The overall complexity of financial disclosures affects the ability of anyone reading the financial statements, including stockholders, regulators, and investors, to analyze and assess the information presented.
One way to measure complexity of disclosures is by determining accounting reporting complexity (ARC) based on the nature and characteristics of a company’s eXtensible Business Reporting Language (XBRL) disclosures. XBRL tags are computer-readable, allowing companies to precisely label thousands of pieces of information in financial reports that can be readily accessed for public consumption.
In a recent study, Accounting Reporting Complexity and Non-GAAP Earnings Disclosure, Nerissa C. Brown [Gies College of Business, University of Illinois at Urbana-Champaign], Shira Cohen [Fox School of Business, Temple University], and Adrienna A. Huffman [The Brattle Group] examined if accounting reporting complexity in financial disclosures has an effect on the use of non-GAAP earnings measures and the quality of those earnings measures.
Proliferation of non-GAAP measures that do not follow Generally Accepted Accounting Principles (GAAP) has become more common than ever before in financial reporting and is a concern of its own. As we discussed in our non-GAAP report and as can be seen below, 96% of S&P 500 companies are using non-GAAP metrics:
Going back to the paper, the authors state that “stakeholders posit that the proliferation of non-GAAP earnings measures in corporate disclosures reflects the increasing complexity of GAAP accounting.” Shareholders reading financial statements may be unable to decipher the complex technical metrics. To assist shareholders, management can use less complicated non-GAAP metrics and remove accounting items that may cause confusion. The decision to use a non-GAAP metric, and which items to remove from the GAAP measure, may be linked to ARC.
To study this phenomenon, Brown et. al, using Audit Analytics data, tested the hypothesis that ARC influences firms’ decisions to voluntarily disclose an adjusted earnings measure. To test the hypothesis, quarterly non-GAAP earnings data was merged with detailed quarterly XBRL tags on annual reports (10-Ks) and quarterly reports (10-Qs) for U.S. based firms between 2011 and 2015.
The selection criteria for the study returned a population sample of 23,524 firm-quarters for 2,653 firms over 18 calendar-quarters between Q2 2011 and Q3 2015. Of the sample, roughly 50% disclosed a non-GAAP EPS figure in the quarterly earnings release.
Overall, the results of the study suggest that non-GAAP disclosure decisions made by management are sensitive to ARC, particularly complexity arising from reporting standards related to GAAP.
The study found that when ARC was in the 75th percentile, or more complex, management was 16% more likely to disclose a non-GAAP adjusted earnings metric. Results indicate that when ARC is higher, earnings line items are more likely to be excluded when they have complex accounting guidelines.
Previous literature has discussed substantial overlap between managers’ and analysts’ provisions for non-GAAP earnings – when reporting metrics and accounting areas are particularly complex, managers and analysts are more likely to use customized earnings metrics.
This study found novel evidence to the current literature that managers and analysts are more likely to deviate in their provision of non-GAAP earnings when accounting reporting complexity is high in particular accounting areas – specifically, deferred revenue and business combinations, suggesting that revenue streams and business combinations are an important factor in explaining differences between managers’ and analysts’ provision of non-GAAP earnings information.
According to the results of the study, the effect of ARC on non-GAAP disclosures is incrementally related to the effects of other forms of complexity, such as operational complexity and disclosure readability. The results indicate that certain variables, such as the total number of words in the filing and the number of geographic reporting segments, are positively associated with managers’ propensity to disclose an adjusted earnings figure. Meaning, companies with wordy filings or numerous reporting segments are more likely to have complexities in other areas and are then more likely to use non-GAAP measures.
Further analysis of the study results show that the quality of managers’ earnings exclusions is more likely to increase proportionally with ARC. When ARC is high and non-GAAP figures must be derived, management is likely to exclude earnings items of a higher quality, although low-quality adjustments were observed in some situations with certain GAAP areas that have high reporting complexity.
These results indicate that managers make higher quality earnings adjustments in their efforts to decrease reporting complexity of GAAP accounting. Furthermore, the researchers concluded that the results indicate that investors perceive non-GAAP earnings information as more informative when ARC is high, suggesting that further simplification of certain accounting areas might be necessary in order to improve the quality non-GAAP earnings measures.
The results of this study indicate that accounting reporting complexity plays a significant role in management’s decision to disclose non-GAAP earnings information and speaks to the importance of standard-setting implications of non-GAAP performance measures.
Our Thoughts on Accounting Reporting Complexity and Use of Non-GAAP
Considering over 96% of S&P 500 companies use at least one non-GAAP metric, it is important to understand the relationship between a substantial use of non-GAAP and overly complex accounting.
Although it is not uncommon for large companies to use adjusted earnings that deviate from generally accepted accounting principles, companies with overly complex business may choose to present more than one metric of the same type. According to our analysis, 7% of the S&P 500 used more than one EPS metric. The top six companies by market cap that disclosed at least two non-GAAP EPS metrics are listed below:
Take for example, General Electric [GE], a large conglomerate notorious for the use of multiple complex non-GAAP metrics. In Q3 2017, GE pledged to simplify the adjusted earnings per share (EPS) numbers that are reported to investors after disclosing four distinct EPS metrics in their earnings release. The move came after GE received criticism from investors that the accounting is too complex, and in some cases, too difficult to understand. 1 2 3
As evidenced by GE’s use of extensive adjusted earnings, using non-GAAP metrics in an attempt to simplify financial reporting does not guarantee an increase in readability and transparency. Some even argued that GE’s performance was negatively impacted by the complex reporting.
The use of non-GAAP metrics alone cannot be used as a yard stick for accounting complexity, as presentation of non-GAAP metrics may, in many cases, be helpful in clarifying the underlying business. The important takeaway is that the number of non-GAAP metrics used can provide a good gauge of underlying accounting complexity.
The Accounting Quality + Risk Matrix by Audit Analytics tracks red flags and events, including an Accounting Disclosure Complexity metric, that can be used for screening, idea generation, portfolio monitoring and risk management for every SEC registrant. For more information please contact us at info@auditanalytics.com or (508) 476-7007.
1. https://www.marketwatch.com/story/general-electric-reports-4-different-eps-numbers-2016-07-22 ↩
2. https://www.bloomberg.com/news/articles/2017-10-16/ge-s-profit-reports-are-unfathomable-investors-notice-sec-too ↩
3. https://www.wsj.com/articles/ges-numbers-game-pick-from-four-earnings-figures-1509364801 ↩