Motivation and Information Content of Consistency in Non-GAAP Reporting
MetadataShow full metadata
An observation in the literature is that managers tend to opportunistically use non-GAAP disclosures to manipulate investors’ perceptions of firm performance. Their opportunistic incentives in this regard are noted to lead them to excluding recurring items from non-GAAP earnings to portray a more favorable picture of operating results, or to use non-GAAP earnings to achieve important earnings benchmarks that would be missed on a GAAP basis. Consistency is an important qualitative characteristic of corporate reporting. The discretionary nature of non-generally accepted accounting principles (non-GAAP) disclosures and the numerous ways such disclosures are made have led regulators to question the violation of the consistency concept of corporate reporting. Results of later studies show that, managers are becoming more consistent in excluding items used for computing non-GAAP earnings. However, as the consistency of use of non-GAAP exclusion items is increasing the usefulness of these consistently excluded items, which is measured as its forecasting relevance to future operating performance, is receding. The question that arises in this regard, is what is causing this decline in the usefulness of non-GAAP earnings disclosures in spite of increasing consistency in the use of exclusion items. Prior literature focuses more on the consistency of exclusion of items used for computing non-GAAP earnings. This thesis examines both the use and magnitude of exclusions and examines the relation between management’s motivations behind the use of non-GAAP earnings exclusions, the relation of such motivations with the usage consistency and magnitude consistency of such exclusions, and the information content of non-GAAP earnings disclosed based on such exclusion items. Using a sample of hand-collected non-GAAP earnings data of S&P 500 firms from 2010 to 2016, my research finds that the management’s opportunistic incentive for non-GAAP disclosures is positively associated with the consistency in the use of non- GAAP exclusion items (usage consistency) and negatively related to the value steadiness of those items (magnitude consistency). The results indicate that opportunistic managers attempt to impress investors with high usage consistency, but elude them by managing the values of those items. In other words, these managers manipulate the magnitude of the excluded non-GAAP items under the guise of consistent exclusion of those items to alter investors’ perceptions of firm performance. However, with regard to the capital market impact of such reporting, investors appear to place less weight on non-GAAP earnings disclosures with relatively high magnitude consistency of non-GAAP exclusion items, while the usage consistency of non-GAAP exclusions items does not incrementally draw the attention of the investors. This result challenges the common belief that investors view information consistency as a signal of informative financial disclosures. In fact, additional tests reveal that the weak reaction of investors to non-GAAP earnings is primarily attributable to the opportunistic adjustments of recurring item exclusions. Further, market reaction tests suggest that investors are unable to see through the intentions of managers regarding the consistency in calculating non-GAAP earnings and are misled by non-GAAP disclosures that are consistently defined over time because they only make efficient decisions in some cases of opportunistic non-GAAP reporting. These findings suggest that the regulators’ focus on the consistency of item use does not help improving the informativeness of non-GAAP disclosures to investors. This research contributes to the literature on the consistency of non-GAAP earnings by adding empirical evidence on the management’s opportunistic incentives behind the increasing consistency of non-GAAP earnings and the incremental information content of this growing consistency to investors. Further, the findings of the research are informative for the regulators charged with crafting guidelines on non-GAAP financial disclosures. The results indicate that they should be wary of the issue that while the consistency in non-GAAP reporting is being achieved through the consistent use of non-GAAP exclusion items, opportunistic reporting is being conducted more through the variation in the magnitude of non-GAAP exclusion items. Finally, the results of this research are informative for managers. It informs them of the fact that the potentially misleading non-GAAP disclosures do not affect the perceptions of investors in assessing the financial performance of firms.