In our previous post, The Complex, Contentious, and Changing Nature of Financial Reporting Standards, we show that financial reporting standards, despite what some might think, are hardly set in stone. An ever-changing world can lead to changes in standards, and the process for making these changes is a contentious one. It is thus fair to ask how useful having standards really is in the first place. The answer is that they are very useful because they provide the social construct for the measurement of financial performance. They are a necessary foundation for doing financial analysis, but the statements are not analyses themselves. The types of analysis done are a function of the user of the financial statements. It is also important to note that the preparation and audits of financial statements are done in a broader institutional context intended to ensure the quality of both.

Financial statements are the starting point for companies to provide information on their financial performance. Companies may have incentives to opportunistically use the discretion permitted in GAAP and elsewhere to present their financial performance in ways that favor them. They do this in three ways. First, they report so-called “non-GAAP” profit measures. As explained by the CFA Institute, “Non-GAAP earnings are an alternative method used to measure the earnings of a company. Many companies report non-GAAP earnings in addition to their earnings as calculated through generally accepted accounting principles.” The Institute notes that “The discrepancies between GAAP and non-GAAP earnings can thus be enormous,” but also acknowledges that “some asset managers believe that these alternate figures provide a more accurate measurement of the company’s financial performance” due to the fact that “Standard financial reporting requirements are fairly prescriptive.”

Govindarajan, Shrivastava, and Zhao note that 95% of S&P 500 companies report non-GAAP earnings. They identify three common reasons for this practice intended to provide a “truer” view of a company’s underlying financial performance: Stock option expenses, write-off of acquired intangibles, and restructuring charges. In order to deal with the obvious possibility that non-GAAP measures are an intentional way to report earnings performance as more favorable than it really is (noting that there is no fundamental reality in any of this), the SEC has issued Regulation G which prohibits the dissemination of false or misleading GAAP or non-GAAP financial measures.

Whatever method for reporting earnings is used, the question then becomes “Is this good news or bad news?” There are many factors which shape this answer. A key one is what the market expects the earnings to be. This is the second way in which companies seek to get a positive view of their financial performance. They engage in “earnings guidance” to properly set the expectations of sell-side analysts who publish “earnings forecasts.” The game here—and everyone involved knows it’s a game—is to have a consensus forecast the company knows it can meet or beat.

Source link for this article