Taxes in Non-GAAP Reporting: Evidence of Strategic Behavior in Selecting Tax Rates Applied to Exclusions

Abstract

When reporting after-tax non–generally accepted accounting principles (GAAP) earnings, firms are required to adjust for the tax effects of exclusions. Since 2010, the Securities and Exchange Commission (SEC) has issued and updated compliance and disclosure interpretations (C&DIs), which specifically require firms to disclose the tax effects of exclusions. We assemble a detailed, hand-collected data set of S&P 1500 firms’ disclosures to provide the first large-sample evidence on the reporting of the tax effects of non-GAAP exclusions. We find three key results. First, echoing the SEC’s concern, a significant proportion of non-GAAP reporting firms do not follow the C&DI guidelines (i.e., they do not disclose the tax effects of exclusions). Second, among firms that disclose the tax effects of exclusions, we find that managers strategically select the tax rates applied to exclusions to achieve after-tax earnings targets. Third, manager-reported non-GAAP earnings are less persistent for future operating earnings and cash flows relative to non-GAAP earnings calculated by applying various benchmark tax rates to exclusions. This evidence suggests that managers’ strategic behavior in selecting the tax rates applied to exclusions pollutes reported non-GAAP earnings and reduces their usefulness for predicting future performance. Overall, our results shed light on a specific channel through which firms use non-GAAP reporting to meet or beat earnings expectations. This paper was accepted by Brian Bushee, accounting.

Audit Implications of Non‐GAAP Reporting

“…[2017], Chen et al. [2019]). Thus, auditors may not rely on non‐GAAP PBT as the materiality benchmark if they are concerned that management non‐GAAP reporting is opportunistic.…”

“…Accruals) following Chen et al. [2018]. We include the control variables from equation (1), the controls recommended in Chen et al.…”

“…We include the control variables from equation (1), the controls recommended in Chen et al. [2018] as applied in the audit quality setting in Gipper, Hail, and Leuz [2021], and variables to control for nonrecurring items that could be correlated with both accruals and manager and auditor non‐GAAP adjustments. The coefficients for Auditor Non‐GAAP Adj Amt and Auditor/Analyst Adj Diff are positive and significant (both p < 0.05), indicating that financial reporting quality is lower when auditors rely on a non‐GAAP benchmark.…”