Comparing Non-GAAP EPS in Earnings Announcements and Proxy Statements (Management Science, Forthcoming), 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, Forthcoming), 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.
CEO Pay Components and Aggressive Non-GAAP Earnings Disclosure (Journal of Accounting, Auditing, & Finance, Forthcoming), 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 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.
The Determinants and Informativeness of Non-GAAP Revenue Disclosures (SSRN), with John Campbell and Zac Wiebe
Nearly all research on non-GAAP measures focuses on earnings or earnings per share. Disclosure of non-GAAP revenue has recently attracted SEC scrutiny because revenue, unlike earnings, is a top-line number related primarily to core (i.e., persistent) business activities so it is less clear what adjustments would provide a more useful measure of performance. 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. 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 has information content for investors and predicts future revenue growth better than GAAP revenue growth. Overall, we provide evidence that, on average, non-GAAP revenue disclosures are motivated by economic fundamentals rather than opportunism and provide investors with relevant information.
Comparing Non-GAAP Earnings and ASC 280’s Segment Earnings (SSRN), with Michael Durney and Zac Wiebe
We compare non-GAAP earnings and segment earnings determined by ASC 280’s Management Approach, both of which afford managers flexibility in defining performance. This comparison is relevant because (1) standard setters are considering expanding the use of internally viewed information in external reporting, and (2) segment earnings’ flexibility makes it more suitable than GAAP net income for assessing the usefulness of non-GAAP earnings. Using a sample of firms’ non-GAAP earnings and segment earnings from 2003-2018, we examine the items included in and excluded from these measures and assess whether, and why, they are differentially useful for investors. Both earnings measures are more decision-useful than GAAP net income; however, non-GAAP earnings is more useful than segment earnings. Additional analyses, including an experiment, indicate that the internal purpose of the Management Approach yields earnings measures focused on controllability, rather than persistence, which impairs the usefulness of segment earnings for investors.
Non-GAAP EPS Denominator Choices (available upon request), with Tom Linsmeier and Clay Partridge
Firms frequently report non-GAAP earnings on a per share basis, which conveys information about both the earnings available to common shareholders (numerator) and the number of potential claims on those earnings (denominator). While prior research examines adjustments to the numerator of non-GAAP EPS, we provide the first evidence on non-GAAP EPS denominator choices. For a sample of firms with dilutive instruments, we find the majority of denominator adjustments occurs in firms that convert a GAAP loss into a non-GAAP profit. Most such loss-converting firms increase the denominator (and reduce non-GAAP EPS) to mimic GAAP and reflect the number of shares that would be reported in EPS under a GAAP profit. These denominator adjustments improve the measurement of the number of future claimants and the explanatory power of the price of common equity, which suggests that the adjustments provide improvements over GAAP. We also provide evidence consistent with opportunistic reporting by loss-converting firms that fail to make a denominator adjustment and therefore maximize non-GAAP EPS. This evidence may be of interest to regulators and standard setters as they consider guidance relating to non-GAAP and EPS reporting, respectively.