Taxes in Non-GAAP Reporting: Evidence of Strategic Behavior in Selecting Tax Rates Applied to Exclusions

Abstract

When reporting after-tax non–generally accepted accounting principles (GAAP) earnings, firms are required to adjust for the tax effects of exclusions. Since 2010, the Securities and Exchange Commission (SEC) has issued and updated compliance and disclosure interpretations (C&DIs), which specifically require firms to disclose the tax effects of exclusions. We assemble a detailed, hand-collected data set of S&P 1500 firms’ disclosures to provide the first large-sample evidence on the reporting of the tax effects of non-GAAP exclusions. We find three key results. First, echoing the SEC’s concern, a significant proportion of non-GAAP reporting firms do not follow the C&DI guidelines (i.e., they do not disclose the tax effects of exclusions). Second, among firms that disclose the tax effects of exclusions, we find that managers strategically select the tax rates applied to exclusions to achieve after-tax earnings targets. Third, manager-reported non-GAAP earnings are less persistent for future operating earnings and cash flows relative to non-GAAP earnings calculated by applying various benchmark tax rates to exclusions. This evidence suggests that managers’ strategic behavior in selecting the tax rates applied to exclusions pollutes reported non-GAAP earnings and reduces their usefulness for predicting future performance. Overall, our results shed light on a specific channel through which firms use non-GAAP reporting to meet or beat earnings expectations. This paper was accepted by Brian Bushee, accounting. Funding: N. (X.) Chen appreciates financial support from the University of Houston. T. Shevlin acknowledges financial support from the Paul Merage School of Business at the University of California–Irvine. P.-C. Chiu acknowledges the financial support received from the Hong Kong Research Grant Council [Grant RGC14522716]. Supplemental Material: Data files and the online appendix are available at https://doi.org/10.1287/mnsc.2022.4433 .