Samuel Mautz and Dr. Ted Christensen, School of Accountancy
The financial press has reported considerable disagreement during the past several years about the proliferation of non-standard profitability measures, generally known as ‘pro forma’ earnings. Pro forma earnings are normally defined as standard earnings adjusted for items that managers deem to be ‘one-time’ in nature or non-representative of future earnings (Weil, 2001) and are reported in the same earnings press release with the audited income number calculated according to generally accepted accounting principles (GAAP). Policymakers and regulators allege that pro forma earnings are incomplete, inaccurate, and misleading to investors (Derby, 2001; Dreman, 2001; Elstein, 2001). On the other hand, managers defend this practice asserting that these non-standard earnings measures provide stakeholders a more accurate assessment of their sustainable operating performance than does the standard GAAP EPS figure. In other words, they contend that pro forma earnings numbers provide a better measure of core earnings than GAAP earnings (Bray, 2001). Are these numbers reported in order to better portray economic performance or do they provide managers an opportunity to convince investors that their firms are economically healthier than is actually the case. This study is a step toward being able to distinguish between firms that report pro forma earnings for altruistic reasons and firms that report pro forma earnings opportunistically.
I hypothesize that firms are more likely to report pro forma earnings numbers when they are unable to meet strategic earnings goals using traditional accounting methods. In other words, I expect that managers will first attempt to ‘manage’ earnings using the discretion allowed within existing accounting rules. Once their discretion to influence reported results is exhausted, I posit that managers are more likely to use pro forma reporting to ‘appear’ to meet strategic benchmarks. I use two related measures of earnings management found in Barton and Simko (2002) to investigate whether firms are more or less likely to report pro forma earnings. First I calculate Net Operating Assets (NOA), a measure of the how much “flexibility” a firm’s financial reports or balance sheet has for earnings management. A higher value of NOA indicates that a firm has exhausted its means to bias earnings within existing accounting rules. Second, I calculate abnormal accruals, a measure of the extent to which managers use ‘unexpected’ accounting maneuvers, presumably to meet strategic earnings goals. I calculate abnormal accruals following Barton and Simko (2002). They model total accruals as the sum of all accounting adjustments that would be considered ‘normal’ according to GAAP. Estimating this model using a sample of 2,704 quarterly observations predicts the level of normal accruals. The residual of that model is what Barton and Simko call abnormal accruals and is considered a measure of earnings management. The higher the level of abnormal accruals the more a firm has managed its earnings upward.
I predict that firms are more likely to report pro forma earnings when they have (1) less ‘slack’ in their balance sheet for earnings management (i.e., higher values of the NOA measure) and (2) higher abnormal accruals (ABNACCR) than firms that do not report pro forma earnings. In order to test these hypotheses I investigate an existing sample of 2,704 firms that report pro forma earnings during the 1998-2003 period. Specifically, I compare quarters in which these firms voluntarily report pro forma earnings to quarters in which the same firms choose not to report pro forma earnings. I hypothesize that NOA and ABNACCR will be higher in pro forma versus non-pro-forma quarters.
I first investigate whether the level of NOA and ABNACCR are statistically different from zero for each sub-sample using a t-statistic. As seen in the following table, the results suggest significant balance sheet constraints (NOA) for both pro forma and non-pro-forma quarters. However, abnormal accruals are only significantly different from zero in the non-pro-forma quarters. I test my hypotheses that NOA and ABNACCR are higher in pro forma quarters than non-pro-forma quarters using t-statistics and Wilcoxon rank-sum z-statistics. Consistent with my predictions, the results indicate that NOA is significantly higher in pro forma quarters. This suggests that firms have significantly less flexibility to manage earnings in pro forma quarters. Interestingly, the difference in abnormal accruals (ABNACCR) is not statistically significant based on the t-test, while the Wilcoxon non-parametric test suggests that abnormal accruals are actually higher in the non-pro-forma quarters. While this result is just the opposite of my original prediction, it makes perfect sense. The information presented in the table reveals an interesting story. It indicates that firms with higher balance sheet constraints are more likely to report pro forma earnings. The reduced amount of accruals among these firms supports the finding of Barton and Simko and show that with the high level of balance sheet constraints, manipulating earnings through abnormal accruals is difficult and firms will therefore rely on pro forma earnings.
This study represents a significant step in identifying that firms that report pro forma earnings are doing so because other avenues of earnings management have been exhausted. While this study shows that these firms that cannot manage earnings in other ways will rely on pro forma reporting, the ex post data and has little predictive value. The next step in the study will be to find characteristics of these firms than are observable ex ante and will therefore give us some predictive ability. Those results will be of great interest to managers, standard setters, and investors as they will be able to identify firms more likely to report pro forma numbers for opportunistic reasons.