Called to Account: Study: Earnings surprises are bigger, thanks to growing use of non-GAAP metrics

Called to Account: Study: Earnings surprises are bigger, thanks to growing use of non-GAAP metrics

The stock market isn’t rewarding small earnings beats the way it used to, so companies have upped their game, according to new research. A larger number use non-standard numbers to report bigger beats that boost share prices.

“Evidence of a Positive Trend in Positive Quarterly Earnings Surprise over the Past Two Decades,” provides evidence that, for the last 17 years, companies have been using non-standard numbers to produce quarterly earnings per share that exceed analysts’ forecasts by 5 to 15 cents not a penny or two.

Professors Paul A. Griffin of the University of California at Davis and David H. Lont of University of Otago in New Zealand found that the proportion of reported earnings among the S&P 500 that were between 5 to 15 cents per share above analyst forecasts had doubled over a 17-year period.

There are those who claim, the researchers write, “that so far this century the U.S. economy has experienced such an unusual period of economic growth and success that it has taken analysts and investors increasingly by surprise each quarter with better-than-expected earnings performance for almost two-decades. This view strains credulity, however,” say the authors.

In the last twenty years Generally Accepted Accounting Principles or GAAP—the standards all public companies must use to report their results to the Securities and Exchange Commission—have been increasingly ignored by companies and research firms that provide data on predicted and actual earnings. About 90% of S&P 500 companies use at least one non-GAAP measure in earnings releases instead, Griffin and Lont write.

In May 2016 the SEC told companies who present rosier results via unaudited, non-GAAP numbers that, as a regulator, it was concerned. The SEC issued updated guidelines to reset behavior.

Read: SEC targets companies who use made-up accounting metrics

By late 2016, according to research firm Audit Analytics, more than 25% of S&P 500 companies had changed their presentation to put GAAP numbers at the top of quarterly earnings releases again and 81% reestablished GAAP numbers as the most prominent results compared with only 52% in the prior quarter. In Oct. 2017 the SEC published a lengthy update to the 2016 guidelines, reaffirming its rules for presentation and consistency and adding some very specific new items such as treatment of funds from operations, free cash flow, and forecasts provided during a merger or acquisition.

See also: SEC is once again ‘guiding’ companies on their use of non-GAAP numbers

Also read: SEC tells companies to be careful how they talk about free cash flow

Griffin and Lout presented their paper at the annual meeting of the American Accounting Association, a gathering of accounting academics, on August 7 in Washington D.C. Their findings are based on analysis of hundreds of thousands of quarterly earnings forecasts and reports for more than 4,700 companies. The trend toward bigger earnings surprises appears across the entire sample, but is most pronounced among the S&P 500.

This result is “disquieting” the professors write, “because given their focus on strong corporate governance practices and accounting controls, one might predict that S&P 500 firms as a group should be the least likely to reflect an increasing trend in positive Street earnings surprises driven by a growing gap in Street earnings and Street expectations. Apparently, S&P 500 firms are driven by a stronger need to generate positive earnings surprises than are other firms.”

Large earnings surprises in this range grew to about 25.5% of all earnings surprises in 2016 from only about 12.1% in 2000. At the same time, the proportion of Street earnings reports that barely met or exceeded analysts’ predictions by between zero and a penny dropped by about 15% and the proportion between a penny and two cents fell by about 5%.

Why are companies using non-GAAP metrics to manipulate results? If the trend in bigger earnings surprises points to earnings manipulation, the manipulation “must be of a different form and, possibly, one more acceptable to shareholders’ agents such as auditors, directors, and regulators.”

See: From a wrist slap to jail time: how the SEC deals with dodgy accounting

See also: SEC fines marketing company for perks, non-GAAP metric disclosure issues

Auditors and regulators are traditionally focused on ferreting out small-time earnings manipulation. Driving bigger earnings surprises through non-GAAP metrics works because of the growing acceptance of non-GAAP numbers. Analysts enable this behavior, since they may “increasingly bias their Street expectations downwards to generate a more positive response [from earnings surprises] for their clients – that is, they engage in strategic pessimism,” the authors write.

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