Accounting Valuation: Is Earnings Quality an Issue?

From a valuation perspective, no “best”—or even consistent—measure of pro forma earnings exists. An increasing number of companies are including pro forma earnings together with net income figures in their earnings releases. The explanation offered by these companies is that the pro forma numbers reflect the company's true earning power more accurately than net income numbers based on generally accepted accounting principles. Company support for such estimates of earnings is echoed by analysts. Regulators, however, are concerned about the potentially misleading qualities of non-GAAP earnings measures. In response to concerns about pro forma earnings, the Financial Accounting Standards Board recently proposed an agenda project related to the use of pro forma data in which it cites three concerns. First, companies are increasingly relying on pro forma performance measures in earnings releases and other investor-related communications. Second, no common definitions of the elements of financial performance exist and practices regarding their presentation are inconsistent. Third, no consensus exists about which performance measures should be in financial statements. The concern over which measure of income is the most meaningful for valuation has produced a host of empirical studies designed to estimate the “quality” of competing earnings measures. The specific results are a mixed bag; findings depend on the earnings measures being compared, the time period, the sample of companies, and the metric used. The overall result, however, is that the differences in information conveyed by the competing definitions of earnings—from GAAP earnings to pro forma income—are not large. In addition, the empirical studies suffer from the problems that non-GAAP earnings also are not unambiguously defined and that different companies compute pro forma income differently. As a result, studies that compare GAAP earnings with pro forma income may not be comparing the same two measures for all companies. The thesis of this article is that, from a valuation perspective, the entire debate about earnings quality is theoretically unresolvable. No consistently meaningful way is available to condense all the historical financial information that is relevant for forecasting future performance into one measure (or a time series of one measure). Furthermore, attempts by regulatory/standard-setting bodies to determine an appropriate definition of “pro forma income” distracts attention from more-critical problems involving omissions and ambiguities in the constituent items that make up any measure of earnings. We make two arguments. First, none of the measures of earnings, including GAAP, condenses financial statement information satisfactorily for forecasting purposes. Second, no meaningful criterion exists for determining whether one earnings measure is better than another. The principal conclusion of the discussions is that efforts to determine which measure of earnings is appropriate for a company to disseminate are misguided. What is critical is that the basic elements that comprise any measure of earnings be presented with sufficient clarity and at a sufficient level of disaggregation that investors can answer fundamental questions about revenues, costs, and capital. If sufficient data are available to answer these questions, investors can aggregate the basic information into any earnings measure they believe provides the most insight into forecasting future cash flows. The second conclusion is that, although companies should be free to provide any aggregate measure of earnings that they deem appropriate, they should follow some basic guidelines. Because none of the alternatives to GAAP earnings is precisely defined or consistently applied, companies that release non-GAAP numbers should explain how the numbers differ from the GAAP numbers.