Earnings Quality in the Microfinance Industry
by
Leif Atle Beisland
and
Roy Mersland
Abstract
This study investigates the popular claim that reported earnings are invalid as a performance measure of microfinance institutions. Using earnings quality metrics from the accounting literature, we are unable to document lower earnings quality for microfinance institutions than for listed corporations. Moreover, we find that the proposed alternative in the microfinance industry to reported earnings, adjusted earnings, do not score higher on earnings quality metrics than do reported earnings. This first study of earnings quality in the microfinance industry suggests that reported earnings are a relevant measure of the current and future financial performance of microfinance institutions.
1. Introduction
Microfinance institutions (MFIs) supply financial services to micro-enterprises and low income families. MFIs pursue the double bottom lines of social development and financial returns, and their funding is supplied by a range of sources, from donations to commercial investments. Microfinance is thus an arena in which donors meet professional investors. MFIs can be incorporated as banks, non-bank financial institutions, non-governmental organisations, cooperatives/credit unions, and state banks. Mersland and Strøm (2008) show that legal incorporation has little influence on MFIs’ performance as they all are required to be financial sustainable in order to survive over time. Microfinance is now a large industry. Currently, more than 3000 MFIs report their numbers to www.microfinancesummit.org and serve altogether more than 150 million people with microcredit. More than 100 international funds invest in MFIs, and microfinance is about to become an important asset class for investors, particularly those pursuing both financial and social returns (www.mixmarket.org).
Measuring the performance of MFIs has long been a controversial topic in the industry. First, measuring the social outcome of microfinance is a problem (Schreiner 2002; Hashemi 2007). Secondly, it is also frequently claimed that bottom line accounting earnings are invalid as financial performance measures because subsidies and grants may constitute a portion of the income for many MFIs (Yaron 1992; Christen et al. 1995; Schreiner 1997; Manos and Yaron 2009). Moreover, the financial information issued by the MFIs has been criticised for being scarce and inadequately standardised (Gutierrez-Nieto and Serrano-Cinca, 2007). Various guidelines on how to measure financial performance have been issued in response to these claims (Bruett 2005), and subsidy adjusted earnings measures have sometimes been applied as alternative performance measures for MFIs. In addition to adjusting for subsidies, this earnings number may include adjustments for inflation, loan provisions and write-offs (Manos and Yaron 2009). However, despite the claim that bottom line earnings are almost useless as a measure, and that the adjusted earnings measure constitutes a better alternative, little has been done to examine the quality and information content of the two measures.
Financial reporting trustworthiness is of vital importance to the stakeholders of the microfinance industry. For instance, lenders and donors study accounting reports in detail before contracting with an MFI. At the MIXMARKET site (www.mixmarket.org), MFIs can present their profiles to investors and others; the best grade is only given to those presenting audited and externally rated financial accounts. In this study, we set out to be the first to consider MFIs’ accounting numbers in relation to earnings quality literature, and to apply earning quality theories and statistical tests to these numbers. We examine whether the earnings quality of MFIs differ significantly from that of publically listed companies, and we investigate whether the quality of reported earnings differs from the supposedly improved adjusted earnings measures. Our research is motivated by prior research suggesting that earnings quality is of great importance to investors (Michelson and Jordan-Wagner 2000; Francis et al. 2003), and to all parties that use accounting measures for contracting purposes (Crabtree and Maher 2005; Francis et al. 2006). Although MFIs have important social objectives as well, we expect that donors and investors nonetheless have an interest in knowing whether MFIs’ earnings accurately convey information about the current and future profitability of the MFIs.
In the accounting literature, earnings are said to be of high quality if they are representative of long term earning ability (Melumad and Nissim, 2008). We apply earnings quality metrics similar to those used in traditional accounting literature and analyse the quality of both reported bottom line earnings and adjusted earnings measures. Our results indicate that the quality of reported earnings in the microfinance industry differs little from that of other industries. The scores on earnings attributes, such as stability and predictability, are very similar to the values reported for listed companies. We find no evidence of more widespread earnings manipulation in microfinance than in other industries, and the reported earnings that have been brought into question do appear relevant to the industry’s stakeholders. Moreover, we do not find that adjusted earnings are superior to reported earnings, as far as earnings quality is concerned. Reported earnings generally achieve at least as high of scores on earnings quality metrics as do adjusted earnings. However, we cannot rule out the possibility that adjusted earnings is a superior measure if the purpose is to compare the financial performance of a microfinance institution with that of an “ordinary”, private corporation.
This paper is organised as follows: Section 2 discusses the theoretical background for the paper, presents our expectations and lays out the research design of the empirical study. Section 3 describes the data sample, and Section 4 displays and discusses the empirical findings. Section 5 concludes the paper.
2. Theoretical Background, Expectations and Research Design
2.1. Earnings quality
Accounting information is used for a variety of purposes, such as equity investment, management compensation and debt contracts (Barth et al. 2001). Bottom line earnings are the financial report’s summary measure of the value creation of a company or organisation. However, the information content of bottom line earnings is dependent on the so-called earnings quality. Professionals use the term “high earnings quality” to signal high reporting trustworthiness. Nonetheless, no unique definition of earnings quality exists (Ben-Hsien and Da-Hsien 2004). Earnings quality relates to how well accounting figures reflect a firm’s economic state, but earnings quality can be measured based on a variety of factors. For instance, Francis et al. (2004) consider the following factors, which they refer to as earnings attributes: accrual quality, persistence, predictability, smoothness, value relevance, and timeliness and conservatism. In a similar vein, Barth, Landsman and Lang (2008) maintain that earnings quality is associated with less earnings management, more timely loss recognition and higher value relevance of earnings and book values of equity. We will define the earnings attributes applied in this study later in this section, but for now we turn to Melumad and Nissim (2008) who offer a more specific interpretation of the general concept of earnings quality. Melumad and Nissim (2008) simply contend that “earnings are of high quality if they are representative of long term earning ability” (p. 91). Moreover, they maintain that earnings are representative of long term earnings ability if they are less likely to be overstated, reflect the change in net asset value due to earning activities, are recurring, stable and predictable, and include accruals that are strongly related to cash flows.
Prior accounting research has documented that earnings quality matters to stock investors (Michelson et al. 2000; Francis et al. 2004). Francis et al. (2004) conclude that the companies with the least favourable values on the various earnings attributes experience larger cost of capital than those with the most favourable values. Their finding is explained by information risk. Firm-specific information risk is priced, and favourable earnings attributes reduce the information risk. Firm value is the present value of future free cash flows, and accounting earnings can be viewed as the allocation of cash flows to reporting periods. Earnings figures reduce investors’ information risk if they reflect the current and future cash flow generating capabilities of a firm. Earnings are of higher quality if they map into future cash flows. Further, earnings are of higher quality if they are persistent, because investors then do not need to be concerned about the likelihood of an earnings increase continuing into future periods. Collectively, an abundance of research suggests that earnings are the foremost measure of company performance (Dechow 1994; Graham et al. 2005; Graham et al. 2006; Subramanyam and Venkatachalam 2007).
The measures of earnings quality can be categorised into accounting-based attributes and market-based attributes, respectively. If considering the attributes investigated by Francis et al. (2004), then accrual quality, persistence, predictability and smoothness can be labelled accounting based attributes, whereas value relevance and timeliness are the market based earnings attributes. The metrics can nonetheless be expected to be highly related. For instance, from the perspective of investors, the main purpose of financial reporting is to assist in the valuation of companies, or more precisely, the valuation of equity. The degree to which accounting information is able to fulfil this important goal can be determined through studies of the accounting information’s value relevance. However, earnings attributes such as persistence and predictability are often a prerequisite for relevance. If earnings lack persistence and predictability, it is very unlikely that earnings numbers will be particularly useful in valuation (cf. Beisland Forthcoming). Melumad and Nissim (2008) argue that practitioners seem to equate earnings quality with earnings persistence, possibly due to the extensive use of multiple-based valuation, such as the price-to-earnings ratio. This claim is indirectly supported by Francis et al. (2004), who report that the largest cost of equity effects are observed for the accounting based attributes of earnings quality. Moreover, Francis et al. (2003) document higher price-earnings multiples for firms with smooth earnings, while Michelson et al. (2000) show that U.S. earnings smoothers have a higher cumulative abnormal return than non-smoothers. Crabtree and Maher (2005) find that the degree of predictability of firms earnings is positively associated with a firm’s bond rating, and negatively associated with the firm’s offering yield. All these studies contribute to explaining managers’ “obsession” with stable earnings; in a survey by Graham et al. (2005), 96.9% of all CFOs prefer stable earnings, with a surprising 78% willing to give up company value for this stability. Note, however, that earnings quality is not only relevant in company valuation; earnings quality is also of interest to those who use financial reports for contracting purposes (e.g., manager compensations). Schipper and Vincent (2003) state that contracting decisions based on low quality earnings in general will induce unintended welfare transfers.
2.2 Earnings quality in the microfinance industry
Most research on earnings quality has been conducted on publicly listed companies (Dechow and Dichev 2002; Francis et al. 2004; Barth et al. 2008; Dichev and Tang 2009). As far as we know, no prior studies have analysed the earnings quality of MFIs as measured with the earnings quality metrics developed in the accounting literature. However, several stakeholders have interest in and study in detail the financial numbers reported by the MFI. For example, debt holders in the microfinance industry normally demand quarterly or monthly reporting of earnings, boards use financial reports to monitor management and negotiate CEO compensation, and employees, donors, and others are informed about the MFI’s situation through financial numbers. Financial reports make up the core of MFI information at the MIXMARKET site (www.mixmarket.org), the most important matching website for MFIs, funders, service providers and networks. Earnings quality is thus also important in the microfinance industry.
Earnings quality is a more complicated measure for MFIs than for private corporations. The main goal of a private corporation is to maximise shareholder wealth. An MFI typically has multiple sets of goals, of which several are related to so-called social performance. Zeller and Meyer (2002) argue that the performance of MFIs should be assessed according to the following three attributes: financial sustainability, outreach to the poor and the welfare impact of microfinance. Financial sustainability can be seen as a prerequisite for the two latter purposes, as the MFI, by definition, will cease to exist if not financial sustainable. Thus, regardless of the multidimensional goals of MFIs, there is a considerable need for trustworthy financial performance and sustainability measures. In this study, we focus solely on the financial performance measurement, but it should be noted that the challenges related to correct measurement of social performance are equally important in the industry (see discussion in Gutierrez-Nieto and Serrano-Cinka, 2007).
Prospective investors in exchange listed companies typically have access to large amounts of financial performance information that they can investigate before making a decision about whether or not to invest in a company. Investors can also obtain thorough information about the corporation through participation in the company’s board. However, MFIs are mostly financed through loans and grants, and the lenders and donors often have limited knowledge about the companies that they want to invest in. Decisions are often based on rather scarce and poorly standardised financial information (Gutierrez-Nieto & Serrano-Cinka, 2007). Moreover, due to the fact that that traditional profitability metrics ignore subsidies and grants received by many MFIs and overlook their opportunity costs, it is often claimed that standard accounting measures of profitability are invalid for assessing the financial sustainability of MFIs (Yaron 1992; Christen et al. 1995; Manos and Yaron 2009). This acknowledgement has led to the establishment of adjusted earnings measures for the microfinance industry. The adjusted earnings measures have facilitated the computation of adjusted return on equity (AROE) and adjusted return on assets (AROA).[1]
The adjusted earnings measures are typically estimated by MFI rating agencies. These rating agencies conduct so-called “global risk assessments” of MFIs, and profitability measures are important components when assigning grades to MFIs (Reille et al., 2002). The MFIs ratings are more comprehensive than traditional credit risk ratings and are an assessment of the overall activities of the MFI. The rating agencies conduct the following three types of adjustment to bottom-line earnings: adjustment for inflation, adjustment for subsidies and adjustment for loan provisions and write-offs (see www.ratingfund.org for more details). Manos and Yaron (2009) describe these adjustments, “The adjustment for inflation is to account for the fact that inflation decreases the value of net monetary assets. The adjustment for subsidies is to account for three types of subsidies: concessionary borrowings; cash donations; and in-kind subsidies. The adjustment for loan loss provisions and write-offs is to account for variation in the recognition of delinquencies and writing off of bad loans” (Manos and Yaron 2009). Bruett (2005) states that the adjustments are made to reflect the true performance of MFIs, to measure the MFIs’ ability to maintain their level of operations over the long term, and to enable benchmarking across a wide range of institutions. However, one may ask if the microfinance industry is really that different from others? Currently, the microfinance industry does not seem to acknowledge that they are not the only industry to be affected by inflation, receive different forms of subsidies, or account differently for delinquencies and loan/asset losses.