Non-GAAP Reporting Research Articles

Economic Policy Uncertainty and Firms’ Non-GAAP Reporting

Using the US economic policy uncertainty (EPU) index developed by Baker, S. R., Bloom, N., & Davis, S. J. [2016. Measuring economic policy uncertainty. The Quarterly Journal of Economics, 131(4), 1593–1636. https://doi.org/10.1093/qje/qjw024], we examine the impact of policy uncertainty on firms’ non-GAAP reporting practices. We show that EPU increases both the likelihood and quality of non-GAAP earnings disclosures. These effects are more pronounced for firms with higher index ownership and for those with less informative GAAP earnings. Furthermore, we show that non-GAAP disclosures provide tangible economic benefit during periods of increasing EPU, including compensating for the reduced informativeness of GAAP earnings and reducing information asymmetry. Overall, our evidence suggests that non-GAAP reporting is a means by which managers communicate value-relevant information about their firms’ performance to investors during periods of high EPU.

Non-GAAP Reporting and Investment

ABSTRACT The wide-spread reporting of non-GAAP earnings suggests efficiency gains from doing so. By estimating a dynamic investment model, we examine the real implications of investors using both GAAP and non-GAAP earnings to value firms. When investors use the firm’s GAAP earnings only, the firm’s manager—who cares about current stock prices—underinvests, and his investment is sensitive to transitory earnings. Non-GAAP earnings can improve investment efficiency by adjusting for these transitory earnings, but can also hide inefficient investment by introducing opportunistic bias. Although non-GAAP earnings induce overinvestment, they dominate GAAP-only reporting. Counterfactual analysis reveals supplementing GAAP earnings with biased non-GAAP earnings increases firm value by 3.4 percent relative to GAAP-only reporting. Precluding bias reduces overinvestment and further increases firm value by 1 percent. Data Availability: Data are available from the sources cited in the text. JEL Classifications: E22; G31; G34; M40.

Local newspaper closures and non-GAAP reporting quality

This study examines the impact of local newspapers on the quality of firms’ non-GAAP reporting, a common form of voluntary disclosure. Local newspapers act as effective gatekeepers for local activities and provide valuable information to the public. Using the closure of local newspapers as a plausibly exogenous shock to newspaper coverage, we observe a decrease in firms’ non-GAAP reporting quality following such closures. This suggests that local media coverage is an effective external governance mechanism for firms’ voluntary disclosures. The effect is more pronounced for firms with low-quality ex-ante information environments. Our results remain robust to falsification tests using pseudo-event dates or alternative research designs. This study underscores the importance of supporting the sustainability of local media.

Government Subsidies and Non-GAAP Reporting

Government Subsidies and Non-GAAP Reporting

Passive Ownership and Aggressive Non-GAAP Reporting

Passive Ownership and Aggressive Non-GAAP Reporting

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

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 .

Labor Unionization and Non-GAAP Reporting

Labor Unionization and Non-GAAP Reporting

Essays on the Influence of Accounting Regulation on Non-GAAP Reporting

Essays on the Influence of Accounting Regulation on Non-GAAP Reporting

Non-GAAP Reporting and Investment

Managers’ incentives depend on their firms’ stock prices, which are often determined by investors using earnings. When investors use GAAP earnings, managers’ investment decisions into internally generated intangible assets become sensitive to the transitory items in these earnings. Non-GAAP earnings can remove these transitory items, and thus improve investment efficiency, but also introduce opportunistic bias, and thus hide inefficient investment. We quantify this trade-off by estimating a dynamic model in which a manager makes investment and non-GAAP disclosure decisions and where investors rationally anticipate his incentives. We find the manager’s ability to distort non-GAAP earnings creates inefficient investment choices and destroys firm value. We estimate the magnitude of the loss in the average firm value at just under 1%.

Non-GAAP Reporting and Investor Attention: Are Investors Misled by Exclusions of Recurring Expenses from Non-GAAP Earnings before Restatement Announcements?

Material financial restatements reveal GAAP-based misreporting and thus are a strong signal of low GAAP reporting quality. We explore these reporting shocks and investigate whether heightened investor scrutiny of GAAP reporting quality after material restatements has a spillover effect on investors’ perceptions of aggressive non-GAAP reporting choices. We find that investors reward aggressive non-GAAP reporting choices before material restatements (i.e., ERC premium) but penalize the same reporting choices after material restatements (i.e., ERC discount). Furthermore, we document that short- and long-term market reactions to material restatements are more negative for firms that aggressively reported non-GAAP earnings before the announcement of material restatements. We provide evidence that heightened investor scrutiny of GAAP reporting quality affects investors’ perceptions of aggressive non-GAAP reporting choices. Finally, our findings are consistent with the idea that aggressive non-GAAP reporting choices misled investors before material restatement announcements.

Non-GAAP Reporting and Debt Market Outcomes: Evidence from Regulation G

We exploit the introduction of Regulation G (RegG) by the U.S. Securities and Exchange Commission (SEC) in 2003 to study the association between non-GAAP earnings disclosure and debt market outcomes. Specifically, we focus on a subset of 199 S&P 500 firms to analyse the association between non-GAAP earnings disclosure and long-term issuer credit ratings as well as bond spreads before and after the regulatory intervention. We find that post-RegG, correlation between non-GAAP earnings disclosure and bond spreads changes from positive to negative but do not document any change in its correlation with respect to credit ratings. Our study provides first evidence that post-RegG, bond investors, but not rating agencies, seem to view non-GAAP earnings disclosure favourably as part of their credit risk assessment. In practical terms, our results document a specific benefit of RegG and may inform the SEC that its goal of more accurate security pricing extends to the bond markets, which is an under-researched area in the context of non-GAAP regulation.

Disclosure Prominence and the Quality of Non-GAAP Earnings

The SEC prohibits the presentation of non-GAAP measures before corresponding GAAP measures; however, a large proportion of non-GAAP reporters present non-GAAP EPS before GAAP EPS in their earnings announcements. This noncompliance raises questions about whether firms use prominence to highlight higher- or lower-quality non-GAAP information. For firms reporting non-GAAP EPS between 2003 and 2016, prominent non-GAAP EPS is associated with higher-quality non-GAAP reporting. Further tests reveal that nonregulatory incentives, rather than regulatory costs, explain this relation. Specifically, prominence is associated with higher-quality non-GAAP reporting in settings where prominence is not regulated, investors ignore prominence when non-GAAP reporting quality is lower, and the minority of firms using prominence to mislead exhibit characteristics associated with weaker investor monitoring. Overall, we provide evidence that regulatory noncompliance can reflect an intent to inform, and that most firms use prominence to highlight higher-quality non-GAAP information despite prohibitive regulation.

Analysts’ Role in Shaping Non-GAAP Reporting: Evidence from a Natural Experiment

We examine how exogenous changes in analyst coverage influence the likelihood that managers will voluntarily disclose customized (non-GAAP) performance metrics and the relative quality of their non-GAAP reporting. Specifically, we use a quasi-natural-experimental setting in which brokerage firms terminate analyst coverage and find that, following an unanticipated decrease in analyst coverage, managers are more likely to disclose non-GAAP performance metrics. We also find that managers become more aggressive in their disclosure choices and that the quality of their non-GAAP exclusions decreases after analysts terminate coverage. These effects are more pronounced among firms losing an analyst with greater ability and firms with weaker corporate governance. Overall, our evidence indicates that analysts play a monitoring role with respect to managers' non-GAAP disclosures and that managers become more aggressive in their non-GAAP reporting following an exogenous decline in analysts’ influence.

Policy Implications of Research on Non-GAAP Reporting

Over the past two decades, the regulatory landscape for non-GAAP reporting has evolved significantly. Despite a temporary decline in the frequency of non-GAAP reporting following Regulation G, the incidence of non-GAAP disclosure has continued to increase steadily, leading to a current all-time high in reporting activity. This proliferation of non-GAAP disclosure has captured the attention of standard setters and regulators in recent years. This paper provides an academic perspective on policy implications for both regulation and standard setting. We contend that current Compliance and Disclosure Interpretations (C&DIs) of the SEC staff may perhaps have gone too far in restricting certain types of non-GAAP disclosures. As a result, we advocate a slight relaxation of the current enforcement of Regulation G. We agree with FASB proposals for greater disaggregation in the income statement to allow for more transparency in non-GAAP reporting. Finally, we believe the PCAOB should consider requiring auditors to take a more direct role with respect to non-GAAP disclosures.

Non-GAAP Reporting and Accounting Restatement

In this study, I examine whether disclosing Non-GAAP earnings is a signal of experiencing accounting restatement. I propose a scenario in which earnings are managed within the constraints of GAAP guidelines, as long as there is sufficient leeway to permit income-increasing accounting choices. Managers usually avoid issuing Non-GAAP earnings because of severe penalties. If this becomes no longer possible within GAAP earning management, managers have incentives to cross the line into Non-GAAP territory. At this point, disclosing Non-GAAP earnings is positively associated with accounting restatement because of the great magnitude of earnings management. I find that firms with restatements experience a significant increase in the relative use of disclosing Non-GAAP earnings with positive other exclusions. Firms with the positive other exclusions excluded from Non-GAAP earnings may exhibit increased likelihood of fraud or core-earnings restatement. Finally, firms disclosing Non-GAAP earnings and having high accounting complexity are more likely to restate than those disclosing Non-GAAP earnings and having low accounting complexity.

Non-GAAP Reporting: Evidence from Academia and Current Practice

The SEC, FASB, and IASB have expressed interest in the recent proliferation of non-GAAP reporting, raising questions about what this increasing reporting trend means for IFRS- and GAAP-based reporting. Our goal is (1) to inform standard setters and regulators about the current state of non-GAAP reporting and (2) explore how the discretion afforded in non-GAAP reporting influences earnings consistency and comparability, two tenets of IFRS- and GAAP-based earnings. We begin by providing an up-to-date discussion of the most common questions examined in the extant literature to provide insights on what academics have learned to date about non-GAAP reporting. Next, we utilize a novel dataset of detailed non-GAAP disclosures to provide in-depth descriptive evidence on the current state of non-GAAP reporting. We find that the frequency of non-GAAP reporting has increased by 35% in recent years, a trend that we find in every sector. We also provide evidence on how the frequency and magnitude of specific exclusions has changed over time. Of particular interest is the increasing frequency with which firms exclude items that are not commonly excluded by other firms, indicating that more idiosyncratic definitions of non-GAAP earnings are emerging in the marketplace. Finally, we examine how discretion in non-GAAP reporting affects earnings consistency and comparability. We find that the consistency with which firms exclude specific items varies across exclusion types. Importantly, we also find some evidence that inconsistent non-GAAP reporting is associated with lower quality non-GAAP metrics. In examining across-firm comparability, we find descriptive evidence indicating that within-sector performance rankings based on GAAP earnings better explains concurrent stock returns than comparisons based on non-GAAP earnings. However, our preliminary analyses indicate that these differences are not statistically significant.

Litigation Risk and Non-GAAP Reporting

The SEC has recently raised renewed concerns about firms’ reporting of adjusted (non-GAAP) earnings metrics. Regulators have significant interest in understanding the factors that help constrain non-GAAP reporting. We first provide evidence on the relation between securities litigation risk and firms’ propensity to report non-GAAP earnings. We then provide evidence on how this relation is moderated by the regulation of non-GAAP disclosure under Reg G. Using a plausibly exogenous litigation shock based on a U.S. circuit court ruling, we find a robust negative relation between litigation risk and non-GAAP reporting prior to the passage of Reg G. This negative relation suggests that, in the absence of rules-based regulation of non-GAAP reporting, litigation risk helps to constrain non-GAAP disclosure. However, our evidence suggests that the subsequent regulation of non-GAAP disclosure has decreased the sensitivity of non-GAAP disclosure to litigation risk. Specifically, we find that differences in non-GAAP reporting across judicial circuits are diminished and the negative association between litigation risk and non-GAAP reporting is significantly attenuated following the implementation of Reg G. Our results are consistent with claims that Reg G has had the unintended consequence of shielding firms’ non-GAAP disclosures from litigation risk by creating a de facto “safe harbor” for non-GAAP disclosure. Finally, we use our quasi-natural-experimental setting to validate a new proxy for circuit-specific litigation risk that future researchers can employ in any setting.

Disentangling Managerss and Analystss Non-GAAP Reporting Incentives

Prior research has struggled to disentangle managers’ and analysts’ roles in non-GAAP reporting. As a result, it is unclear whether prior evidence regarding non-GAAP reporting incentives is attributable to managers, analysts, or both parties. We address these challenges by creating a large-scale dataset of managers’ non-GAAP disclosures to compare to analyst-provided non-GAAP numbers. We find that managers’ and analysts’ practices differ in systematic ways, indicating that both parties play a significant role in non-GAAP reporting. Next, we examine the interaction between managers and analysts to identify scenarios where each party is likely responsible for non-GAAP reporting and examine their reporting incentives. We find that informativeness is an important motivator for both parties. However, it is most important when analysts are involved and less important when managers independently report non-GAAP metrics. Thus, we find that both managers and analysts play a role in defining non-GAAP metrics and that considering the reporting practices of both parties is important for identifying who is responsible for, and the incentives that motivate, non-GAAP reporting. In addition to the non-GAAP literature, our study (1) contributes to the disclosure literature more generally by providing evidence on how managers and analysts interact to influence disclosure choices and (2) provides information on the recent proliferation of non-GAAP metrics – a topic of significant interest to regulators and standard setters.

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

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.

Empirical Evidence on the Effects of Measurement Error in Non-GAAP Earnings Research

This study examines how measurement error in earnings expectations affects prior evidence regarding (1) investors’ preferences for GAAP versus non-GAAP earnings and (2) the quality of non-GAAP reporting in meet-or-beat settings. Prior research on non-GAAP reporting computes earnings surprises for both GAAP and non-GAAP earnings relative to analysts’ non-GAAP earnings forecasts. As a result, GAAP earnings surprises are subject to measurement error due to the use of a misaligned earnings expectation. Many studies highlight this measurement error problem and caution that evidence of an investor preference for non-GAAP earnings might simply be due to the mechanical error in GAAP surprises, which creates statistical bias in favor of non-GAAP earnings. Utilizing newly available GAAP forecasts, we find that the traditional GAAP earnings surprise is comprised of 60% measurement error, on average. Nevertheless, we find that the impact of this form of measurement error on inferences regarding investors’ preferred earnings metric is small, and provide evidence that the reason the impact is small is that the components measured with error have low persistence. Next, we examine how measurement error influences inferences regarding the use of non-GAAP exclusions to meet-or-beat analysts’ forecasts. Contrary to prior evidence, after we correct for measurement error, we find that the non-GAAP disclosures of benchmark-beating firms are of lower quality than those of other non-GAAP reporters.