Chapter 1: The role of standard setters in financial reporting (SSRN; Handbook on the Financial Reporting Environment (edited by W. ge, A. Koester, and S. McVay), Edward Elgar Publishing Ltd., Forthcoming), with Christine Botosan, Derek Christensen, Michael Durney, and Cassie Mongold)
Capital markets (like the London Stock Exchange or the New York Stock Exchange) fulfill an essential role in modern economies by matching investors with money to companies that need money. However, various information frictions hinder this matching process. Luckily, mandatory accounting standards provide solutions that help to alleviate such frictions by requiring companies to communicate a set of financial information to investors. Creating accounting standards is not an easy task, however. Political pressure, difficulty quantifying the benefits and costs of a standard, changing economic conditions, and multiple investment domains (e.g., private vs. public company investment) present challenges for standard setters. These challenges are further compounded by cultural and institutional differences around the globe that affect the type, quality, and content of information investors find relevant. To cope with these challenges, most accounting standard setters lean on a judgement and decision-making framework, referred to as a "conceptual framework," to help them consistently issue high-quality standards that foster decision-useful financial reports. In this chapter, we explore standard setting in detail while also answering fundamental questions like "Why do we need accounting standards?", "Who sets standards?" and "How are standards established?".
Segment Profit/Loss and the Limitations of a “Management Approach” (Management Science, Forthcoming), with Michael Durney and Zac Wiebe
GAAP’s “Management Approach” to segment reporting (ASC 280) requires firms to report segment profit/loss as the measure managers use when allocating resources internally across segments under the assumption that investors benefit from viewing segment performance through the eyes of management. We examine how segment performance measurement aligns with the way that investors use segment profit/loss measures externally. We first survey professional investors and find that they primarily use segment profit/loss to assess firm value and therefore desire measures focused on persistent income items that help predict future performance. Next, for a sample of public multi-segment firms from 2003 to 2018, we hand-collect details on the construction of firms’ segment profit/loss measures and compare them to the same firms’ valuation-focused measures (i.e., non-GAAP earnings and non-GAAP segment profit/loss). Relative to non-GAAP measures, ASC 280 segment profit/loss is significantly more likely to include less persistent items (e.g., restructuring charges) and exclude more persistent items (e.g., interest expense). ASC 280 segment profit/loss is also less predictive of future performance and less value relevant than non-GAAP measures. These differences are attributable to ASC 280 yielding segment profit/loss measures that focus on the controllability of items by segment managers instead of items’ persistence. Overall, ASC 280’s segment profit/loss exhibits misalignment between its internal use by managers (i.e., internal resource allocation) and its primary external use by investors (i.e., valuation), which limits its usefulness for investors. Our study informs market participants and standard setters considering the usefulness of segment disclosures.
Accounting and Innovation: Paths Forward for Research (Journal of Accounting and Economics, 2024), with Mary Barth
Glaeser and Lang (2024; GL) reviews the accounting literature on innovation, which has increased substantially in recent years. GL makes an important contribution to accounting research by bringing into the literature the implications of Romer’s Nobel Prize winning endogenous growth theory and by explaining how accounting research addresses questions related to innovation. We contribute to accounting research by building on GL’s foundation to suggest three main paths forward for future innovation research. First, focus on innovation’s three defining attributes: novelty, nonrivalry, and partial excludability. Second, determine the needs of various users of information about a firm’s innovation activities and how to meet those needs; we focus on the needs of investors. Third, address questions our discussion highlights as potentially important for future research on financial reporting and innovation, including the crucial question of an innovation’s identifiability.
Non-GAAP EPS Denominator Choices (The Accounting Review, 2024), with Tom Linsmeier and Clay Partridge
We provide the first evidence after Regulation G on firms’ non-GAAP EPS denominator choices and whether they provide useful information or are opportunistic. From 2013-2019, 17 percent of annual non-GAAP EPS numbers use denominators different from that of GAAP diluted EPS, which makes denominator adjustments among the most prevalent individual types of non-GAAP adjustments. For firms reporting GAAP and non-GAAP profits or GAAP losses and non-GAAP profits, we provide evidence consistent with denominator adjustments increasing non-GAAP EPS informativeness. Our evidence also suggests that opportunism in denominator choices is concentrated in firms reporting GAAP losses and non-GAAP profits and failing to adjust the denominator. Such non-adjustment is inconsistent with SEC requirements to report non-GAAP EPS “on a diluted basis” because the EPS denominator for a GAAP loss excludes dilutive claims. While the SEC largely overlooks such firms, they are more likely, on average, to report non-GAAP EPS that analysts consider inflated.
CEO Pay Components and Aggressive Non-GAAP Earnings Disclosure (Journal of Accounting, Auditing, & Finance, 2023), with Dirk Black, Ervin Black, and Theodore Christensen
We examine the relation between CEO pay components and aggressive non-GAAP earnings disclosures using CEO pay components as proxies for managers’ short- versus long-term focus. Specifically, we explore the extent to which short-term bonus plan payouts and long-term incentive plan payouts are associated with: (1) Managers’ propensity to exclude expense items in excess of those excluded by equity analysts; and, (2) The magnitude of those incremental exclusions. We find that long-term incentive plan payouts are negatively associated with the likelihood and magnitude of aggressive non-GAAP exclusions. Our results are consistent with managers reporting non-GAAP information less aggressively when they are more focused on long-term, rather than short-term, value.
The Determinants and Informativeness of Non-GAAP Revenue Disclosures (The Accounting Review, 2022), with John Campbell and Zac Wiebe
Nearly all research on non-GAAP financial measures focuses on earnings or earnings per share, although non-GAAP revenue disclosure has recently attracted SEC scrutiny. It is unclear ex ante what non-GAAP adjustments could improve revenue’s usefulness because, unlike earnings, revenue is a top-line number related primarily to core (i.e., persistent) business activities. We present the first archival analysis of non-GAAP revenues based on a large, hand-collected sample of disclosures from 2015-2018. Approximately one in five earnings announcements contains a non-GAAP revenue disclosure, focused on revenue growth. Our evidence suggests that firms disclose non-GAAP revenue when GAAP revenue is incomparable with prior periods, and not to compensate for poor GAAP performance. Furthermore, non-GAAP revenue growth predicts future revenue growth better than GAAP revenue growth, and the market responds to this information. Overall, non-GAAP revenue disclosures are motivated by economic fundamentals rather than opportunism, on average, and they provide investors with relevant information.
Comparing Non-GAAP EPS in Earnings Announcements and Proxy Statements (Management Science, 2022), with Dirk Black, Ervin Black, and Theodore Christensen
We compare non-GAAP EPS in firms’ annual earnings announcements and proxy statements using hand-collected data from SEC filings. We find that proxies for capital market incentives (contracting incentives) are more highly associated with firms’ disclosure of non-GAAP EPS in annual earnings announcements (proxy statements). However, we find systematic differences in the properties of firms’ non-GAAP earnings and exclusions depending on whether they disclose non-GAAP EPS in both the earnings announcement and the proxy statement. When firms disclose non-GAAP EPS in both documents, we find that non-GAAP EPS is more useful for assessing firm value. Specifically, these firms are more likely to: (1) Exclude nonrecurring items; (2) Exclude less persistent earnings components; and, (3) Provide less aggressive non-GAAP EPS. Our results suggest that non-GAAP EPS is higher in quality for investors when disclosed in both the annual earnings announcement and the proxy statement. We provide the first large-sample evidence consistent with the use of non-GAAP EPS metrics in both financial reporting and compensation contracting.
Stock Price Management and Share Issuance: Evidence from Equity Warrants (The Accounting Review, 2021), with Mary Barth, Doron Israeli, and Ron Kasznik
We investigate whether firms manage stock prices in anticipation of share issuance. Warrant exercise results in share issuance and warrant expiration dates are fixed years in advance, which precludes market timing. We predict firms manage stock prices to prevent (induce) warrant exercise when exercise is dilutive (anti-dilutive) to existing shareholders. To test our prediction, we examine stock returns around warrant expiration dates. We find that the difference between out-of-the-money (OTM) and in-the-money (ITM) firms’ return patterns (i.e., post-expiration minus pre-expiration returns) is positive, and OTM (ITM) firms’ return pattern is positive (negative). Return patterns of three sets of pseudo warrant firms differ from patterns of warrant firms. Return patterns are stronger when more feasible price changes are required to affect warrant expiration status, and firm-issued news items is a mechanism for price management. Thus, our findings provide evidence that firms engage in stock price management in anticipation of share issuance.
Disclosure Prominence and the Quality of Non-GAAP Earnings (Journal of Accounting Research, 2021), with Jason Chen and Jed Neilson
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’ GAAP earnings forecasts and their implications for accounting research (Journal of Accounting and Economics, 2018), with Mark Bradshaw, Theodore Christensen, and Benjamin Whipple
We use newly available GAAP forecasts to document that traditionally-identified GAAP forecast errors contain 37% measurement error. Correcting for this measurement error, we settle a long-standing debate regarding investor preference for GAAP versus non-GAAP earnings and provide strong evidence of a preference for non-GAAP earnings. We also revisit the use of non-GAAP exclusions to meet analysts’ forecasts when GAAP earnings fall short. Results indicate that 34% of these traditionally-identified meet-or-beat firms are misidentified due to measurement error, and this error masks evidence that firms more frequently exclude transitory rather than recurring expenses for meet-or-beat purposes.
Disentangling Managers' and Analysts' Non-GAAP Reporting (Journal of Accounting Research, 2018), with Jeremiah Bentley, Theodore Christensen, and Benjamin Whipple
Researchers frequently proxy for managers’ non‐GAAP disclosures using performance metrics available through analyst forecast data providers (FDPs), such as I/B/E/S. The extent to which FDP‐provided earnings are a valid proxy for managers’ non‐GAAP reporting, however, has been debated extensively. We explore this important question by creating the first large‐sample data set of managers’ non‐GAAP earnings disclosures, which we directly compare to I/B/E/S data. Although we find a substantial overlap between the two data sets, we also find that they differ in systematic ways because I/B/E/S (1) excludes managers’ lower quality non‐GAAP numbers and (2) sometimes provides higher quality non‐GAAP measures that managers do not explicitly disclose. Our results indicate that using I/B/E/S to identify managers’ non‐GAAP disclosures significantly underestimates the aggressiveness of their reporting choices. We encourage researchers interested in managers’ non‐GAAP reporting to use our newly available data set of manager‐disclosed non‐GAAP metrics because it more accurately captures managers’ reporting choices.
March Market Madness: The Impact of Value-Irrelevant Events on the Market Pricing of Earnings News (Contemporary Accounting Research, 2016), with Michael Drake and Jacob Thornock
Each year, the NCAA basketball tournament (March Madness) is a daytime distraction for millions of people, providing a largely exogenous shock to investor attention. We investigate whether March Madness influences the market response to earnings by diverting investor attention away from earnings news. We find that the price reaction to earnings news released during March Madness is muted. This result generally holds across several samples and additional analyses. We also find that the result is more muted for low institutional ownership firms, consistent with the effect being driven by less-sophisticated investors. Furthermore, we find that it takes the market 30 to 60 days to correct for the distraction effect. Overall, we provide a unique test of the theory of limited attention by documenting that extraneous events can have a significant impact on the pricing of earnings.
Investor Mispricing of Persistent Non-GAAP Exclusions (SSRN), with Ken Li and Ben Whipple
Despite concerns that non-GAAP earnings misleads investors, prior research has found little evidence to support these concerns after Regulation G. If mispricing exists, it likely occurs when firms exclude persistent items from non-GAAP earnings. Therefore, we develop a measure that captures exclusion persistence and we incorporate this measure into pricing tests. We find that investors misprice persistent exclusions, which is consistent with investors being misled by these non-GAAP adjustments. Further, the mispricing is greater when firms’ non-GAAP reporting changes from prior periods and is evident for both sophisticated and unsophisticated investors. Finally, we find that firm insiders sell more shares after firms exclude more persistent items, which is consistent with insiders exploiting inflated market values. Overall, we find that a nontrivial set of firms report non-GAAP earnings that excludes persistent items, that these exclusions mislead investors, and that firm insiders benefit from this mispricing.
The Usefulness of EBITDA (SSRN), with Erik Elfrink, Robert Hills, and Ben Whipple
Despite investors’ claims that they commonly use EBITDA, the amount of EBITDA information available to investors and the extent of its usefulness is largely undocumented. We find that analysts provide EBITDA information for more than 85 percent of firms since 2015, and that these measures are largely on an “adjusted” basis, which excludes items beyond just interest, taxes, depreciation and amortization (ITDA). Relative to a variety of performance measures (net income, operating cash flows, street earnings), portfolios formed on EBITDA are the best at predicting future operating cash flows—especially across firms with differences in capital assets, financing, or tax planning. However, EBITDA portfolios are generally worse at predicting future operating earnings and free cash flows. Thus, EBITDA’s usefulness depends on which measure of future performance investors care about. Further, we find that the exclusion of non-ITDA items improves EBITDA’s usefulness, which is inconsistent with concerns that additional “adjustments” to EBITDA reduce its quality. Finally, investors do not fixate only on EBITDA but also price EBITDA’s exclusions, although they incorporate some of this information with a delay. Overall, our evidence confirms EBITDA’s usefulness for investors and also highlights its limitations, providing support for both the proponents and critics of EBITDA.
When are expected credit losses decision-useful and new to investors? Evidence from CECL adoption (SSRN), with Jed Neilson, Brent Schmidt, and Biqin Xie
The Financial Accounting Standards Board replaced the “incurred loss” (IL) model with the “current expected credit loss” (CECL) model, which requires entities to recognize lifetime expected credit losses upon loan origination. We investigate four controversies surrounding CECL to provide evidence on when expected credit losses are decision-useful and new for investors. We examine whether (1) CECL allowances are only decision-useful for larger banks, (2) CECL allowances provide new credit loss information, (3) credit losses expected to emerge beyond one year are relevant for investors, and (4) separately reporting IL and CECL allowance amounts has more information content than reporting a single CECL allowance amount. Contrary to the views of community banks and evidence in prior literature, we find that CECL allowances are decision-useful for both small and large banks. However, CECL allowances are new information only for smaller banks. We also find that CECL allowances are decision-useful regardless of the loss emergence period, despite later-emerging losses being unrecognized under IFRS 9, CECL’s international counterpart. Finally, we find that reporting a single CECL allowance amount is relatively less decision-useful than an alternative accounting regime that reports incurred and expected future credit losses separately.
On the potential outcomes of standardizing non-GAAP financial measures: Evidence from the REIT industry (SSRN), with K.J. Park
The FASB has recently considered standardizing non-GAAP financial measures, based on the belief that doing so would yield a measure that either supplants or enhances firms' existing performance measures. We test this belief by examining standardization of non-GAAP financial measures in the Real Estate Investment Trust (REIT) industry where firms report a “funds from operations” (FFO) measure defined by industry experts. Despite the existence of standardized FFO, we find that 78 percent of US REITs from 2007-2020 disclose unstandardized “adjusted FFO” (AFFO). Further, AFFO is more useful for investors than standardized FFO, which is inconsistent with standardized measures supplanting unstandardized measures. We also utilize the 2017 standardization of AFFO in Canada to examine whether standardization enhances previously unstandardized measures. We find no evidence that standardization of AFFO enhances the usefulness of Canadian REITs’ AFFO measures. Overall, we find no support for the belief motivating standardization. Our study raises questions about whether standardizing non-GAAP financial measures in the current regulatory environment will yield significant benefits.
Investment Professionals' Asset Measurement Preferences (SSRN), with Spencer Anderson, Shannon Garavaglia, and Michael Durney
Academic research provides mixed claims and evidence regarding the situations under which different asset measurement methods aid investment decisions. Surprisingly, evidence of actual resource providers’ views on this issue is sparse. We survey 528 and interview 13 investment professionals to provide evidence of their preferences among four common measurement methods and how these preferences vary when considering different assets, situations, and financial statements. Our results provide new insights to the literature including investors’ support for a mixed-method measurement model, how investors would benefit from multiple measures for the same asset at the same time, how disaggregation on the income statement can accommodate preferences for different balance sheet and income statement information, and investors’ informed, overall preference for more assets measured using a market- or company-based measure of value. Accordingly, our findings suggest that financial statement users have more relevant information when accounting standards use different measurement methods for different types of assets, provide multiple measurement methods for each asset in each reporting period, and separately provide relevant balance sheet amounts and earnings information, such as by using Other Comprehensive Income.
How do Subsidized Firms Report Non-GAAP EPS? (SSRN), with Cephas S.P. Dak-Adzaklo, Dorcas Nduakoh, Emmanuel Obiri-Yeboah, and Emmanuel Ofosu
We examine how firms’ non-GAAP earnings per share (EPS) reporting differs when firms receive government subsidies. We predict that subsidized firms face political costs which incentivize them to report lower performance. Non-GAAP EPS reporters could accomplish this by either (1) curtailing non-GAAP EPS disclosures or (2) recalculating non-GAAP EPS to exclude gains. We find that subsidized firms engage in both strategies, especially when facing greater political costs. Relative to prior literature which suggests that subsidized firms increase voluntary disclosure, we find that subsidized firms decrease disclosure which would convey higher performance or, alternatively, adjust calculations to report lower performance.