Abstract
We examine disagreement between management and Thomson Datastream over the persistence of earnings components. Using income statement and footnote disclosures, we identify the source and properties of disputed items. Disagreements typically reflect opaque reporting practices (for example, in the case of transitory operating items) and restrictive classification rules (for example, in the case of discontinued operations). Incremental and relative value relevance tests suggest that the majority of management-specific adjustments reflect appropriate classification of earnings components by insiders. Nevertheless, evidence consistent with strategic disclosure does emerge for a subset of management adjustments.
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Notes
We use the nomenclature “non-GAAP” earnings (or EPS) throughout the paper when referring to supplementary earnings metrics disclosed by management. While prior U.S. research often labels such disclosures “pro forma earnings”, our tests relate to the U.K. where the term pro forma earnings is not used.
Bhattacharya et al. (2003) report that non-GAAP earnings correspond to IBES actual earnings in approximately 65% of cases. Such is the level of correspondence that several studies use IBES actuals as a proxy for management-reported non-GAAP earnings (Brown and Sivakumar 2003; Doyle et al. 2003; Doyle and Soliman 2004; Landsman et al. 2006).
Doyle et al. (2003) present evidence that analysts’ classification errors are largely confined to operating items. In particular, they partition the difference between GAAP EPS and IBES actual EPS into special (non-operating) items and other (operating) exclusions and find that recurring exclusions are confined to the latter category where financial statement disclosures are especially opaque (Doyle et al. 2003: 151).
The U.K. approach contrasts with APB 30 in the United States and International Accounting Standard No. 35, both of which allow operations to be classified as discontinued as soon as a detailed formal plan for disposal has been adopted and announced or when the enterprise has already contracted for the disposal.
Other specified operating items comprise a broad class of components including fixed asset and goodwill impairments, costs associated with acquisitions and demergers, aborted acquisition costs, compensation for loss of office, costs associated with integration, reorganization, restructuring, rationalization and redundancy, provisions against loans to associate undertakings, pension scheme credits, exploration costs written off, and foreign currency gains.
Although Thomson provides few details of the specific process used to identify non-recurring earnings components, comparison of Thomson’s non-recurring items with those classified as “exceptional” in firms’ financial statements reveals material differences. Thomson therefore appears to take its own view on the persistence of earnings components rather than relying exclusively on classifications provided by management. Further, total non-recurring items identified by Thomson include transactions reported by management within both non-operating and operating profit, indicating that Thomson’s adjustment process recognizes the discretion afforded to U.K. management over the positioning of transitory items. Thomson scrapped its Datastream Company Accounts service in April 2004 and as a result no longer reports this definition of non-recurring items.
Greater consensus between management and IBES is consistent with (a) IBES analysts’ superiority at identifying non-recurring earnings components compared with other sophisticated financial statement users (Brown and Sivakumar 2003) and (b) analysts’ reliance on management guidance regarding the incidence and magnitude of non-recurring items.
One could also treat as disagreements those cases where Thomson (IBES) reports adjustments to GAAP earnings but managers do not disclose a non-GAAP figure. Marques (2006) includes such cases in her analysis. We do not follow this route because the focus of our paper is on cases where managers make an explicit decision to report a competing earnings number to GAAP earnings. Although the question of why managers choose not to disclose non-GAAP earnings is an interesting one (particularly when transitory items exist), this issue lies beyond the scope of our paper.
Two further practical considerations concerning the reconciliation process are worthy of note. The first involves the treatment of taxation. While Thomson reports all non-recurring items on a pre-tax basis, the approach used by firms is mixed: some report reconciliation items on a pre-tax basis with the aggregate tax effect disclosed separately while others report reconciliation items net of tax. The task of reconciling Thomson adjustments with management adjustments is relatively straightforward when the tax treatment is consistent. For cases where the treatment differs, we restated management exclusions to a pre-tax basis using footnote disclosures. The second complication involves the treatment of goodwill amortization. While non-GAAP EPS often excludes goodwill amortization, Thomson’s recurring earnings metric is computed before deducting goodwill. To ensure comparability between the two metrics, we adjusted the Thomson number to a pre-goodwill amortization basis using the adjustments reported by management. This procedure ensures that in no case does the treatment of goodwill amortization account for disagreement between Thomson and management.
We also estimated all models using unscaled data (Barth and Kallapur 1996). None of the key inferences are affected.
From Eq. 2 and consistent with Marques (2006), the expected coefficient sign on MANINCL is negative for included items that are value relevant.
We examined the robustness of these results across sample years. Since the number of observations available for separate annual regressions is small, we reestimated the models reported in Table 5 using combinations of any two sample-years (i.e., 1993/4 and 1996, 1993/4 and 2001, and 1996 and 2001). Untabulated regression results for all 2-year combinations are consistent with those reported in Table 5 using the full sample. In particular, the estimated coefficient on MANEXCL is always insignificant, whereas MANINCL is always negative and generally significant. Since 1993/4 was the first year under FRS 3, we also tested for the presence of adoption-period effects by interacting the management inclusion and exclusion variables with a 1993/4 indicator variable. No systematic differences for the 1993/4 period are apparent.
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Acknowledgements
We thank IBES International for providing IBES actual EPS data. We gratefully acknowledge helpful comments and suggestions from David Citron, Andrew Jones, Paul Klumpes, Stephen Penman (the editor) and two anonymous reviewers, as well as from seminar participants at Lancaster, the London School of Economics, Warwick, the 2004 Financial Reporting and Business Communication Conference (Cardiff), and the 2005 Annual Meetings of the American Accounting Association (San Francisco). We also thank Valentine Ururuka for research assistance. Generous financial support has been provided by the Institute of Chartered Accountants in England and Wales’ Centre for Business Performance. A previous version of this paper was titled “Voluntary disclosure of adjusted earnings per share numbers”.
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Appendix: description of reconciliation method
Appendix: description of reconciliation method
Non-GAAP earnings numbers are hand-collected from firms’ financial statements and reconciled with Thomson Datastream recurring earnings (item #210). Item #210 equals GAAP net income (#625) minus total non-recurring items (net of tax and minority interests) identified by Thomson (#194). Thomson decomposes #194 as follows:
where #1079 is gains and losses on termination of operations; #1080 is reorganization and restructuring costs; #1081 is gains and losses on the sale of fixed assets; #1082 is other special gains and losses; #1091 is other non-operating adjustments; #1090 is adjustments to associate profits; #981 is net non-recurring operating losses before tax; #989 is total tax adjustments; and #1097 is minority interests in non-operating items.
Items in [.] in Eq. A1 are compared with management’s adjustments to GAAP earnings using mandated footnote disclosures reconciling non-GAAP earnings with earnings computed under GAAP. Disagreement between management and Thomson over the classification of earnings components occurs when the values reported in management’s list of adjustments to GAAP earnings do not match those contained in Thomson’s list.
1.1 Incremental inclusions by management
Items unique to Thomson’s list of non-recurring items represent transactions that management elected not to exclude from GAAP earnings despite Thomson having classified the item as transitory (that is, management effectively reverse Thomson adjustments). We label these as “management inclusions,” an example of which is illustrated by Nurdin and Peacock PLC for the financial year ending December 31 (all figures in £000):
Non-GAAP earnings | Thomson recurring earnings | ||||
|---|---|---|---|---|---|
GAAP earnings | 21877 | Item #625 | 21877 | ||
Less Thomson operating items (pre-tax) | |||||
Net deficit on revaluation | −147 | ||||
Permanent diminution in fixed asset value | −779 | ||||
Provision for compensation for loss of office | −346 | ||||
Total non-recurring operating items | (−1272) | Item #981 ( × − 1) | (−1272) | ||
Less Thomson non-operating items (pre-tax) | |||||
Item #1079 | 0 | ||||
Item #1080 ( × − 1) | 0 | ||||
Loss on sale of fixed assets | −550 | Item #1081 | −550 | ||
Item #1082 | 0 | ||||
Gain on sale of current asset investment | 438 | Item #1091 – #1090 | 438 | ||
(−112) | (−112) | ||||
Less: tax and minority interests | (660) | Item #989 – #1097 | (660) | ||
Thomson non-recurring earnings | 22601 | Item #210 | 22601 | ||
Management reversal of Thomson exclusions | |||||
Provision for compensation for loss of office | −346 | ||||
Gain on sale of current asset investment | 438 | ||||
Aggregate management inclusions | 92 | ||||
Reversal of tax and minority interests effects | 479 | ||||
Non-GAAP earnings | 23172 | ||||
1.2 Incremental exclusions by management
Items unique to management’s list represent components excluded from GAAP earnings by management in addition to items excluded by Thomson. We label these “management exclusions”, an example of which is illustrated by W. H. Smith Group PLC for the financial year ending June 1, 1996 (all figures in £000):
Non-GAAP earnings |
|
| Thomson recurring earnings | ||
|---|---|---|---|---|---|
GAAP earnings | −200300 | Item #625 | −200300 | ||
Less agreed operating items (pre-tax) | |||||
Redundancy and associated costs | −16600 | ||||
Fixed asset write-offs | −9400 | ||||
Property costs | −30400 | ||||
Other operating costs | −24600 | ||||
Total non-recurring operating items | (−81000) | Item #981 ( × − 1) | (−81000) | ||
Less agreed non-operating items (pre-tax) | |||||
Loss on sale of operations | −151300 | Item #1079 | −151300 | ||
Item #1080 ( × − 1) | 0 | ||||
Loss on sale of land and buildings | −9100 | Item #1081 | −9100 | ||
Item #1082 | 0 | ||||
Item #1091 – #1090 | 0 | ||||
Total non-recurring non-operating items | (−160400) | (−160400) | |||
Less: tax and minority interests | (29300) | (29300) | |||
Thomson non-recurring earnings | 11800 | Item #210 | 11800 | ||
Less additional management exclusions | |||||
Stock provisions and write offs | −42000 | ||||
Discontinued operations | −10100 | ||||
Aggregate management exclusions | (−52100) | ||||
Less: additional tax and minority interests | (400) | ||||
Non-GAAP earnings | 63500 | ||||
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Choi, YS., Lin, S., Walker, M. et al. Disagreement over the persistence of earnings components: evidence on the properties of management-specific adjustments to GAAP earnings. Rev Acc Stud 12, 595–622 (2007). https://doi.org/10.1007/s11142-007-9048-x
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DOI: https://doi.org/10.1007/s11142-007-9048-x