Academic journal article Management Accounting Quarterly

The Value Relevance of S&P's Core Earnings vs. GAAP Earnings

Academic journal article Management Accounting Quarterly

The Value Relevance of S&P's Core Earnings vs. GAAP Earnings

Article excerpt

In 2002, Standard & Poor's (S&P) introduced a proprietary earnings measure called Core Earnings that is based on inputs received from financial analysts, portfolio managers, corporate executives, and academic researchers. The distinguishing feature of Core Earnings is its consistent treatment of seven adjustments to U.S. Generally Accepted Accounting Principles (GAAP) earnings, which managers and analysts often use inconsistently. This article reports the results of a study we conducted that provides empirical evidence about the value relevance of Core Earnings relative to GAAP earnings and is an extension of a prior academic study. (1)

We will discuss the practical implications of our study's primary findings. Specifically, if Core Earnings is more value relevant than GAAP earnings, then corporate controllers and CFOs should give serious consideration to reporting the Core Earnings number on a supplementary basis once S&P releases it. In fact, a reconciliation schedule highlighting the nature and amounts of the Core Earnings adjustments most likely would be even more useful to financial analysts and other investment professionals. Analysts could provide forecasts of both Core Earnings and GAAP earnings to better inform investors about their expectations of the firm's ongoing core operations on both a short-term and long-term basis.

What's in a Number?

In addition to its value to analysts, the Core Earnings number is potentially very useful to a company's corporate and divisional controllers. For example, Core Earnings would be a more suitable measure to apply in evaluating the performance of individual divisions. Whether return on investment (ROI) or residual income is the performance metric, the Core Earnings number is the more appropriate earnings base for the evaluation process because it eliminates items that do not represent the fundamental operating activities of the firm. For example, a gain or loss on the sale of a plant asset affects a division's normal income, but using Core Earnings as the base for evaluation would eliminate the gain or loss. Also, removal of a material gain may unmask poor divisional core operating performance, and, in similar fashion, the removal of a material loss may reveal exceptional core operating performance. Another example is the elimination of the goodwill impairment charge, which would enable the divisional manager to be evaluated based on factors that are within his or her control rather than on factors brought on by macroeconomic downturns, such as the recession of 2008.

The Core Earnings number also allows the controller to prepare a reconciliation of GAAP earnings and Core Earnings. This detailed explanation of the sources of difference between the two numbers would provide a de facto form of variance analysis at a corporate-wide level that will enable management to determine which nonrecurring reconciliation items affect the GAAP net income number. Furthermore, such an analysis would enable managers to consider whether they may have some degree of discretion over any of the reconciliation items. For example, pension interest costs and postretirement costs are mostly nondiscretionary, while a plant asset sale that would trigger the recognition of a gain or loss is more subject to managers' discretion. Thus, management accountants within the firm could work closely with managers to effect changes in the events that give rise to the reconciliation adjustments.

From an external perspective, the company's corporate controller and CFO should give serious thought to reporting both the GAAP earnings number and the Core Earnings number in their earnings announcement releases. Through such a dual reporting mechanism, analysts and investors will have ready access to the Core Earnings number without having to perform the necessary reconciliation process to GAAP earnings. Given that our empirical results have indicated that the Core Earnings number is the more informative one, analysts and investors would immediately benefit from such ready access and would enable the capital market to operate more efficiently in the process. …

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