Non-GAAP reporting following debt covenant violations

Abstract

We investigate whether firms change their non-GAAP reporting practices after debt covenant violations. We find that the likelihood that a firm will disclose non-GAAP earnings decreases and (for those that continue to disclose) the quality of non-GAAP reporting improves following covenant violations, consistent with stronger shareholder monitoring during this period of scrutiny. Consistent with increased monitoring following a debt covenant violation, cross-sectional analyses indicate that these changes in non-GAAP reporting are concentrated among firms with strong governance. Moreover, we find that investor demand for disclosure (proxied by analyst-provided non-GAAP performance metrics and EDGAR search volume) increases following a covenant violation. Collectively, our evidence is consistent with heightened investor scrutiny following covenant violations, and it casts doubt on the competing explanation that shareholders delegate monitoring to creditors following a covenant violation. Overall, our evidence provides new insights on the determinants of firms' non-GAAP reporting practices and an alternative view about how debt covenant violations influence voluntary disclosure.

Non‐GAAP reporting: Evidence from academia and current practice

“…In addition, creditors often frame debt covenants based on customized non‐GAAP performance metrics (Christensen, Pei, Pierce, & Tan, ; Dyreng, Vashishtha, & Weber, ). Christensen et al.…”

“…Christensen et al. () find that the frequency of non‐GAAP reporting drops off significantly following debt covenant violations. However, the quality of exclusions of firms that continue to disclose non‐GAAP performance metrics increases significantly, consistent with the notion that managers are reluctant to disclose lower quality non‐GAAP metrics when they are under scrutiny.…”

“…Christensen et al. () find that the quality of non‐GAAP reporting improves following a debt covenant violation, presumably because both creditors and shareholders take on a stronger monitoring role . Further, compensation committee use of non‐GAAP reporting for performance evaluation can enhance the quality of non‐GAAP earnings metrics reported to investors (Black et al., ).…”

“…While early empirical evidence (both experimental and archival) suggests that less sophisticated investors are more likely than sophisticated investors to rely on non‐GAAP information (Allee et al., ; Bhattacharya et al., ; Elliott, ; Frederickson & Miller, ), subsequent research has found evidence that many different stakeholders (who are presumably “sophisticated”) rely on non‐GAAP performance metrics. For example, sell‐side analysts revise their forecasts based on non‐GAAP information (Bhattacharya et al., ), credit analysts use adjusted performance metrics (Batta & Muslu, ), compensation committees evaluate directors and executives based on non‐GAAP earnings targets (Black et al., ; Curtis et al., ), creditors evaluate borrowers based on non‐GAAP performance metrics (Christensen et al., ; Dyreng et al., ), and short sellers view non‐GAAP earnings numbers as a red flag indicating declining performance and lower quality reporting (Christensen et al., ; Bhattacharya et al ). Recent research has focused on various stakeholders, but a fundamental question with respect to investors is whether early evidence indicating that non‐GAAP reporting differentially influences less sophisticated investors still applies today.…”

Credit Default Swaps and Non-GAAP Earnings Disclosure.

“…First, credit markets are a key source of capital for firms, and non-GAAP disclosure plays a fundamental role in facilitating borrowers' access to credit. Anecdotal evidence and research both suggest that the information needs of equity and debt investors differ and that credit events affect the characteristics of non-GAAP earnings (Batta and Muslu [2017], Christensen et al [2019], Dyreng et al [2017], Kraft [2015], Thielemann et al [2019]). Second, reporting non-GAAP earnings has become the norm, rather than the exception (Black et al [2020]).…”