Creditor Intervention and Non-GAAP Reporting: Evidence from Debt Covenant Violations

Abstract

We investigate how firms strategically vary their non-GAAP reporting policies following debt covenant violations. We find that while the frequency of non-GAAP reporting declines following covenant violations, the quality of non-GAAP reporting improves significantly along multiple dimensions. Specifically, when firms decide to report non-GAAP earnings after a covenant violation, the customized performance metric is (1) placed less prominently within the press release, (2) less likely to meet or beat analysts’ forecasts when the GAAP number falls short, and (3) marginally less likely to exclude recurring expenses. Moreover, the significant association between non-GAAP exclusions and future GAAP operating earnings disappears following covenant violations, indicating improvement in exclusion quality. Overall, our evidence indicates that non-GAAP reporting at least partly reflects managers’ opportunistic motives, and firms adjust their non-GAAP reporting policies in response to increased shareholder monitoring resulting from the transfer of control rights following covenant violations. Additional analyses rule out the alternative explanation that shareholders delegate monitoring to creditors. More importantly, these analyses indicate that shareholders’ demand for financial information actually increases following covenant violations, and that shareholders appear to achieve their monitoring objectives through independent directors and auditor scrutiny.