An understanding of the choices that companies make in financial reporting is fundamental to evaluating the overall quality—both financial reporting and earnings quality—of the reports produced. Choices exist both in how information is presented (financial reporting quality) and in how financial results are calculated (earnings quality). Choices in presentation (financial reporting quality) may be transparent to investors. Choices in the calculation of financial results (earnings quality), however, are more difficult to discern because they can be deeply embedded in the construction of reported financial results.
The availability of accounting choices enables managers to affect the reporting of financial results. Some choices increase performance and financial position in the reporting period (aggressive choices), and others increase them in later periods (conservative choices). A manager who wants to increase performance and financial position in the reporting period could:
- recognise revenue prematurely;
- use non-recurring transactions to increase profits;
- defer expenses to later periods;
- measure and report assets at higher values; and/or
- measure and report liabilities at lower values.
- A manager who wants to increase performance and financial position in a later period could:
- defer current income to a later period (save income for a “rainy day”); and/or
- recognise future expenses in a current period, setting the table for improving future performance.
Presentation Choices
Because investors try to make intercompany comparisons on a consistent basis, earnings before interest, taxes, depreciation, and amortisation (EBITDA) has become an extremely popular performance measure. EBITDA is widely viewed as eliminating noisy reporting signals. That noise may be introduced by different accounting methods among companies for depreciation, amortisation of intangible assets, and restructuring charges. Companies may construct and report their own version of EBITDA, sometimes referring to it as “adjusted EBITDA,” by adding to the list of items to exclude from net income. Items that analysts might encounter include the following:
- rental payments for operating leases, resulting in EBITDAR (earnings before interest, taxes, depreciation, amortisation, and rentals);
- equity-based compensation, usually justified on the grounds that it is a non-cash expense;
- acquisition-related charges;
- impairment charges for goodwill or other intangible assets;
- impairment charges for long-lived assets;
- litigation costs; and
- loss/gain on debt extinguishments.
The SEC intended that the definition of non-GAAP financial measures would capture all measures with the effect of depicting either:
- a measure of performance that differs from that presented in the financial statements, such as income or loss before taxes or net income or loss, as calculated in accordance with GAAP; or
- a measure of liquidity that differs from cash flow or cash flow from operations computed in accordance with GAAP.
