The Effects of Pro Forma Earnings Disclosures on Analysts' and Nonprofessional Investors' Equity Valuation Judgments

Abstract

This paper presents an experiment that examines the effect of pro forma earnings disclosures on the judgments of analysts (i.e., more sophisticated investors) and nonprofessional (i.e., less sophisticated) investors. In the experiment, participants developed stock price assessments after reviewing background financial information and a current earnings announcement for a company. The earnings announcement was manipulated to report only GAAP earnings in one condition and both pro forma and GAAP earnings in the other condition. Consistent with empirical evidence, the pro forma earnings in our experiment exceeded GAAP earnings. The results indicate that nonprofessional investors who received an earnings announcement that contained both pro forma and GAAP disclosures assessed a higher stock price than did nonprofessionals who received an announcement containing only GAAP disclosures. Financial analysts' stock price judgments were not affected by the pro forma disclosures. Followup analyses suggest that analysts and nonprofessional investors used different valuation models and information processing. Analysts used well-defined valuation models, based on either earnings-multiples or cash flows, while the nonprofessional investors were more likely to use simpler, heuristic-based valuation models. The pro forma disclosure did not cause nonprofessional investors to assess a higher earnings number for determining a stock price, but rather caused nonprofessionals to perceive the earnings announcement as more favorable, which in turn caused them to convert earnings or some other performance metric into a higher stock price. This effect appears to be due to unintentional cognitive effects, rather than nonprofessionals relying on pro forma earnings information because they perceived it to be informative.

Are MBA Students a Good Proxy for Non-professional Investors?

“…Frederickson and Miller (2004) In an experiment, participants made stock price judgments based on an earnings release that reported only GAAP earnings or that reported both GAAP and pro forma earnings.…”

Comprehensive income information: a user's perspective

“…Each scenario also included a positive (actuarial gain) or negative (actuarial loss) OCI item. As in prior research, MBA students were used as proxies for nonprofessional investors (Maines and McDaniel, 2000;Frederickson and Miller, 2004;Hodge et al, 2004;Elliott, 2006;Fortin and Berthelot, 2012). In fact, Elliott et al (2007) established that second-year MBA students enrolled in or having completed a financial statement analysis course make good proxies for nonprofessional investors in tasks relatively low in integrative complexity.…”

“…H1 and H2 were tested by asking respondents to use a Likert-type scale (0-10) to make 10 financial analysis judgements and decisions (see Table 2, Section 1, questions I.5 to I.14). These questions were selected from prior studies that examined nonprofessional and/or analyst investment judgements and decisions (e.g., Anandarajan et al, 2008;Belzile et al, 2006;Fortin and Berthelot, 2012;Frederickson and Miller, 2004). After answering Section 1 questions, participants were instructed to put the materials back in the first envelope provided to them and seal it before opening the second envelope, which contained Sections 2-4.…”

Who Uses Financial Reports and for What Purpose? Evidence from Capital Providers

“…In addition, they are more easily misled by pro-forma earnings disclosures and often use overly simplistic valuation models (Elliot, 2006;Frederickson and Miller, 2004). As is the case for professional investors, accounting presentation matters for retail investors' information analysis and different weights are assigned depending on location in the financial statements (Hodge et al, 2010;Lachmann et al, 2011;Maines and McDaniel, 2000).…”