Non-GAAP Earnings Disclosure and IPO Pricing

Abstract

The disclosure of non-GAAP earnings measures is increasingly common among firms undergoing initial public offerings (IPOs). However, the influence of this disclosure practice on IPO price formation is largely unexplored. We address this issue by investigating the underlying determinants of non-GAAP disclosure in IPO prospectuses and the effect of these metrics on asymmetric uncertainty and partial price adjustment in the IPO process. Using a sample of 696 book-built IPOs completed between 2003 and 2012, we find that firms disclosing non-GAAP earnings figures exclude an economically significant amount of income statement line items in calculating their non-GAAP earnings figures. Our manual inspection of IPO prospectuses reveals that the majority of these exclusions pertain to recurring expenses. We find that the disclosure of non-GAAP earnings in IPO filings is largely influenced by (1) GAAP-based operating performance, (2) industry-peer effects, (3) litigation risk, (4) the presence of venture funding, and (5) the use of non-GAAP metrics in debt covenants. Our pricing tests indicate that the earnings adjustments contained in non-GAAP prospectuses are positively associated with asymmetric uncertainty as proxied by IPO underpricing and post-issue return volatility. Underwriters tend to lowball the initial price estimates of non-GAAP IPOs (especially when issuers exclude recurring expenses), followed by under-adjustment of the offer price after book building. Additional analyses suggest that this under-adjustment reflects agency conflicts between issuers and underwriters. Lastly, we find evidence that, while some firms use non-GAAP disclosures to mitigate underpricing and lowballing, others act aggressively in their disclosure practices.