Research

Publications

Segment Profit/Loss and the Limitations of a “Management Approach”  (SSRN; 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 2003-2018, 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. 

Non-GAAP EPS Denominator Choices (The Accounting Review, Forthcoming), 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. 

Working Papers

Investor Mispricing of Persistent Non-GAAP Exclusions (SSRN), with Ken Li and Ben Whipple

Despite SEC concerns that investors are misled by firms’ non-GAAP earnings, prior research finds little evidence to support these concerns after Regulation G. If mispricing exists, it is most likely to occur when firms exclude persistent items from non-GAAP earnings because ignoring such exclusions is most detrimental to investors. To test this assertion, we first develop a firm-quarter measure of exclusion persistence to identify which firms exclude persistent items. We then incorporate this measure into pricing tests and find evidence of significant mispricing of persistent exclusions. This mispricing is evident for sophisticated and unsophisticated investors, for firms excluding expenses/losses, and for firms with the most persistent exclusions. Further, insiders of firms with persistent exclusions sell more shares after the earnings announcement, consistent with them exploiting inflated valuations. Overall, our study suggests that a nontrivial set of firms report non-GAAP earnings in a manner that misleads investors and firm insiders take advantage of this. These results help to reconcile the disconnect between SEC concerns and the lack of empirical evidence in the extant literature.

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. 

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. 

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.