An Analytical Model Of Audits In Disclosure Of Pro Forma Earnings

Abstract

Firms have discretion on financial reporting under Generally Accepted Accounting Principles or GAAP. The proliferation in recent years of earnings metrics that deviate from GAAP figures confounds investors' ability to compare firm financial performance. Non-GAAP (or pro forma) figures usually do not include certain balance sheet or income statement items that are required under GAAP. Regulators and accounting standard-setting body are concerned that pro forma financial measures have been used by management to mislead investors by overstating or smoothing earnings or to meet Wall Street earnings expectations. On the other hand, management asserts that by excluding certain nonrecurring and noncash items, pro forma earnings are more relevant in measuring firm performance. Indeed, prior empirical studies provide evidence that certain pro forma measures may have incremental information content over GAAP earnings. Pro forma earnings are typically unaudited and the quality of disclosures accompanying such measures varies across firms. This paper develops an analytical (mathematical) model to examine whether firms will exhibit higher credibility through auditor selection when disclosing pro forma earnings. This study extends prior empirical literature by providing an analytical perspective on the importance of attestation performed by auditors regarding pro forma earnings. The model in this study suggests that managers who possess superior information than shareholders in an asymmetric information setting and expect high future earnings are more likely to engage large auditors when disclosing pro forma earnings. As such, the model may explain the voluntary disclosure of accounting information by managers in capital markets.