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Professor Explores Non-GAAP Accounting Pluses, Minuses

August 17, 2011 (Business Wire) Both corporate governance and the Sarbanes-Oxley Act work well in helping non-GAAP earnings reports toe the line, but opportunities for gaming the figures remain, a researcher with the University of Utah's David Eccles School of Business has found.

In her paper Non-GAAP earnings and board independence, Dr. Sarah McVay, an associate professor with the David Eccles Accounting Department, concludes that while non-GAAP methods do a better job predicting a company's future income than GAAP (Generally Accepted Accounting Principles), this unaudited figure lends itself to opportunistic manipulation and even insider trading. McVay and co-authors Richard Frankel, an Olin School of Business professor at Washington University in St. Louis, and Mark Soliman, an associate professor of accounting at the University of Washington's Foster School of Business, conclude that independent boards keep this opportunism in check.

Given the nation's recent economic woes and market instability, such weaknesses in earnings reports become even more critical as investors seek safer havens.

Since enacted in 2002, Sarbanes-Oxley's Regulation G in particular has done much to discourage such practices. However, McVay says its effectiveness relies on managers' incentives -- whether they have a direct stake in what information is released or withheld from a non-GAAP report.

"Regulation G requires a lot more exposure (of financial data). It gets us a lot of the way to where we need to be for accuracy, requiring reconciliation between non-GAAP and GAAP numbers," McVay says. "There's still some opportunism after Regulation G, but not as much." A next step would be to require non-GAAP figures to be audited to further safeguard the accuracy of these reports.

Making disclosures mandatory for a wider range of financial data, along with an emphasis on board independence and continued regulatory and investor scrutiny, would further eliminate the potential for non-GAAP inaccuracies, McVay adds.

Next up for McVay and her colleagues: a closer look at consistency, or the lack of it, in non-GAAP reporting of so-called "transitory charges." If a company excludes such charges deemed to be income-decreasing, they should also omit that data when it is income-increasing, she says. Interestingly, preliminary analyses suggest this isn't always the case.

The paper, published in the Review of Accounting Studies, can be viewed in its entirety at the SpringerLink website.  

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Copyright Business Wire 2011

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