Pro Forma Earnings Research Articles

Adjusted versus unadjusted earnings: An empirical analysis of pro forma adjustments in large German public companies

AbstractThis article analyzes non‐GAAP, pro forma earnings metrics of large German publicly traded companies to better understand their usage and relevance in practice. We base our analysis on a hand collected data set compiled from annual reports. Almost all companies in our data set use pro forma earnings. Typically, legal, restructuring, acquisition and accounting related costs get adjusted. EBIT, EBITDA, EPS and Net income are the most frequently adjusted earnings metrics. In almost all observed cases, pro forma earnings are higher than their underlying GAAP earnings. Our study addresses the challenge of investors to understand a company's “true” operating performance. Only when one understands the historically observable financial performance, one can make better predictions of its recurring, future financial performance. The article adds to the existing literature by analyzing in which part of the annual report pro forma earnings are typically disclosed, how transparent they are presented and reconciled, and what impact adjustments have compared to the unadjusted GAAP earnings.

An Analytical Model Of Audits In Disclosure Of Pro Forma Earnings

Firms have discretion on financial reporting under Generally Accepted Accounting Principles or GAAP. The proliferation in recent years of earnings metrics that deviate from GAAP figures confounds investors' ability to compare firm financial performance. Non-GAAP (or pro forma) figures usually do not include certain balance sheet or income statement items that are required under GAAP. Regulators and accounting standard-setting body are concerned that pro forma financial measures have been used by management to mislead investors by overstating or smoothing earnings or to meet Wall Street earnings expectations. On the other hand, management asserts that by excluding certain nonrecurring and noncash items, pro forma earnings are more relevant in measuring firm performance. Indeed, prior empirical studies provide evidence that certain pro forma measures may have incremental information content over GAAP earnings. Pro forma earnings are typically unaudited and the quality of disclosures accompanying such measures varies across firms. This paper develops an analytical (mathematical) model to examine whether firms will exhibit higher credibility through auditor selection when disclosing pro forma earnings. This study extends prior empirical literature by providing an analytical perspective on the importance of attestation performed by auditors regarding pro forma earnings. The model in this study suggests that managers who possess superior information than shareholders in an asymmetric information setting and expect high future earnings are more likely to engage large auditors when disclosing pro forma earnings. As such, the model may explain the voluntary disclosure of accounting information by managers in capital markets.

Street versus GAAP: Which Effective Tax Rate Is More Informative?*

ABSTRACTThis study investigates how sophisticated market participants use tax‐based information by examining whether analysts' street effective tax rates (ETRs) are informative. When assessing firm performance, analysts exclude items they believe do not reflect current performance, resulting in “street” metrics such as street ETR. However, evidence on the properties of the components of street earnings is limited. Examining the informativeness of street ETRs is important because taxes are a significant component of earnings, and the extent to which analysts understand taxes and incorporate them into their analyses is not clear. Using a hand‐collected sample of analyst reports, we find that while approximately 35% of street ETRs have at least one tax‐specific exclusion, over 90% reflect the tax effects of pre‐tax exclusions. Further, both tax‐specific exclusions and the tax effects of pre‐tax exclusions significantly contribute to differences between GAAP and street ETRs. Consistent with analysts' understanding of the implications of tax and nontax exclusions, our results suggest that street tax metrics exhibit greater predictive ability about future tax outcomes and provide more information to investors than GAAP tax metrics. We also find that ETR exclusions are of higher quality when the magnitude of the potentially excluded item is greater and when managers disclose pro forma earnings. Collectively, our findings suggest that analysts understand taxes, but selectively exert effort to incorporate tax‐based information into their assessment of firm performance. Our study should be informative to regulators and users of financial information because it provides evidence regarding the usefulness of street earnings metrics.

Street vs. GAAP: Which Effective Tax Rate Is More Informative?

This study investigates how sophisticated market participants use tax-based information by examining whether analysts’ street effective tax rates (ETRs) are informative. When assessing firm performance, analysts exclude items they believe do not reflect current performance, resulting in “street” metrics such as street ETR. However, evidence on the properties of the components of street earnings is limited. Examining the informativeness of street ETRs is important because taxes are a significant component of earnings, and the extent to which analysts understand and incorporate taxes into their analyses is not clear. Using a hand-collected sample of analyst reports, we find that while approximately 35 percent of street ETRs have at least one tax-specific exclusion, over 90 percent reflect the tax effects of pre-tax exclusions. Further, both tax-specific exclusions and the tax effects of pre-tax exclusions significantly contribute to differences between GAAP and street ETRs. Consistent with analysts understanding the implications of tax and non-tax exclusions, our results suggest that street tax metrics exhibit greater predictive ability about future tax outcomes and provide more information to investors than GAAP tax metrics. We also find that ETR exclusions are of higher quality when the magnitude of the potentially excluded item is greater and when managers disclose pro forma earnings. Collectively, our findings suggest that analysts understand taxes, but selectively exert effort to incorporate tax-based information into their assessment of firm performance. Our study should be informative to regulators and users of financial information because it provides evidence regarding the usefulness of street earnings metrics.

Bidder earnings forecasts in mergers and acquisitions

This study finds that pro-forma earnings forecasts by bidding firms during acquisitions are associated with a higher likelihood of deal completion, expedited deal closing, and with a lower acquisition premium − but only in stock-financed acquisitions. Analysts also respond to these forecasts by revising their forecasts for the bidder upward. However, the benefits of forecast disclosure only accrue to bidders with a strong forecasting reputation prior to the acquisition. Explaining why not all bidders forecast, we document a higher likelihood of post-merger litigation and CEO turnover for bidders with a weak forecasting reputation and for those that underperform post-merger.

Alternative performance measures: An assessment after ESMA Guidelines

In July 2016, ESMA Guidelines that set out principles regarding the presentation of non-GAAP measures (ESMA Guidelines on Alternative Performance Measures – APMs) became effective. The guidelines should reduce the mispricing caused by pro forma earnings, and improve investor protection and the transparency of financial information. We provide a preliminary assessment of the impact of these guidelines on 2016 reports on a sample of European Small and medium-sized enterprises (SMEs) listed on regulated markets. Using univariate and multivariate regressions, we demonstrate a significant relationship between Alternative performance measures disclosed in the press releases and stock prices in the period after the ESMA Guidelines. APMs are relevant information for investors and more adherence to the ESMA reporting guidelines may generate a positive impact on stock prices and short-term returns. The findings also contribute to demonstrate that the European regulation about non-GAAP measures will reduce the asymmetry of information between users, particularly between capital owners and management, which may lead to increased users’ confidence since they will be able to evaluate more effectively issuers’ performance.

Presentation Slides for 'Limited Attention, Information Disclosure, and Financial Reporting'

This paper models firms' choices between alternative means of presenting information, and the effects of different presentations on market prices when investors have limited attention and processing power. In a market equilibrium with partially attentive investors, we examine the effects of alternative: levels of discretion in pro forma earnings disclosure, methods of accounting for employee option compensation, and degrees of aggregation in reporting. We derive empirical implications relating pro forma adjustments, option compensation, the growth, persistence, and informativeness of earnings, short-run managerial incentives, and other firm characteristics to stock price reactions, misvaluation, long-run abnormal returns, and corporate decisions. The paper is available at: http://ssrn.com/abstract=334940.

Do aggressive pro forma earnings-reporting firms have difficulty disclosing intellectual capital? Australian evidence

PurposeThe purpose of this paper is to investigate whether aggressive pro forma earnings-reporting firms are difficult in relation to signalling sufficient intellectual capital (IC), and how the market reacts to aggressive pro forma earnings reporting.Design/methodology/approachContent analysis of 610 annual reports of Australian firms listed on the Australian Securities Exchange 200 is used to obtain IC information. Fixed-effects logistic and ordinary least squares (OLS) regressions are used to examine the hypotheses.FindingsThe study finds that aggressive pro forma earnings reporting is negatively and significantly associated with sufficient IC disclosure. Moreover, this paper finds that investors react favourably to aggressive pro forma earnings reporting, and believe that pro forma earnings have greater incremental value-relevance information than statutory earnings.Research limitations/implicationsThe coding framework used in this study comprises 33 IC items. Other studies have used coding frameworks comprising fewer or more varied IC items. Therefore, when comparing the results of this and other studies, the interpretation of the findings must recognise the differences in approach.Practical implicationsSufficient IC disclosure may help investors to distinguish high-reporting-quality firms and low-reporting-quality firms. The paper demonstrates that aggressive pro forma earnings-reporting firms, which are low-reporting-quality firms, are less likely to disclose sufficient IC.Originality/valueThis paper is the first to examine the relationship between aggressive pro forma reporting and IC disclosure. Moreover, this paper built a theoretical framework based on signalling theory to develop research hypotheses, which extend the research on IC underpinned by signalling theory.

Pro Forma Disclosure and Investor Sophistication: External Validation of Experimental Evidence Using Archival Data

Insights on how ordinary, less-sophisticated investors interpret and process management-issued pro forma earnings numbers are useful to regulators because of concerns that pro forma disclosures are misleading to ordinary investors. Two recent experimental studies (Frederickson and Miller, 2004 and Elliott, 2006) find that the existence of a pro forma number in the earnings press release as well as the relative placement of the pro forma and GAAP earnings figures within the press release affect the judgments of less-sophisticated investors but not those of more-sophisticated investors. Experimental and archival methodologies complement one another and results that persist in both settings are likely to be robust to both internal and external validity concerns. Therefore, we complement experimental evidence using trade-size-based proxies constructed from intraday transactions data to distinguish the trading activities of less-sophisticated investors from more-sophisticated investors. Our results suggest that less-sophisticated investors rely significantly more on quarterly earnings press releases that include a pro forma number than on those that do not, while more-sophisticated investors exhibit the opposite behavior. This result is consistent with Frederickson and Miller's experimental evidence. Further, consistent with Elliott's results, we find that less-sophisticated investors rely more on the pro forma figure when it is placed before the GAAP earnings number in the press release, while more-sophisticated investors' trading behavior is unaffected by the relative placement of the two earnings metrics. We conclude that the existence of a pro forma number as well as its strategic placement in the press release generally affect the judgments of less-sophisticated (but not more-sophisticated) investors and these inferences are robust because they persist in both experimental and archival settings.

Extraordinary Items—An Elusive Concept

ABSTRACT Since the appearances of “extraordinary” gains and losses in the authoritative GAAP literature in 1917, the debate over how to report such items has continued for a century. Until the 1970s, the reporting of extraordinary items was widespread. During recent decades, however, the frequency of reported extraordinary items decreased sharply. Only 1.5 percent of companies reported them in 2014, followed in January 2015 by their elimination from U.S. GAAP. In this paper, we investigate factors affecting the decline in reporting of extraordinary items and reasons for their elimination from U.S. GAAP. Factors include evolving criteria for defining extraordinary items, variation in their financial statement placement, and their changing nature and size over the years. We examine several important FASB pronouncements and events that contributed to the elimination of extraordinary items, including APB Opinion No. 30 in 1973, the FASB's treatment of the losses from the World Trade Center attack in 2001, the FASB and IASB's convergence initiative, the FASB's simplification initiative, and widespread use of pro forma earnings in practice.

Pro Forma Accounting Reconciliation Disclosures: The Effect of Financial Reporting Knowledge and Information Viewing Behavior on Judgments of Nonprofessional Investors

This study extends prior research by examining the extent to which financial reporting knowledge and information viewing behavior affect the influence of reconciled non-GAAP, or “pro forma” earnings disclosures on nonprofessional investors’ judgments. We find that the effects of pro forma earnings information on participants’ judgments differ, depending on their level of financial reporting knowledge and the amount of time they spent viewing the earnings reconciliation relative to other earnings information. Our results suggest that the effectiveness of financial reporting regulation may be dependent on characteristics of the general investing public that vary across investors. Regulators and standard setters need to be aware of the possible differential effects of financial reporting knowledge and investor type as they consider non-GAAP earnings reporting requirements.

Pro Forma Earnings Presentation Effects and Investment Decisions

ABSTRACTReacting to the criticism that companies routinely mislead investors by emphasizing non-GAAP or pro forma numbers, the SEC promulgated Regulation G in 2003, which requires firms to provide a reconciliation of the pro forma and GAAP numbers. In this study, we conduct an experiment to examine how investors' GAAP and non-GAAP earnings performance assessments affect their financial evaluations and investment decisions based on the presentation format of the reconciliation (presenting a full non-GAAP income statement, referred to as the full NGIS format, versus presenting only the items that caused the difference between GAAP and non-GAAP measures, referred to as the summary NGIS format). We find that even though a summary NGIS format for the reconciliation of pro forma earnings does not increase the perceived non-GAAP earnings performance, it does increase the weight given to non-GAAP earnings performance when making investment-related judgments and decisions, relative to a full NGIS format. These findings regarding the evaluation and weighting of non-GAAP earnings performance extend prior studies and suggest that non-GAAP earnings information may be processed differently based upon the format of the reconciliation. Further, our finding regarding the weighting of non-GAAP earnings performance is inconsistent with the concern expressed by the SEC that the full NGIS format may give greater prominence to non-GAAP information. Finally, the implications of these findings for regulators, investors, and future research are discussed.Data Availability: Contact the authors.

Are CEOs Held Accountable for Unrecognized Expenses? The Case of Implied Employee Option Expense

An extensive body of research has investigated whether CEOs are held accountable for various earnings components by testing the sensitivity of CEO cash compensation to these earnings components. No study, however, has examined whether CEOs are held accountable for expenses unrecognized in earnings. This study investigates whether CEOs were held accountable for fair value employee stock option (ESO) expense in the period 1996-2005, during which the expense was not recognized, but rather implied by pro forma earnings disclosed in the footnotes under SFAS No. 123. Controlling for CEO stock option grants and other variables, I find that CEO cash compensation decreased with implied fair value ESO expense in the second half of the period 1996-2005 but not in the first half. The result represents the first evidence that CEOs can be held accountable for unrecognized expenses and how boards of directors view an unrecognized expense may be influenced by public opinions (accounting for fair value ESO expense was hotly debated in late 1990s and early 2000s). In high-tech industries, however, the result is very different. In these industries, CEO cash compensation was related to fair value ESO expense in neither the first half nor the second half of the period 1996-2005. The result is unsurprising given the strong position taken publicly by high-tech industry leaders that fair value ESO expense is not an expense to the firm and cannot be measured accurately.

INFORMATION CONTENT OF PRO FORMA EARNINGS

An increasing number of firms release “pro forma” earnings along with net income in their financial reports in the press. The pro forma earnings are defined by individual firms which are different from the net income defined under Generally Accepted Accounting Principles (GAAP). Lougee and Marquardt (2004) indicated that companies with less informative GAAP earnings were more likely to engage in reporting pro forma earnings than others. This study examines whether the pro forma earnings provide information to investors about future earnings in the Taiwanese stocks market. A condition of information asymmetry exists between investors and managers, and pro forma earnings are a way to disclose the latter’s ideas about their firms’ future profitability to investors. The quality of the financial information that is provided will impact investors’ predictions about firms’ future earnings, and so affect stock prices. The purpose of this study is thus to investigate the information content of pro forma earnings, and examine whether pro forma earnings can provide details of future earnings to the investors in the Taiwanese stock market. We collect 3,287 firm-year observations listed on the Taiwan Stock Exchange or Gre Tai Securities Market from 2008 to 2012, and our data is from the Taiwan Economic Journal (TEJ) database. Our results show that the disclosure of pro forma earnings can improve the association between current returns and future earnings. This implies that the disclosure of pro forma earnings reveals credible information, which is then incorporated into current returns.

Discussion

Discussion

The informativeness of pro forma and street earnings: an examination of information asymmetry around earnings announcements

Using adverse-selection cost as a proxy for information asymmetry, we find evidence that non-GAAP earnings numbers issued by management (pro forma earnings) and analysts (street earnings) improve price discovery. First, information asymmetry before an earnings announcement is positively associated with the probability of a non-GAAP earnings number at the forthcoming earnings announcement. Second, the post-announcement reduction in information asymmetry is greater when managers or analysts issue non-GAAP earnings at the earnings announcement and when the magnitude of the non-GAAP earnings adjustment is larger. Our results suggest that earnings adjustments by analysts and managers increase the amount and precision of earnings information and help to narrow information asymmetry between informed and uninformed traders following earnings announcements. Alternatively, the findings may be attributable to characteristics of non-GAAP firms and overall better reporting quality for those firms rather than non-GAAP earnings disclosure per se.

Editorial Policy

Editorial Policy

The Presentation Arrangements of Pro Forma Earnings Disclosures: Managerial Incentives and Market Responses

This study examines whether the presentation of pro forma earnings disclosures within earnings announcements reflects managerial incentives, as well as the impact of these presentation decisions on equity market pricing of earnings. Using hand-collected data, I measure “presentation” along two dimensions: emphasis of pro forma earnings within the earnings announcement, and the display format of earnings. Consistent with expectations, I document three empirical regularities. First, these presentation decisions appear to reflect managerial opportunism, such as the desire to beat benchmark earnings. Second, these decisions affect the market reaction to disclosed earnings. Finally, implementation of Regulation G, which mandated improved reconciliation of pro forma earnings to GAAP earnings, reduces both opportunistic presentation as well as the influence of presentation arrangements over investors’ decision making. Overall, the results suggest that presentation of pro forma earnings also reflects managerial incentives and market pricing, and that regulatory efforts to mitigate these effects have been successful.

EDITORIAL POLICY AND STYLE INFORMATION

EDITORIAL POLICY AND STYLE INFORMATION

The drivers, consequences and policy implications of non-GAAP earnings reporting

Non-generally accepted accounting principles (GAAP) (pro forma) earnings form an increasingly important part of firms’ performance reporting narrative. This paper reviews the academic and professional debate surrounding non-GAAP earnings reporting by management. I argue that the demand for customised performance reporting is a natural response to constraints imposed by a one-size-fits-all reporting system and that the non-GAAP phenomenon forms part of a long-standing debate over the definition and presentation of periodic performance. A review of extant research suggests non-GAAP disclosures are driven by informative reporting and opportunistic motives. Opaque presentation of non-GAAP earnings is associated with earnings mispricing, particularly among unsophisticated investor groups. Regulations and governance systems designed to ensure transparency are associated with higher quality disclosures and less mispricing. While customised reporting behaviour is evident in many settings, I argue that such disclosures create particular risks in a financial reporting context because they threaten the integrity of the underlying reporting system. Prevailing regulatory approaches are reviewed and factors limiting disclosure transparency are highlighted. The paper concludes with suggestions for further research.