Pro Forma Earnings Presentation Effects and Investment Decisions

Abstract

Reacting to the criticism that companies routinely mislead investors by emphasizing non-GAAP or pro forma numbers, the SEC promulgated Regulation G in 2003, which requires firms to provide a reconciliation of the pro forma and GAAP numbers. In this study, we conduct an experiment to examine how investors' GAAP and non-GAAP earnings performance assessments affect their financial evaluations and investment decisions based on the presentation format of the reconciliation (presenting a full non-GAAP income statement, referred to as the full NGIS format, versus presenting only the items that caused the difference between GAAP and non-GAAP measures, referred to as the summary NGIS format). We find that even though a summary NGIS format for the reconciliation of pro forma earnings does not increase the perceived non-GAAP earnings performance, it does increase the weight given to non-GAAP earnings performance when making investment-related judgments and decisions, relative to a full NGIS format. These findings regarding the evaluation and weighting of non-GAAP earnings performance extend prior studies and suggest that non-GAAP earnings information may be processed differently based upon the format of the reconciliation. Further, our finding regarding the weighting of non-GAAP earnings performance is inconsistent with the concern expressed by the SEC that the full NGIS format may give greater prominence to non-GAAP information. Finally, the implications of these findings for regulators, investors, and future research are discussed. Data Availability: Contact the authors.

Non‐GAAP earnings and executive compensation: An experiment

“…Previous non‐GAAP research documents that non‐GAAP disclosures, relating to (a) and (b) above, affect investors' quantitative financial judgements. In experimental settings, non‐GAAP disclosures affect investors' forecasted earnings per share estimates (Andersson & Hellman, 2007; Elliott, 2006), forecasted stock price valuations (Frederickson & Miller, 2004; Reimsbach, 2014) and the amount investors are willing to invest (Dilla et al, 2013; Hogan et al, 2017). The effects are observed among both less sophisticated (Elliott, 2006; Frederickson & Miller, 2004; Hogan et al, 2017; Reimsbach, 2014) and professional investors (Andersson & Hellman, 2007; Dilla et al, 2013).…”

“…Registrants must present non-GAAP measures | 4379 with equal or lesser prominence than their GAAP counterparts, reconcile non-GAAP measures to the most directly comparable GAAP measure, state why management believes the non-GAAP measure provides useful information to investors and disclose any internal, material use of the non-GAAP measure. Prominence and reconciliation are extensively studied in archival and experimental settings (Allee et al, 2007;Elliott, 2006;Frederickson & Miller, 2004;Hogan et al, 2017). However, the final two requirements, managements' justification and use of non-GAAP measures, have as yet received little research attention.…”

Happy 20-year anniversary non-GAAP earnings: a systematic review of the literature

“…The presence and prominence of non-GAAP disclosures (Allee et al, 2007;Elliott, 2006;Frederickson and Miller, 2004) and emphasis of prior period benchmarks (Krische, 2005) can affect the investment decisions of investors. The presence of a GAAP reconciliation (Dilla et al, 2014;Elliott, 2006) and the format of the reconciliation (Hogan et al, 2017) also affect users' decision making. Aubert and Grudnitski (2014) find that high-quality non-GAAP reconciliations reduce market mispricing [12].…”

“…Frederickson and Miller (2004) and Johnson et al (2014) employed a GAAP and non-GAAP scenario that did not contain a reconciliation, while Andersson and Hellman (2007) only investigated the decisions of analysts. Hogan et al (2017) utilise two different reconciliation types but lacked a GAAP-only control group or separation of participants based on financial knowledge. Guggenmos et al (2022) look at disclosures from a managerial perspective.…”

“…The presence of a GAAP reconciliation (Dilla et al. , 2014; Elliott, 2006) and the format of the reconciliation (Hogan et al. , 2017) also affect users' decision making.…”