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USC study details flawed economic forecasts

Mark Soliman, Arthur Andersen & Co. Alumni Associate Professor of Accounting at the USC Leventhal School of Accounting, and two colleagues have broken new ground with an article published in the Journal of Accounting and Economics.

Studying 237,617 earnings announcements from 1998 to 2009, the authors have conducted the first large-scale study showing a definitive relationship between issuing nongenerally accepted accounting principles (GAAP) or pro-forma earnings (which deviate from what are considered GAAP) and a propensity to exceed analyst forecasts.

Approximately 25.5 percent of firms in the sample issued non-GAAP earnings. According to Soliman, this pro-forma earnings reporting allows firms to classify expenses as “one-time charges,” such as nonrecurring, noncash or nonrelevant expenses. These are highly discretionary expenses that firms arbitrarily remove from their financials in order to increase earnings. The authors found that managers tend to do this when other forms of earnings management have already been used and “maxed out.”

The result? Firms that report non-GAAP earnings, the USC study showed, tend to beat analysts’ expectations more often than firms that solely report GAAP earnings. Exclusions in these earnings are driving results as non-GAAP reporters meet or beat analysts’ expectations 65 percent of the time. In fact, the authors found that the probability of a firm meeting or beating analysts increases 20 percent when the firm incorporates “other exclusions” into their reporting.

What’s the danger? Analysts, the authors concluded, are not entirely unwinding the opportunistic expenses excluded from GAAP (for example, when an expense is labeled as “other” but is, in fact, an ongoing or reoccurring expense). The big danger is that analysts are not able to anticipate all of these exclusions to generate accurate forecasts.

bull market

This is the first study to document that highly discretionary pro forma earnings give managers an opportunity to beat the forecasts of analysts.

The authors conceded, however, that the market does a fair job of recognizing what managers are doing as stocks get lower returns than one might expect. The researchers found that the market discounts the firm’s earnings surprise by 10 percent to 14 percent when it is associated with the use of income-increasing exclusions.

“One cost of the use of exclusions may be that the market discounts the firm’s earnings surprise, suggesting that the market partially understands the opportunistic nature of these exclusions,” the authors said.

This study is the first to document that these highly discretionary pro forma earnings that were first regulated by the U.S. Securities and Exchange Commission in 2003 continue to give managers another lever to pull in order to beat analyst forecasts, especially when other forms of earnings management are no longer available to them or more costly to employ.

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USC study details flawed economic forecasts

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