Misleading Disclosure of Pro Forma Earnings: An Empirical Examination

Abstract

The Sarbanes–Oxley (SOX) Act was passed in 2002 in response to various instances of corporate malfeasance. The Act, designed to protect investors, led to wide-ranging regulation over various actions of managers, auditors and investment analysts. Part of SOX, and the focus of this study, targeted the disclosure by firms of “pro formaâ€\x9D earnings, an alternate (from GAAP earnings), flexible and unaudited measure of firm performance. Specifically, SOX directed the Securities and Exchange Commission (SEC) to craft regulation which would reduce – and preferably eliminate – any pro forma earnings disclosure which might be “misleadingâ€\x9D. Examining earnings press releases over a 3-year period, this study addresses three questions. Were firms disclosing pro forma in a potentially misleading manner, what was the nature of this potentially misleading disclosure, and did SOX affect the disclosure practices? We find the following. In 2001 (prior to SOX), 53 firms – over 10% of all U.S. S&P 500 firms – were disclosing pro forma earnings in a potentially misleading manner. This was being done most commonly by using traditional GAAP terminology (e.g., “net incomeâ€\x9D) in the press release headline to describe what was later in the press release revealed to be a pro forma amount (i.e., “net income excluding special itemsâ€\x9D). By 2003 (subsequent to the SEC regulation), potentially misleading disclosure practices were seen in less than 1% of the earnings press releases of S&P 500 firms. This significant reduction suggests that managers, prior to the regulation, were either careless in their pro forma reporting practice, or were intentionally – and unethically – attempting to mislead investors. Either way, we conclude that the SEC regulation was both necessary and effective. Copyright Springer Science+Business Media, Inc. 2006pro forma earnings, disclosure management, misleading, regulation,

Testing vs. building accounting theory with experimental research: insights from management research

“…Findings of archival empirical research support the (additional) information (e.g., Bhattacharya et al, 2003;Lougee and Marquardt, 2004) and the strategic reporting hypotheses (Bhattacharya et al, 2004;Entwistle et al, 2006). As management's true motivation cannot be observed though, both motives are hard to disentangle empirically (Entwistle et al, 2006).…”

“…As management's true motivation cannot be observed though, both motives are hard to disentangle empirically (Entwistle et al, 2006). Furthermore, to stir further regulatory actions -which are currently much stricter in the USA than in Europe (Hitz, 2010) -proof is needed that investors are indeed influenced and thus potentially misled by pro forma earnings information.…”

Information versus adverse Anlegerbeeinflussung: Befund und Implikationen der empirischen Rechnungswesenforschung zur Publizität von Pro-forma-Ergebnisgrößen

“…11 Strikt zu unterscheiden ist die Berichterstattung von Pro-forma-Ergebnisgrößen von sogenannten Pro-forma-Darstellungen 6 Siehe auch Johnson u. Schwartz (2005), S. 922; Marques (2006), S. 550;Yi (2008), S. 6. 7 Siehe auch Entwistle et al (2006aEntwistle et al ( , 2006bPhillips et al (2002). Allerdings verlangt in Deutschland DRS 15, Lageberichterstattung, in Rz.…”

“…Grundlegend hierzu Gibbins et al (1990). 44 Entwistle et al (2006b) 53 Regressiert werden Überrenditen auf die unerwartete Ergebniskomponente und den Betrag der gegenüber der regulären Gewinngröße eliminierten Ergebnisbestandteile (Doyle et al 2003, S. 154). Der Regressionskoeffizient für die aus den Pro-forma-Ergebnissen entfernten Erfolgskomponenten fällt negativ aus und erklärt somit den Befund des komparativ höheren Informationsgehalts gegenüber der Jahresabschlussgröße, wie ihn Brown u. Sivakumar (2003) zu Tage fördern (Doyle et al 2003, S. 163).…”

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

“…Specifically, while the SEC acknowledges that pro forma information can serve useful purposes (SEC 2001), they question whether the use of pro forma metrics confuses investors and makes comparisons between reporting periods and between companies difficult. Congress addressed this concern in Section 401 of the Sarbanes-Oxley Act (U.S. House of Representatives 2002), which directed the SEC to develop regulation to reduce or eliminate pro forma earnings disclosures which might be misleading (Entwistle, Feltham, and Mbagwu 2006). The SEC responded by issuing Regulation G (SEC 2003) which establishes disclosure rules for reconciling pro forma information to the relevant GAAP measures.…”