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.
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.
Non-GAAP EPS Denominator Choices (SSRN), with Tom Linsmeier and Clay Partridge
We provide the first evidence on firms’ non-GAAP EPS denominator choices in the post-Regulation G period, and whether these choices provide useful information to investors or are opportunistic. From 2013-2019, approximately 17 percent of non-GAAP EPS numbers use a different denominator than that of GAAP diluted EPS (with increasing prevalence over time). Denominator adjustments are among the most prevalent individual type of non-GAAP EPS adjustment. For firms reporting GAAP and non-GAAP profits or GAAP losses and non-GAAP profits, denominator adjustments increase non-GAAP EPS informativeness. Opportunism in denominator choices is concentrated in firms reporting GAAP losses and non-GAAP profits that fail to adjust the denominator. This practice is inconsistent with SEC guidance to report non-GAAP EPS “on a diluted basis” because the diluted EPS denominator for a GAAP loss excludes dilutive claims. Such firms failing to adjust the denominator are significantly more likely to report non-GAAP EPS that analysts consider inflated.
A Firm-Quarter Measure of Non-GAAP Exclusion Persistence (SSRN), with Ken Li and Ben Whipple
Managers commonly justify non-GAAP reporting by claiming that their calculation of non-GAAP earnings excludes items that do not reflect core operations. However, the non-GAAP literature lacks a firm-quarter measure to identify which firms have non-GAAP exclusions that are consistent versus inconsistent with this justification. We create a firm-quarter measure that predicts how a firm’s non-GAAP exclusions will associate with future performance, an association we label as “exclusion persistence.” We find that our measure has significant predictive ability and is superior to existing measures of non-GAAP reporting quality in distinguishing firms based on actual exclusion persistence. We also highlight several unique applications of our measure, including: (1) providing evidence that investors misprice non-GAAP exclusions and that this finding was previously masked when using existing measures of non-GAAP reporting quality, and (2) finding settings where GAAP earnings is superior to non-GAAP earnings at predicting future performance.
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. We examine how this internal resource allocation purpose aligns with the way investors use segment profit/loss measures, a comparison that is relevant for ongoing standard setting efforts to improve the usefulness of segment disclosures. We first survey professional investors and find that they primarily use segment profit/loss for valuation and desire that such measures include persistent income items that are useful for predicting future performance. However, this is inconsistent with how segment profit/loss measures are constructed by managers; in an experiment, managers creating segment profit/loss measures for internal resource allocation focus on the controllability of items by segment managers, regardless of persistence. For a sample of public multi-segment firms from 2003-2018, we 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) in archival analyses. Relative to the non-GAAP measures, segment profit/loss is significantly (i) more likely to include less persistent items (e.g., restructuring charges), (ii) less predictive of future performance, and (iii) less value relevant. Overall, ASC 280’s segment profit/loss suffers from 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 relevance of segment disclosures.
Are recognized 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 recently replaced the “incurred loss” (IL) model of credit loss recognition with the “current expected credit loss” (CECL) model to improve the timeliness of credit loss information. CECL requires entities to recognize lifetime expected credit losses upon loan origination, which is timelier than the IL model but potentially less accurate. Using the incremental credit loss allowances that banks recognized upon day one of CECL implementation, we find that CECL improves the value relevance of credit loss allowances and their ability to predict future credit losses for both small and large banks, consistent with CECL allowances being decision-useful for investors. CECL allowances also provide new information about expected credit losses to investors, but only for smaller banks not previously releasing analogous information through stress testing. Finally, CECL allowances are relevant and equally likely to provide new information for investors in situations where a substantial proportion of the allowance would be omitted under IFRS 9, which suggests that IFRS 9’s divergence from CECL omits relevant information from credit loss allowances.
Debates persist among academics, regulators, practitioners, and standard setters regarding the extent to 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 professional investors to provide evidence of their preferences among four common measurement methods. Overall, we find a general inclination for more assets measured at market price or discounted cash flows. However, we document considerable variation in measurement preferences based on the type of asset (e.g., trademarks vs. fixed assets), characteristics of the asset and its environment, and the financial statement that remeasurement affects. Accordingly, our findings suggest that providing professional investors with relevant asset information would require accounting standards that: (1) use different measurement methods for different types of assets; (2) provide multiple measurement methods in each reporting period; and (3) consider how to separately provide relevant balance sheet amounts and earnings information, such as by using Other Comprehensive Income.
On the potential outcomes of standardizing non-GAAP financial measures: Evidence from the REIT industry (SSRN), with K.J. Park
The proliferation of unstandardized performance measures (e.g., non-GAAP financial measures) has prompted recent discussion about standardizing such measures. We assess the likelihood that such efforts would curtail the disclosure or replicate the usefulness of unstandardized measures. We examine reporting practices in the Real Estate Investment Trusts (REIT) industry where nearly all REITs report “funds from operations” (FFO), a measure standardized by industry experts and backed by regulators. Despite FFO’s existence, the majority of REITs also disclose unstandardized “adjusted FFO” (AFFO), which is more predictive of future operating performance, more value relevant, and more comparable across REITs than standardized FFO. We examine a recent attempt to standardize AFFO, and find no evidence that this provides benefits to capital market participants. Overall, standardizing performance measure calculations in the current regulatory environment is unlikely to fully curtail the disclosure or replicate (or enhance) the usefulness of unstandardized measures.