Financial accounting balancing between predictive power and prudence

24 October 2018

By presenting alternative earnings, companies try to draw a better picture than the one emerging from the official results. Professor of Financial Accounting David Veenman from the University of Amsterdam investigated the extent to which investors are being misled.

EBITDA, earnings per share before special items or before amortisation of goodwill, autonomous turnover and net debt. This is just a random selection of terms denoting financial measurements that public companies use in their quarterly and half-yearly figures. They are called non-standard accounting metrics or non-GAAP metrics. Non-standard, because they differ from the official items that must be included in the audited annual accounts under official reporting rules.

“For a long time, I thought that public companies are trying to mislead investors and other stakeholders by using non-standard accounting”, says David Veenman, Professor of Financial Accounting at the Amsterdam Business School (ABS) since September 2016. Veenman points out that, in general, alternative earnings are more positive than official results. The fact that these companies are usually not very consistent in their use of non-standard metrics and therefore seem to be cherry picking also feeds mistrust. Veenman, who held his inaugural lecture at the end of last year, studied business economics at the University of Amsterdam (UvA) and obtained his PhD in 2010. Until his appointment at the UvA, he was successively associate professor and endowment professor at Erasmus University.

The use of alternative performance indicators is not well-regarded by the organizations responsible for the International Financial Reporting Standards (IFRS) – the reporting requirements that are mandatory for, among others, European public companies and, for American companies, the Generally Accepted Accounting Principles (GAAP). However, companies are allowed great latitude in using alternative measures in interim reports. At best, these items can be derived from the official metrics, such as EBITDA (earnings before interest, tax, depreciation and amortisation). Sometimes the relationship is tenuous, as in the case of autonomous turnover.

Field of tension

“Accounting standards must have some predictive power, which means that they need to reveal something about future cash flows and profits, so a company can be valued”, says Veenman, adding: “At the same time, accounting must be based on the principle of prudence.” IFRS an GAAP apply both principles, but according to Veenman they struggle to find the right balance: “There has always been a tension between both principles, but the emergence of companies from the new economy has increased this tension, which has, for that matter, been admitted by the authors of the standards.”

The tension is clearly visible, says Veenman, when valuing intangibles, such as publishing rights. The official standards require that such items can only be included in the balance sheet, after an acquisition, as ‘intangible fixed assets’ and must then be amortised within a few years, which reduces profits. This is a prudent method of valuation, but in many cases intangibles do not lose any value, even after a certain period of time.

Google

“A company like Google is not allowed to assign value to most of its self-generated intangibles”, says Veenman.

“The balance sheet of this company is relatively short in comparison to its market value of hundreds of billions. Information about the true value of the intangibles can reveal a lot about future cash flows and profits. This is what these companies try to do with reporting alternative metrics.”

As another example, Veenman mentions the issue of how to account for stock-based compensation to the staff, a form of remuneration commonly used by internet companies. “These packages should officially be regarded as costs, because they dilute shareholders’ interests. Nevertheless, many companies do not include these packages as costs in their alternative earnings. They believe that these rewards attract well-qualified staff who will create sizeable added value in the future, which in their view is a compensation for the costs involved. However, according to official reporting requirements, it is not possible to assign value to human capital.”

Research

The growing use of non-GAAP figures can usually expect to receive a great deal of criticism. “I was also among the sceptics,” says Veenman, “especially in cases where non-standard results were very different from standard figures.” He cites the case of Twitter as an example: it recorded a loss in the first sixteen quarterly reports according to official accounting, but always made a profit according to its own standards.

It was partly his own research, published in the Journal of Accounting Research in 2018, that made Veenman change his mind. He now no longer believes that companies simply want to mislead their investors. He analysed thousands of press releases of American public companies reporting losses under official standards. About half of these companies published alternative results, which were usually more positive than the official results.

“There is more uncertainty about the operations of loss-making companies, so it was likely that non-GAAP results provided additional information to investors in companies in this category.” Veenman compared both the official and alternative results with cash flows in following years. Cash flows are a good indicator, because they hardly depend on reporting methods. Furthermore, they are decisive for the dividends to be paid and therefore for the value of a company.

Correlation

Veenman: “On average, in the case of companies that publish alternative earnings, there appears to be no correlation between the GAAP-figures and future cash flows. There is, however, a strong correlation between the alternative results and future cash flows. Because of this outcome, I had to adjust my initial expectations about the nature of alternative performance indicators.” The correlation between official results and future cash flows appears to be present as well in the case of loss-making companies that do not use alternative metrics: “This leads to the conclusion that companies know very well in which circumstances the use of alternative metrics helps their investors to be informed properly. Therefore, misleading is out of the question.”

Other research has provided evidence that the predictive power of official reporting standards is fairly strong in the case of relatively stable and profitable companies. Nevertheless, many profitable companies use alternative metrics. “The difference between official and alternative metrics for these companies is usually smaller”, says Veenman. “The alternative figures often serve as extra information for stakeholders, although in 90% of the cases they give a more positive picture.” According to Veenman, this could well indicate there is some kind of misleading, especially when companies are not consistent in their use of alternative performance indicators. “This is not easy to determine and will have to be examined on a company-by-company basis. This will require much more research.”

By Bendert Zevenbergen

Published by  Economics and Business