Earnings Quality of earnings Application of GAAP Earnings management Proforma earnings How can GAAP help to sustain a bubble? Earnings management checklist

Problems with Companies’ Application of GAAP – Levitt Speech (1998)  Big Bath charges  In-Process R&D (IPRND) charges  “Cookie Jar” reserves  Materiality  Revenue recognition

Recommended Actions Increased disclosure of restructuring charges (beginning/ending balances and activity) Increased scrutiny of IPRND Qualitative as well as quantitative description of materiality New guidance on revenue recognition Strengthening audits, auditors, and audit committees

Proforma Earnings Proforma earnings More than EBITDA Generally, excluding transitory items (restructuring expenses, etc) Analysts are increasingly projecting proforma (“operating” or “core”) earnings and these are reported in First Call, I/B/E/S and Zachs

What companies are trying to do is entice analysts into excluding certain charges and value them only on that basis…Companies are creating their own grading systems to help ensure that, no matter how their business is doing, they will get an A or an A+.” WSJ 8/24/99 Examples of things left out in proforma earnings: 1.Restructuring charges 2.Write-downs and impairments 3.R&D expenditures 4.Merger and acquisition costs 5.Goodwill amortization “Bad terminology is the enemy of good thinking. When companies or investment professionals use terms such as ‘EBITDA’ and ‘pro forma,’ they want you to unthinkingly accept concepts that are dangerously flawed. (In golf, my score is frequently below par on a pro forma basis: I have firm plans to ‘restructure’ my putting stroke and therefore only count the swings I take before reaching the green.)”— Berkshire Hathaway annual report

Empirical Research Bradshaw and Sloan, 2001 Stock prices are becoming more highly correlated with proforma earnings than with GAAP earnings There is a growing disparity between proforma and GAAP earnings

EPS Proforma GAAP

Proforma GAAP

Other research Doyle, Lundholm and Soliman (2003) Higher levels of exclusions lead to predictably lower future cash flows. We also find that investors do not fully appreciate the lower cash flow implications at the time of the earnings announcement. A trading strategy based on the excluded expenses yields a large positive abnormal return in the years following the announcement, and persists after controlling for various risk factors and other anomalies. Bhattacharya, et. al. (2004) Our intraday investigation of transactions around pro forma earnings announcements reveals that small investors’ announcement-period abnormal trading volume is significantly positively associated with the earnings surprise based on pro forma earnings. In contrast, we find that large, sophisticated investors either do not trade on pro forma information or they take the position opposite to that of small investors (i.e., while small investors predominantly buy following a favorable pro forma announcement, large investors generally sell). Collectively, our results indicate that the segment of the market that relies on pro forma earnings information is populated predominantly by small investors.

Watch out for Proforma Earnings Company focus on EBITDA May help to sustain aggressive borrowing May hide capitalization issues Promotes excess substitution of capital for labor (can lead to excess capacity) Promotes capitalization of costs that should be expensed Watch for excesses in any area the company wants to exclude in proforma earnings.

How does GAAP Help to Sustain a Bubble? Inclusion of market prices. Accounting for passive investments - recognize gains by selling AFS securities when needed and relegate unrealized losses to OCI Accounting for sale of put options - Sale proceeds are tax free cash flow, not income. “Losses” occur when the stock declines, but the share purchase is reported like a normal share purchase, with no loss reported in I/S Accounting for convertible securities - if conversion option is not valued separately, it is not accounted for. Conversion is recorded at book value. The “cost” is not reflected in earnings, only diluted EPS via share increase. Accounting for subsidiary IPOs – Gains can be recognized on increases in equity investment account following sub IPO. Accounting for Pensions - Net pension obligations reduce when market increases. Also, pension investment increases affect profit via reduction of pension expense. Accounting for business combinations - recorded at market value. Non- amortization of goodwill may encourage overpayment. But, subsequent goodwill write-offs can reflect either overvalued target company or overvalued parent. Hard to distinguish between the two.

How does GAAP Help to Sustain a Bubble (part 2)? Keeping assets off the balance sheet results in higher book rates of return Pooling of interest accounting for acquisitions Equity method investments SPEs

Tale of a 1990s Firm

Lessons from the 1990s GAAP was assailed in the 1990s bubble for not recognizing the value of knowledge assets. Some desired to impute knowledge assets by the difference between market capitalization and equity book value Some thought that GAAP earnings should be replaced with “value reporting” (remember clicks and page views?) Justification for high valuations also came in the form of suggestions that estimates of the cost of capital were too high. “Enron’s collapse, like the dot-com meltdown, is a reminder that our financial reporting model is out of date.” Joe Bernardino, CEO of Arthur Andersen and shortly before its demise

Earnings Management Checklist