The more highly paid the chief executives of publicly listed companies, the more likely they are to use figures that don’t conform to generally accepted accounting principles, according to a University of Otago study.
Not only is the use of such non-GAAP figures increasing, but managers are more likely to use them when they miss their GAAP earnings benchmarks, the study found.
“Firms experiencing a decrease in earnings demonstrate a stronger association between CEO cash compensation and the likelihood of non-GAAP disclosure,” says one of the three authors, Dr Dinithi Ranasinghe.
“This suggests some managers may be disclosing these measures with opportunistic intentions,” Dr Ranasinghe says.
The other two authors are Dr Helen Roberts and Professor David Lont, head of the university’s department of accountancy and finance.
All the companies in the study were NZX-listed. Between 50 and 60 company reports were examined each year between 2004 and 2013 for a total of 622 in total. The financial sector was excluded.
The study found that the proportion of loss-making firms using non-GAAP figures rose from 33 percent in 2004 to 70 percent in 2013. However, in 2006 only 13 percent of loss-making firms used non-GAAP numbers.
The proportion of profitable firms reporting an earnings increase using non-GAAP figures varied considerably from 53 percent in 2004 to as few as 28 percent in 2006 and as many as 65 percent in 2012.
“Put simply, when targets are missed, it can be argued that managers are using non-standard reporting methods to help protect their compensation or detract from poor GAAP-based earnings results,” Dr Ranasinghe says.
Professor Lont says shareholders need to be wary of the use of non-GAAP numbers.
“A company may argue that their use of non-GAAP measures is to explain their performance better. But if CEOs are highlighting selective profit metrics instead of GAAP measures, due to a desire to improve their compensation or disguise poorer performance – essentially painting the picture they want investors to see whilst detracting from potential negative performance shown in GAAP measures – then this should raise alarm bells,” the professor says.
That may mean more regulation of New Zealand’s reporting of non-GAAP profit figures might be needed, he says.
On the other hand, the study found no evidence of a relationship between equity-based incentives and disclosures, “despite their inclusion in the compensation contract reducing moral hazard.”
In other words, equity-based incentives tend to better align a chief executive’s interests with that of shareholders.
“The power of the equity incentives model may be weaker because of the opaque nature of equity compensation disclosure in New Zealand,” the study says.
The authors suggest their findings can inform regulatory guidance in smaller markets with similar institutional structures to New Zealand.
“In particular, the results regarding opportunistic intentions related to CEO cash compensation indicate that regulators should mandate reconciliation provision requirements and reasons for releasing non-GAAP measures,” the study says.
It notes that GAAP accounting earnings-based performance measures often fail to capture managers’ value-increasing actions, encouraging the use of alternative performance measures such as non-financial measures, revenue targets and cost reduction goals in compensation contracts.