Issue 6 | Spring 2010

business & finance

Earnings Quality Not Necessarily Impacted by GAAP Effect

Key metric is still evolving

Despite a reliance on umpteen pages of principles and prescriptive rules for the preparation of financial statements, much depends on professional judgment and corporate governance. That’s why the quality of the company’s reported earnings is such an important consideration for analysts and investors.

Analysts watch closely for the possibility that management may have manipulated earnings through the way transactions were recorded and/or structured. Earnings quality can just as easily be affected by honest errors in professional judgment. After all, exercising of professional judgment and interpretation of accounting standards are activities conducted by human beings and, as such, perfection may not always be consistently achievable.

But what if the accounting standards themselves were to change? Would that impact in any way the quality of the firm’s reported earnings? Should the earnings from one jurisdiction be considered more reliable than the earnings from a jurisdiction using different standards? A CGA-Canada research report explores this topic by analyzing the accrual ratios (as a proxy for earnings quality) of 100 Canadian and 100 comparable American companies to assess the earnings quality differential between them. It found no statistically significant evidence to conclude that financial statements from one jurisdiction would feature higher earnings quality than those from the other jurisdiction.

There are numerous definitions of earnings quality, but generally the term refers to the reliability and reasonableness of the earnings reported in an entity’s financial statements. It is also used as an indicator of whether those reported earnings might be sustained in future years. It is a factor of corporate governance, the rigor of accounting standards, and the efficacy of capital market regulators.

Canadian public companies prepare their financial reports according to Canadian Generally Accepted Accounting Principles (GAAP), while U.S. companies follow U.S. GAAP. While all accounting standards are in reality a mix of principles and rules, Canadian GAAP is generally thought to be more principles-based (as are International Financial Reporting Standards, which will take effect in Canada on January 1, 2011), while U.S. GAAP is generally considered more rules-based. The purpose of the study was to determine whether there was a consistent difference in earnings quality in the two jurisdictions and if such a difference could be attributed to the different accounting standards employed.

The report builds on earlier research studies, in particular one comparing earnings quality under rules-based accounting standards to earnings quality under principles-based standards conducted by Erin Webster and Daniel B. Thornton of Queens University. The CGA report, written by the association’s Research and Standards department principal Kamalesh Gosalia, identifies and addresses potential limitations in the previous study.

As proxy for earnings quality, the CGA study compared accrual ratios – the difference between reported earnings and cash flow, scaled to make allowance for the differences in size – for Canadian and U.S. public companies over the period 1998 to 2008, a period that coincided with the boom to bust cycle of the stock markets in both countries. Ten companies were selected from both Canada and the United States in each of ten major sectors matched for size. Accrual ratios were used as a proxy for earnings quality in both the CGA study and the earlier Webster and Thornton study as aggregate accruals are an inverse measure of earnings quality. While minor differences were found in the materials and consumer discretionary sectors in certain reporting years, differences in other sectors were not significant.

Mean Accrual Ratios for 10 different economic sectors for both Canada and the United States during the period 1998 to 2008. Click on the numbers at the bottom of the graph (or the arrows that appear to the sides of the graph) to advance to the next sector.

The report is CGA-Canada’s first foray in recent years into academic accounting research and its intent is to build on previous research and contribute to the profession’s body of knowledge. Unlike the association’s applied research into public policy issues, the report does not lead to policy recommendations directly, but advances knowledge that may facilitate policy formulation.

“Recent corporate scandals have illustrated once again why earnings quality is such an important metric,” says Rock Lefebvre, CGA-Canada’s Vice-President of Research and Standards and sponsor of the report. “The concept of earnings quality is still evolving. It is influenced by many variables and there are still different opinions as to how it should be defined and measured.”

Differences in oversight between jurisdictions may also impact earnings quality. The study points out that oversight of U.S. financial reporting is carried out by the “supposedly extremely vigilant U.S. Securities and Exchange Commission” while “an allegedly lax and fragmented securities regulation regime” provides that function in Canada. As a result, it is not possible to isolate the impact of different accounting standards on earnings quality from other contributing factors.

The report notes that there is a tremendous opportunity for more research into the measurement of earnings quality and how it is impacted by various factors. However, the real opportunity to study the “GAAP effect” will come when a jurisdiction switches from one system of GAAP to another, provided the other contributing factors do not change. A likely opportunity may arise if the U.S. adopts IFRS, however such a scenario would likely make the whole question of the “GAAP effect” somewhat of a moot point.

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