.e., pro forma earnings) could lead to biased results.
Consistent with our prediction, logistic regressions show that the probability of adjusted eps disclosure is higher for firms where: (1) I/B/E/S earnings are negative and hence relatively uninformative about sustainable performance; (2) FRS 3 eps indicates losses whereas I/B/E/S eps is positive; and (3) the absolute difference between FRS 3 eps and I/B/E/S eps is large. The latter result holds for both positive (I/B/E/S-defined eps > FRS 3 eps) and negative (I/B/E/S-defined eps < FRS 3 eps) differences between sustainable eps and GAAP eps. These findings are inconsistent with claims that adjusted eps disclosures are generally motivated by opportunistic reporting considerations. A multinomial logit analysis yields similar insights insofar as the magnitude of the gap between FRS 3 eps and I/B/E/S-defined eps predicts disclosure both where the adjusted number increases reported performance (adjusted eps > FRS 3 eps) and where it decreases reported performance (adjusted eps < FRS 3 eps).
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