Pro Forma Earnings Disclosures: Do Analysts and Nonprofessional Investors React Differently?

Abstract

The increase in the number of firms disclosing pro forma earnings in their earnings announcements in addition to disclosing earnings calculated according to generally accepted accounting principles (GAAP) has prompted regulators, Congress, and the financial press to voice concerns about pro forma earnings. A major concern is that pro forma earnings disclosures affect less sophisticated and more sophisticated investors differently. This paper presents an experiment that examines the effect of pro forma earnings disclosures on the judgments of nonprofessional (i.e., less sophisticated) investors and analysts (i.e., more sophisticated investors). Consistent with empirical evidence, the pro forma earnings in our experiment exceeded GAAP earnings. The results indicate that nonprofessional investors who see an earnings announcement that contains both pro forma and GAAP disclosures assess a higher stock price than do nonprofessionals who see an earnings announcement that contains only GAAP disclosures, whereas analysts' stock price judgments are not affected. Follow-up analyses suggest that the differential effect of the pro forma disclosure is due to analysts and nonprofessional investors using different valuation models and information processing. Analysts used well-defined valuation models, based on either earnings multiples or cash flows, while the nonprofessional investors generally used simpler, heuristic-based valuation models. The pro forma disclosure also caused nonprofessionals to perceive the earnings announcement as more favorable, which in turn caused them to assess a higher stock price. This effect appears to be due to unintentional cognitive effects, rather than nonprofessionals relying on the pro forma earnings information because they perceived it to be informative.