Academic journal article Management Accounting Quarterly

The Predictive Ability of S&P's Core Earnings: An In-Sample, Out-of-Sample Estimation Approach

Academic journal article Management Accounting Quarterly

The Predictive Ability of S&P's Core Earnings: An In-Sample, Out-of-Sample Estimation Approach

Article excerpt

An important characteristic of decision-useful accounting information is its predictive or confirmatory value. Since valuation methodologies typically feature the discounting of expected future cash flows, any accounting metric that enhances the accuracy of operating cash flow forecasts should be compelling to business managers, investors, and academics alike.

A long-standing body of accounting literature analyzes the relative predictive ability of earnings and cash flow measures. Generally, these discussions assert that earnings calculated in accordance with Generally Accepted Accounting Principles (GAAP) are a better predictor of future cash flows than past cash flows.1 Further, disaggregation of GAAP earnings into different accrual components seems to improve their predictive ability.2

Nevertheless, several issues might impair the predictive capacity of GAAP earnings. For example, GAAP results are prone to earnings management, may be too standardized to be useful, and often include nonrecurring items. In principle, manager-adjusted, "non-GAAP" earnings could alleviate these drawbacks, but at the risk of an acute credibility problem.

In 2002, Standard & Poor's (S&P) seized on its position as an objective arbiter and set out to combine the strengths of GAAP and non-GAAP earnings with its own adjusted earnings metric, Core Earnings. This metric is calculated through standardized adjustments to GAAP earnings in order to measure companies' core operating performance.3 To the extent that this approach succeeds in eliminating nonrecurring or otherwise uninformative items, it should yield an earnings figure more apt at predicting future performance than GAAP earnings do.

This poses an interesting line of inquiry worth testing: Has S&P's Core Earnings metric indeed lived up to this expectation? These days it also bears renewed relevance as standard setters, including the International Accounting Standards Board (IASB), contemplate the inclusion of non-GAAP earnings measures on financial statements. One potential avenue open to the IASB is to require that companies present on their financial statements a standardized measure of operating/recurring profit defined by the Board.4 Given the inherent similarity of such an approach with the underlying idea of Core Earnings, new insights from this study on the predictive ability of S&P's Core Earnings may contribute to the current debate.

CORE EARNINGS

Non-GAAP earnings are described as those that "either exclude or include amounts that are included or excluded in the most directly comparable GAAP measure."5 Although the term "non-GAAP earnings" typically refers to adjusted earnings calculated and communicated by managers, this definition highlights that the universe of non-GAAP earnings is much larger. In fact, S&P's Core Earnings also exclude or include amounts included or excluded in GAAP earnings and therefore fall within the scope of this definition. Thus, the Core Earnings metric-and potentially other objective proprietary metrics-can be seen as a special type of non-GAAP earnings metric that has stronger credibility compared to manager-communicated non-GAAP earnings.

The introduction of Core Earnings in 2002 coincided with a challenging period for corporate financial reporting and the accounting profession. High-profile corporate bankruptcies and accounting scandals that engulfed companies such as Enron and WorldCom fed an erosion of trust in GAAP earnings. An increasing proliferation of manager-reported non-GAAP earnings also nurtured uncertainties about companies' true earnings power. In response, U.S. lawmakers would pass the SarbanesOxley Act of 2002, and the U.S. Securities & Exchange Commission (SEC) would adopt regulations to address manager-adjusted non-GAAP measures/earnings.

Given that backdrop, S&P's Core Earnings metric was applauded upon its initial release. Bloomberg Businessweek hailed it with the expectation that it "would make it far more difficult for companies to hoodwink investors by playing games with their earnings" and argued Core Earnings would ultimately ensure more accurate valuations. …

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