THE IMPACT OF THE FLEXIBILITY AND REPORTING NON-RECURRING ITEMS UNDER IAS 1 UPON FIRMS AND INVESTORS BEHAVIOUR

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THE IMPACT OF THE FLEXIBILITY AND REPORTING NON-RECURRING ITEMS UNDER IAS 1 UPON FIRMS AND INVESTORS BEHAVIOUR

RESEARCH PROPOSAL

THE IMPACT OF THE FLEXIBILITY AND REPORTING NON-RECURRING ITEMS UNDER IAS 1 UPON FIRMS’ AND INVESTORS’ BEHAVIOUR

Abstract

The thesis focusses on the use of pro forma earnings by many companies in their quarterly press releases in the belief that the disclosure provides a clear picture of companies’ main earnings. However, there are arguments by various groups including policymakers and regulators that the move tends to mislead investors because at times, management may be tempted to portray overly optimistic financial performance. In this case, disclosure of pro forma earnings greatly exposes less wealthy individual investors at risk and this research emphasizes on engagement of UK firms in earnings management and exploring classification shifting of core expenses to non-recurring items. The impact on increasing income, inclusion of abnormal working capital accruals as well as the need of meeting analysts forecast does not however relate as may be expected although huge firms tend to shift small core expenses to other non-recurring items to meet analysts’ expectations.

Introduction

Meeting analysts’ expectations by most companies is the key strategy of most management because of the consequences associated with it. The impact of the flexibility on reporting non-recurring items under IAS 1 upon firms and investors behaviour is undoubtedly immense and the act is practiced by many firms across UK (Bhattacharya et al., 2007). There are always unfortunate reactions to negative earnings and a market reward to positive earnings because of the ability to meet analysts’ expectations thus leading to actions such as inflating core earnings through classification shifting of core expenses to income increasing items (Yi, 2012).

However, when managers and analysts omit non-recurring items from core earnings, companies may decide to get involved in classification shifting of recurring losses or expenses as a way of meeting analysts’ expectation (Aubert & Grudnitski, 2012). Initially, classification shifting was empowered by FRS 3 between 1993 until the adoption of IFRS in 2005 (Athanasakou, Strong & Walker, 2009; Gori & Fissi, 2013). The adoption of 2005 IFRS enabled firms to report net income per share; nevertheless, they were supposed to differentiate between core and transitory earnings through exercise of decision in categorizing non-recurrent items. IAS 1 Presentation of Financial Statements in line with FRS 3’s provides a good peculiarity core and exceptional income components thus enabling companies to consider material items distinctly in the income statement (Bhattacharya et al., 2007; Hollie & Yu, 2012). It is worth understanding that quality of earnings improved post-FRS 3 and most firms do not use discretionary accounting choices as a way of satisfying analysts’ expectations as it used to be and there is a general concern over the potential manipulation of non-recurring items (Porter & Miles, 2013; Cameron & Gallery, 2012).

Literature Review

By analysing the impact of the flexibility and reporting non-recurring items under IAS 1 upon firms and investors’ behaviour, there are several issues that are examined such as whether UK investors trade on earnings before non-recurring and why companies voluntarily disclose earnings before non-recurring items (Yi, 2012). Adoption of FRS 3 might appear as if it has made issues clear in terms of disclosure of material items in the income statement but it is still worth proving if firms using non-recurring items. This article examines the application accruals management, classification shifting and earnings forecast in order to meet analyst expectations and logistic analysis is analysis the association of income-increasing, discretionary accruals and downward-guided forecasts (Porter & Miles, 2013). The research examines whether UK managers shift core expenses to non-recurring items to meet analyst expectations where total non-recurring items are decomposed into non-operating exceptional items and other non-recurring items.

Research Questions

Recent studies indicate that pro forma earnings information may mislead investors because expenses excluded from analysts’ street earnings tend to affect future cash flows. The study aims at answering the following research questions;

Whether investors usually understand the exclusions and perhaps the implications of excluding the expenses and the fact that investors misprice management issued pro forma numbers (Aubert & Grudnitski, 2012; Athanasakou, Strong & Walker, 2009).

Finding out who trades on pro forma earnings information and the extent in which the more and less sophisticated investors trade incrementally.

To examined whether UK investors trade on earnings before non-recurring items and why companies voluntarily discloses earnings before non-recurring items as well as whether companies use non-recurring items to mislead investors (Bhattacharya et al., 2007).

The research will further shed light on the mechanisms UK companies use to meet analysts’ expectations including focussing on the downward-guided forecasts’ effects on the probability of meeting analysts’ expectations. It also gathers evidence that is consistent with classification shifting of other non-recurring items to hit analyst earnings forecasts and if the UK firms are likely to engage in earnings forecasts guidance for a subset of larger firms. Moreover, the investors who are always at risk are the ordinary ones because they lack proper information that can help them in making decision. The main reason for carrying out the research is to understand the impact of reporting non-recurring earnings and the eventual effect it has on both investors and the firms including the investors’ behaviour towards investment. Amid the introduction of FRS 3, there have been several challenges that encompass most firms in UK when it comes to reporting of the non-recurring earnings and this is what the study intends to focus on.

Methodology

Goal of the study is to examine whether UK firms usually engage in accruals, classification shifting and examination of earnings or expectations management to meet analyst expectations that requires testing of the association between probability of hitting the target and earnings. There will be estimation of abnormal accruals, misclassified non-recurring items as well as downward guided analysts’ forecasts while for non-recurring items, it may be difficult to estimate the part resulting from intentional misclassifications because of uncertainty (Barth, Gow & Taylor, 2012). The actual methodologies that will be used in the research process from its time of inception to the end include the role of both the secondary and the primary data in the process of addressing the various research questions will be. Data will be collected from the managers, peer reviews and a few identifiable investors especially ordinary investors (Bhattacharya et al., 2007). This will be done with an in-depth reflection of the research design and other related ethical issues and on choosing the best design, different aspects will be considered like the availability of resources in terms of finances and time.

An evaluative case study approach will be done for in this research as well as qualitative approaches to descriptive and non-experimental research methods for a more accurate result. Questionnaires designed and used to collect data on different personal views will apply and they will be given to managers who will respond to their views on reporting non-recurring items under IAS 1 upon firms and investors’ behavior. This research will incorporate phenomenology in carrying out the study because it is best suited for the proposed study since it corresponds with the study question (Barth, Gow & Taylor, 2012). The study will try to find out the main underlying reasons for reporting non-recurring items and emphasize on the intentionality of perception in situations where experiences have both inward and outward. The study will involve participants such as the managers and experts within the financial sector as well as investors who are likely to be affected by management decisions.

PR Newswire and Business Wire on LexisNexis will be researched to gather sample of pro forma press releases where a typical pro forma press release will contain the GAAP earnings per share figure. There will also be a pro forma earnings number for an adjusted GAAP earnings measure voluntarily disclosed by managers for the current year as well as other relevant information that may help in completing the research (Crawford & Weirich, 2011). There are also earnings announcements where the company discloses a pro forma that is different from the diluted EPS that are released in the same press (Bhattacharya et al., 2007). Firms’ quarter observations that can make data available will be searched from some other intraday transactions data will be obtained from all trades and quotes from the NYSE, AMEX and NASDAQ especially those trades with a condition code of regular sale. Opening trade will be excluded because it can add challenge to the measures put in place but trade with regular sales are included they result from continuous two-sided auctions (Athanasakou, Strong & Walker, 2009). There will be collection of adjusted-GAAP diluted earnings per share numbers disclosed by managers in their earnings press release and benchmark investor reactions with diluted earnings per share from operations.

Importance of the Study

This study is very significant because regulators and standard setters’ opinions are very important, as far as investment is concerned. The research indicates that manager’s pro forma disclosures are incomplete, inaccurate, and misleading investors and that more versus less sophisticated investors may respond differently to these nonstandard. The research will show how less wealthy and less sophisticated individual investors are affected by the management information; something that may impose a great risks to the investors in general (Johnson, Lopez & Sanchez, 2011). Pro forma earnings greatly informs the investors especially the sophisticated investors who reject trading around pro forma earnings announcements even though they do not welcome the trade that is based on manager disclosed pro forma earnings information (Christensen, 2012).

Most investments are evaluated in terms of return expectations, which are geared towards achieving long-term goals that have always been susceptible. The management information may serve the major function of risk and investments evaluation amongst ordinary investors who are susceptible (Bhattacharya et al., 2007; Enahoro & Jayeoba, 2013). Management information on pro forma earnings may help in establishing the relative long-term stability of risk rather than the associated returns and provide unique insights with practical applications for more maximizing returns and less risk.

The study will further shed light on the mechanisms UK firms apply in meeting expectations and provide examination of earnings forecast guidance and two earnings management mechanisms (Aubert & Grudnitski, 2012). The research will also help in understanding the market and even help investors know what to expect as a certain degree of earnings or expectations from the firms’ managers. Moreover, the significance of the research is the fact that it provides an idea regarding how UK firms guide analysts forecast down or perhaps engages in classification shifting (Frankel, Mcvay & Soliman, 2011). The main aim of managers is to make sure the target is attainable although and even enable investors understand the market rewards. Understanding accounting standards based on earnings management and the outcome of the UK regulatory bodies in the early 1990s. The research may provide a good guidance regarding earnings forecast and provide an avenue for further research in the area of study (Athanasakou, Strong & Walker, 2009; Eccles, Holt & Zatolokina, 2011). The study will provide important knowledge deemed vital in understanding the influence of the flexibility and reporting non-recurring items under IAS 1 upon firms and investors’ behavior. The way in which the issue raises auditor’s suspicion will be keenly looked at in order to shed light on the dangers of the management’s decisions when it comes to pro forma.

Conclusion

It is apparent that less sophisticated investors’ abnormal net buying activities but only affects the ordinary investors who are exposed to higher risk because of their full dependence on the information (Ben-Shahar, Sulganik & Tsang, 2011). Disclosures by the management may at times be misleading because there are expenses and other material items left behind (Aubert & Grudnitski, 2012). Regulators and other standard setters should therefore come out clearly to defend the ordinary investors who are less informed concerning activities taking place. Rigorous transparent requirements should be employed to make sure those investors or firms do not negative impact that may be associated with the management’s decisions. The regulatory framework applied in reporting financial performance and the mechanisms firms utilize should focus on improving general quality of earnings.

References

Athanasakou, Vasiliki, Strong, Norman and Walker, Martin. 2009. Earnings management or forecast guidance to meet analyst expectations? Accounting and Business Research, 39.1. 3-35.

Aubert, F. & Grudnitski, G. 2012, “Analysts’ estimates”, Review of Accounting & Finance, vol. 11, no. 1, pp. 53-72.

Barth, M. E., Gow, I. D., & Taylor, D., J 2012. Why do pro forma and street earnings not reflect changes in GAAP? evidence from SFAS 123R. Review of Accounting Studies, 17(3), 526-562. doi:http://dx.doi.org/10.1007/s11142-012-9192-9

Ben-Shahar, D., Sulganik, E. & Tsang, D. 2011, “Funds from Operations versus Net Income: Examining the Dividend Relevance of REIT Performance Measures”, The Journal of Real Estate Research, vol. 33, no. 3, pp. 415-441.

Bhattacharya, Nilabhra, Black, Ervin, Christensen, Theodore and Mergenthaler, Richard. 2007. Who Trades on Pro Forma Earnings Information? The Accounting Review, 82.3. 581-619.

Cameron, R. & Gallery, N. 2012, “Were regulatory changes in reporting “abnormal items” justified?”, Journal of Accounting & Organizational Change, vol. 8, no. 2, pp. 160-185.

Christensen, T.E., 2012. Discussion of “Why do pro forma and street earnings not reflect changes in GAAP? Evidence from SFAS 123R”. Review of Accounting Studies, 17(3), pp. 563-571.

Crawford, R.L. & Weirich, T.R. 2011, “Fraud guidance for corporate counsel reviewing financial statements and reports”, Journal of Financial Crime, vol. 18, no. 4, pp. 347-360.

Eccles, T., Holt, A. & Zatolokina, A. 2011, “Commercial service charge management: benchmarking best practice”, Journal of Corporate Real Estate, vol. 13, no. 4, pp. 200-215.

Enahoro, J.A. & Jayeoba, J., 2013. Value Measurement and Disclosures in Fair Value Accounting. Asian Economic and Financial Review, 3(9), pp. 1170.

Frankel, R., Mcvay, S. and Soliman, M., 2011. Non-GAAP earnings and board independence. Review of Accounting Studies, 16(4), pp. 719-744.

Gori, E. & Fissi, S. 2013, “From Cash to Accrual Accounting: A Model to Evaluate the Performance of Public Museums”, Revista de Management Comparat International, vol. 14, no. 4, pp. 519-541.

Hollie, D. & Yu, S.C. 2012, “Do Reconciliations Of Segment Earnings Affect Stock Prices?”, Journal of Applied Business Research, vol. 28, no. 5, pp. 1085-1106.

Johnson, P.M., Lopez, T.J. & Sanchez, J.M. 2011, “Special Items: A Descriptive Analysis”, Accounting Horizons, vol. 25, no. 3, pp. 511-536.

Porter, T. & Miles, P. 2013, “CSR Longevity: Evidence from Long-Term Practices in Large Corporations”, Corporate Reputation Review, vol. 16, no. 4, pp. 313-340.

Yi, H. 2012, “Has Regulation G Improved the Information Quality of Non-GAAP Earnings Disclosures?”, Seoul Journal of Business, vol. 18, no. 2, pp. 95-145.

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