Non-GAAP Reporting: Evidence from Academia and Current Practice

Transcription

1 Non-GAAP Reporting: Evidence from Academia and Current Practice DIRK E. BLACK Dartmouth College THEODORE E. CHRISTENSEN University of Georgia JACK T. CIESIELSKI R. G. Associates, Inc. BENJAMIN C. WHIPPLE University of Georgia May 2017 We thank the editors, Andy Stark and Peter Pope, along with an anonymous referee for helpful comments and suggestions. We also express gratitude to Melissa Herboldsheimer and Paula Tanabe for their extensive efforts in hand collecting the data used in this study. We thank Enrique Gomez for his research assistance, Denny Beresford for valuable insights, and Kris Allee, Nerissa Brown, Rick Cazier, Vicky Kiosse, Ana Marques, Roy Schmardebeck, and participants at the 2016 FASB Project Development Session on non-gaap reporting and the University of Western Australia workshop for helpful comments.

2 Non-GAAP Reporting: Evidence from Academia and Current Practice Abstract: The number of firms reporting earnings on a non-gaap basis has dramatically increased over the last decade, and non-gaap reporting is now commonplace in capital markets. This proliferation of non-gaap reporting has renewed both regulators and standard setters interest in these alternative performance metrics. For example, the SEC, FASB, and IASB have all recently questioned what this increasing reporting trend means for IFRS- and U.S.-GAAP-based reporting and whether these measures are misleading to investors. This increasing focus on non- GAAP metrics motivates us to synthesize the nearly two decades of research on non-gaap reporting to provide insights on what academics have learned to date about this reporting practice. Then, we utilize a novel dataset of detailed non-gaap disclosures to provide new descriptive evidence on current trends in non-gaap reporting and its recent proliferation. Finally, we discuss important questions for future researchers to consider in moving the literature forward. Keywords: Non-GAAP earnings, regulation, standard setting

3 1. INTRODUCTION The growth in non-gaap reporting (i.e., the disclosure of adjusted earnings metrics) over the past twenty years has led many managers, analysts, and investors to embrace non-standard performance metrics as an important way to evaluate firm performance. Although skeptics have frequently viewed non-gaap disclosure as a threat to the traditional GAAP-based income statement, standard setters recognize that non-gaap metrics can be informative to investors and have laid the groundwork for firms to disclose these metrics in a transparent manner. Standard setters and regulators have recently renewed their interest in non-gaap reporting as these metrics have increased in popularity (Rapoport, 2016; Golden, 2017), raising questions about what these metrics mean for GAAP-based earnings and whether they mislead investors. In short, non-gaap reporting has become commonplace in capital markets, and this increase in the popularity of non-standard performance measures has created questions about the motives and implications of these metrics. 1 We assert that a review of the academic literature is necessary to provide insights on what we have learned in the academic community after nearly two decades of work. In addition, since the extant literature contains little descriptive evidence on what has changed in non-gaap reporting during this recent proliferation, we use a novel dataset of managers non-gaap exclusions to provide descriptive evidence on how non-gaap reporting has changed during this time period. Finally, we conclude by providing suggestions for future researchers to consider for advancing the non-gaap literature. For over 20 years, regulators and standard setters have expressed concern about, and interest in, non-gaap disclosure. In the early days of non-gaap reporting (i.e., mid-1990s to early 2000s), these alternative metrics were generally less common, more opaque, clustered in certain industries, and unregulated. As a result, regulators during this time period frequently expressed skepticism regarding the motives behind non-gaap disclosures, which led the SEC to caution financial statement users about the potentially misleading nature of non-gaap metrics (Dow Jones, 2001; SEC, 2001a; 2001b). When the U.S. Congress enacted the Sarbanes-Oxley Act (SOX) in 2002, legislators included a specific 1 Many non-gaap reporting studies focus on adjustments made to bottom-line EPS or net income. However, companies sometimes adjust income statement line items higher up the income statement such as EBITDA, or operating income. Our review of prior research is comprehensive and is intended to include all adjusted or non- GAAP earnings figures that prior researchers have explored. 1

4 provision to address the problem of potentially misleading non-gaap disclosures. As directed by SOX, the SEC implemented Regulation G (hereafter Reg G) in March of 2003 to regulate firms use of non- GAAP disclosures, requiring non-gaap reporting firms to, among other things, reconcile their non- GAAP metrics to the most directly comparable GAAP-based metric. Numerous studies provide evidence that this regulation has improved the transparency and overall quality of non-gaap reporting (e.g., Kolev et al., 2008; Heflin and Hsu, 2008; Black et al., 2017e). Although there was a temporary decline in the frequency of non-gaap reporting following Reg G, the incidence of non-gaap disclosure has rebounded and increased steadily, leading to a current all-time high in reporting activity. For example, Bentley et al. (2016) report that a non-gaap EPS metric is available for approximately 60% of all firms in 2013, while Black et al. (2017b) find that 71% of firms in the S&P 500 disclose non-gaap earnings in Although the regulation of non-gaap reporting has remained largely unchanged since the implementation of Reg G, the SEC has renewed its focus on non-gaap financial measures by issuing Compliance and Disclosure Interpretations on the topic in January of 2010 (updated in July of 2011) and again in May of In addition, the SEC has focused on non-gaap reporting through several means in recent years, including labeling non-gaap earnings a fraud risk factor (Leone, 2010), forming a taskforce to scrutinize companies non-gaap metrics (Rapoport, 2013), and stating that it has a lot of concern regarding the use of non-gaap measures and whether they confuse investors (Cohn, 2016). Finally, the SEC has recently increased the number of comment letters sent to firms about their use of non- GAAP metrics (Rapoport, 2016). Moreover, the recent proliferation of non-gaap metrics has re-kindled standard setters interest in the practice. In particular, the FASB undertook the Financial Performance Reporting project in 2014 and is currently considering whether the prominence of non-gaap metrics indicates a need to better organize the income statement (Siegel, 2014; Linsmeier, 2016; Golden, 2017). Former FASB board member Thomas Linsmeier notes that re-organizing the income statement to include more disaggregated subtotals might better serve the needs of financial statement users both in calculating their own adjusted performance metrics and in better understanding non-gaap disclosures provided by managers. In addition, the IASB s Disclosure Initiative is now considering what the increasing 2

5 frequency of non-gaap reporting means for IFRS. The chairman of the IASB, Hans Hoogervorst, recently noted that the IASB is open to the idea of learning from the use of non-gaap measures, particularly where the use of these metrics is common, and that these metrics might indicate a vacuum in IFRS for the IASB to consider (Hoogervorst, 2015, p. 5). Hoogervorst, also noted, that IFRS income should be the main measure of financial performance, because the measure is neutral, comparable, and verifiable (Hoogervorst, 2015, p. 5), and that there is growing concern that non- GAAP measures are becoming increasingly misleading (Hoogervorst, 2016, p. 5). To address regulators and practitioners questions regarding non-gaap reporting, and to inform academics interested in a global view of the non-gaap literature, we begin by reviewing the extant academic literature related to the most commonly examined questions in non-gaap research. Our objective in providing this summary is to aggregate evidence from the extant literature into one location to inform regulators, investors, and academics about what we know after nearly two decades of research and what questions remain unanswered. We highlight how non-gaap reporting fits within the broader voluntary disclosure literature. We then discuss the major questions this research has attempted to answer. The primary thrust of this discussion indicates that (1) investors pay more attention to non-gaap performance metrics than to standard GAAP earnings when looking for a summary assessment of performance, (2) early on, less-sophisticated investors were more likely than sophisticated investors to rely on non-gaap information, but more stakeholders seem to be focusing on non-gaap metrics in recent years, (3) in calculating non-gaap metrics, managers have frequently excluded one-time transactions over time (e.g., a litigation settlement), but have become increasingly likely to exclude recurring items (e.g., stock-based compensation), (4) both managers and analysts are primarily motivated to provide non-gaap performance metrics to inform stakeholders, but there is evidence of opportunism, particularly prior to Reg G, (5) both managers and analysts appear to influence non-gaap earnings calculations, (6) despite concern about measurement error in early studies, new data allows researchers to mitigate the effects of measurement error and to design cleaner analyses, (7) regulation has generally resulted in higher quality non-gaap disclosures, (8) several monitoring mechanisms, such as independent boards, analysts, creditors, and large blockholders appear to play a role in disciplining managers non-gaap reporting practices, (9) although researchers in the 3

6 U.S. have often been less cognizant of evidence from various countries around the world, a larger body of research has emerged in various countries that provides deeper insights to enhance our understanding of non-gaap disclosure worldwide, and (10) large-scale data on non-gaap disclosure is now available from various sources. Next, we provide a current picture of the non-gaap reporting landscape. Most of the evidence in the extant literature relates to sample periods prior to 2007 (e.g., Bhattacharya et al., 2003; 2004). Although a few more recent studies provide some descriptive evidence on non-gaap reporting (Bentley et al., 2016; Black et al., 2017b), there is little evidence on how non-gaap calculations have changed during this recent proliferation, which limits how academics can inform parties interested in current reporting practices. Therefore, we provide a timely view of how the current non-gaap reporting environment is changing. To provide this insight, we use a novel dataset that contains both the category and dollar value of non-gaap adjustments for S&P 500 firms for years 2009 through We find that non-gaap reporting frequency has increased across all sectors during our sample period, indicating that all sectors are embracing this reporting practice. We also find that firms are excluding more items from their non-gaap calculations across time, with an average of 3.6 items in 2014 versus 3.1 in Time trends also indicate that the magnitude of exclusions has increased substantially over our sample period, from $0.73 of expenses in 2009 to $1.03 of expenses in We also find that the increase in exclusion magnitude is due to nonrecurring exclusions, which has nearly doubled in size over our sample period. Finally, we provide new descriptive evidence on how frequently firms exclude particular items across time, and how much variation exists in the value of these particular exclusions. We conclude by highlighting several unexplored questions that should be examined to move the literature forward. These areas include further analyses on (1) the users of non-gaap earnings, (2) the motives behind recurring adjustments and why they persist post Reg-G, (3) how multiple parties influence non-gaap reporting practices, (4) what the proliferation of non-gaap reporting means for regulators and standard setters, and (5) how cross-country differences in accounting standards and enforcement influence the disclosure and usefulness of non-gaap earnings. 4

7 2. REGULATORY, STANDARD SETTING, AND ACADEMIC FOUNDATIONS (i) Regulatory and Standard Setting Influences on Non-GAAP Reporting In the U.S., regulators and standard setters have consistently expressed interest in non-gaap reporting (see Table 1 for a U.S.-based summary of the regulatory and standard setting timeline). In the late 1990s and early 2000s when non-gaap reporting was less common, statements by regulators and standard setters were often cautious and somewhat negative because non-gaap numbers were unregulated and often opaque in nature (Dow Jones, 2001; SEC, 2001a; SEC, 2001b). For example, the SEC issued cautionary advice to investors in December of 2001, alerting investors to potential dangers of using non-gaap information. When the Sarbanes-Oxley Act (SOX) was enacted (on July 30, 2002), the U.S. Congress included a specific provision, Section 401(b), on non-gaap performance metrics and directed the SEC to issue regulations to place limitations on non-gaap disclosure. To codify the congressional directive specified in SOX, the SEC implemented Regulation G in March of 2003 to regulate firms use of non-gaap disclosures. 2 The SEC further addressed common questions regarding how the regulation applies to reporting practice through Compliance and Disclosure Interpretations on non-gaap reporting in January of (updated in July of 2011) and in May of During this timeframe, Howard Scheck, the SEC s former chief accountant of the Division of Enforcement, labeled non-gaap performance measures as a fraud risk factor (Leone, 2010). Soon thereafter, the SEC also formed a taskforce to closely examine potentially misleading non-gaap earnings metrics disclosed in public filings (Rapoport, 2013). More recently, Mary Jo White, the former chair of the SEC, expressed concern about non-gaap reporting and highlighted that this reporting practice warrants close attention (Teitelbaum, 2015; Cohn, 2016). Following these statements, and the issuance of the 2016 Compliance and Disclosure Interpretations on non-gaap reporting, the SEC encouraged companies to self-correct their reporting practices that are not in compliance with 2 Along with the implementation of Reg. G (which specifically requires a reconciliation of the non-gaap number to the GAAP number that aligns most closely with it), the SEC also imposed a new set of rules related to Reg. S-K (rule 10). Among other things, this modification to an existing regulation requires that the GAAP number be disclosed at least as prominently as the non-gaap number. 3 While the implementation of Reg. G was initially viewed as a deterrent to non-gaap reporting, practitioners generally viewed the 2010 C&DI s as a loosening of the SEC s (perhaps overly stringent) attitude toward adjusted earnings metrics. 5

8 non-gaap reporting regulation. In addition, the SEC has subsequently increased the number of comments letters sent to companies regarding non-gaap metrics (Rapoport, 2016). The SEC is not the only U.S. party that is currently interested in non-gaap reporting. Aside from the numerous articles in the financial press on non-gaap reporting (e.g., Teitelbaum, 2015; Lahart, 2016a; 2016b; Michaels and Rapoport, 2016), the FASB has expressed increased interest in (and concern about) the proliferation of non-gaap reporting. For example, some members of the FASB question whether the proliferation of non-gaap performance metrics indicates a need to better organize the income statement so that investors can more easily calculate their own customized performance metrics (Siegel, 2014; Linsmeier, 2016). In fact, the FASB s Financial Performance Reporting project considers whether more disaggregated disclosure of performance information is needed on the income statement. FASB Chairman Russell Golden echoes similar sentiments when he states that he wonders whether firms using non-gaap numbers are sending a signal about ways to improve GAAP and highlights that in considering potential improvements to GAAP reporting, it is important to see how companies today use non-gaap reporting to communicate their performance to shareholders (Golden, 2017). Golden (2017) also highlights, however, that non-gaap metrics that are inconsistent with the FASB s motives for standards (e.g. consistent and credible information) will not be considered. Outside of the U.S., non-gaap performance metrics are generally more widely accepted and companies are afforded significantly more latitude in where and how they can present non-gaap information. IFRS allows companies to report non-gaap performance metrics on the face of their income statements as long as the corresponding GAAP numbers receive at least equal prominence with adjusted performance metrics and companies provide a reconciliation between the two numbers (IAS 33; Young, 2014). In addition, Young (2014, pp. 448) notes that international securities regulations do not typically place restrictions on non-gaap disclosures presented in communications with investors, and that companies can discuss non-gaap earnings in unaudited report narratives without the need for accompanying definitions, reconciliations or explanations. Nevertheless, the IASB has recently identified non-gaap performance measures as a threat to the integrity of IFRS financial reporting, indicating that regulators should do more to reign in the 6

9 use of non-gaap metrics (Hoogervorst, 2015; Shumsky, 2016). Although the IASB is open to the idea of learning from the use of non-gaap measures, noting that such metrics might indicate a vacuum in IFRS and a need to define more commonly used performance metrics, Chairman Hoogervorst points out that many companies report alternative performance measures that: (1) Exceed their IFRS counterparts; (2) Are misleading; (3) Exclude recurring expense items; and, (4) Are given undue prominence in the financial statements at the expense of IFRS numbers (Hoogervorst, 2015, p. 5). Chairman Hoogervorst specifically highlights that IFRS tries to create comparability across economic sectors (Hoogervorst, 2015, p. 4) and that more discipline in the presentation of non- GAAP metrics would benefit investors (Hoogervorst, 2015, p. 5). 4 (ii) Understanding the Non-GAAP Reporting Literature One of the challenges in summarizing a growing literature on non-gaap reporting is the difficulty in allocating space to each study. Our objective is to provide a comprehensive overview of prior research. We did not search particular journals to identify research. On the contrary, we have attempted to include every known research paper on the topic of non-gaap reporting, both published and at the working paper stage. Panel A of Figure 1 summarizes the source of the papers included in our review. We note that the largest single source of papers included in our review is current working papers. Moreover, Panel A also indicates which journals have published the most non-gaap reporting papers to date. Review of Accounting Studies currently has the largest number of published studies (15), but we note that this number includes conference papers as well as published discussions of those conference papers. We include conference discussions, however, because they also contribute to the literature by helping to distill important insights and guiding future research. We also note that five U.S.-based journals (The Accounting Review, Journal of Accounting and Economics, Journal of Accounting Research, Review of Accounting Studies, and Contemporary Accounting Research) have published the majority (60%) of all published non-gaap reporting studies. However, some non-u.s.- based journals have published significant quantities of non-gaap research. For example, the Journal 4 We note that we generally use the term non-gaap to refer to adjustments to any earnings metric required by standard setters. Technically speaking, in most parts of the world, companies have adopted International Financial Reporting Standards (IFRS), so the adjustments would be to IFRS income or EPS. We don t specifically call these measures non-ifrs. We simply use the generic term to encompass all earnings metrics that adjust a mandated earnings number under whatever set of standards apply in the company s jurisdiction. 7

10 of Business Finance & Accounting has published the highest number of studies outside of the U.S. with a total of seven to date. Obviously, this review would become quite lengthy if we were to provide a detailed discussion of all of the referenced papers. Therefore, our intent is to summarize the main results of prior studies and how they inform the main questions prior research has explored. In order to concisely do so, we focus more on the seminal papers in each area and mention incremental contributions of other papers that examine similar questions. The difficulty lies in determining which studies have the greatest impact on the literature. In order to gain a sense of which studies have had the most influence, we perform a citation analysis of each of these papers using Web of Science citation counts from Google Scholar. Panel B of Figure 1 summarizes the citation counts of non-gaap reporting papers in our reference list by journal. We find that the highest aggregate citations of non-gaap studies is focused on the journals that coincidentally publish the most research in this area. In aggregate, non-gaap studies published in Journal of Accounting and Economics have garnered 544 citations to date. Outside of U.S.-based journals papers published in the Journal of Business Finance & Accounting have tallied 82 citations so far. 5 We do not cater our discussion of papers based on their publication outlets. However, we do focus on specific published papers that have been most influential in prior research. Moreover, we also discuss working papers to the extent that they address emerging topics that appear to be of interest (even though they don t generally have citations from published papers). We believe Figure 1 provides context and scope for our discussion of the extant literature. 6 5 We note that counting Web of Science citations is only one way of measuring citations or impact. We chose this method because it is a widely accepted measure of an article s importance in a given literature. 6 Based on Web of Science citations, the most influential papers in this area are as follows: Rank Paper Citations 1 Bradshaw, M. and R. Sloan (2002) Doyle, J., R. Lundholm, and M. Soliman (2003) 98 3 Bhattacharya, N., E. Black, T. Christensen, and C. Larson (2003) 83 4 Bradshaw, M (2003) 83 5 Frederickson, J. and J. Miller (2004) 79 6 Lougee, B. and C. Marquardt (2004) 78 7 Gu, Z. and T. Chen (2004) 75 8 Bowen, R., A. Davis, and D. Matsumoto (2005) 71 9 Brown, L. and K. Sivakumar (2003) Elliott, W (2006) 56 8

11 (iii) Understanding Non-GAAP Reporting in the Broader Voluntary Disclosure Literature We are only aware of one theory paper that specifically addresses non-gaap reporting (Hirshleifer and Teoh, 2003). However, the broader disclosure theory literature has evolved over time. Generally, disclosure theories attempt to explain why managers choose to disclose information publicly (e.g., Verrecchia, 1983; Dye, 1985; Trueman, 1986; Jung and Kwon, 1988; Diamond and Verrecchia, 1991; Einhorn and Ziv, 2008). Non-GAAP disclosure is a way for managers to reveal their own performance metric, derived from standard GAAP-based measures. Prior theories have often distinguished between public and private information. Moreover, theoretical research also explores the timeliness of earnings information. Generally, theories focus on managers attempts to reduce information asymmetry by providing information to markets either publicly or privately. Theory suggests that managers decision to provide non-gaap performance metrics likely depends on tradeoffs between the costs and benefits associated with this type of disclosure (e.g., Verrecchia, 1983). In reality, the costs and benefits of disclosure are evaluated in an endogenous game between managers and users of financial reports. Both the supply and demand of information disclosed by managers is affected by the signal-to-noise ratio of a given disclosure signal (e.g., performance). If a signal is informative enough relative to its noise or variance, it is more likely to be disclosed and demanded by financial statement users for both valuation and contracting. When GAAP earnings become sufficiently noisy, managers can use non-gaap performance to provide a clearer signal of performance and alleviate information asymmetry resulting from a noisy GAAP metric. For non- GAAP disclosure to be useful, however, they need to be credible and accurate. Otherwise, users of the financial information would simply discount or entirely disregard the non-gaap disclosure. In addition, while some disclosure models focus on a one-period setting, non-gaap reporting is part of a multi-period disclosure policy. As a result, the users of financial statements will learn from prior firm actions, indicating that managers who mislead stakeholders with aggressive non-gaap disclosures will likely harm the firm s reputation in the long-run. Thus, we predict that non-gaap disclosures will, on average, be motivated by a desire to inform investors and reduce information asymmetry (and the cost of capital). Nevertheless, there may be situations where the opaqueness of a firm s disclosures 9

12 may lead managers to provide potentially misleading performance metrics in an attempt to extract rents by providing over-optimistic disclosures. (iv) Non-GAAP Reporting What Do We Know after Nearly Two Decades of Academic Research? We next summarize the extant literature to focus on the most common questions examined in prior non-gaap studies. We note that this is not the first review of the non-gaap literature. As part of their broader review of the financial reporting environment, Beyer et al. (2010) provide a short discussion of non-gaap reporting. Clearly, because they review such a broad topic (financial reporting), they are limited in how much they can discuss each of the sub-literatures that comprise this larger topic. Young (2014) provides an informative overview of non-gaap reporting in general, including discussions of the reasons for this type of reporting and the challenges that this reporting presents. In addition, he incorporates discussions of the academic literature with many valuable insights and informative references to international evidence. More recently, Black (2016) provides a brief, yet insightful commentary on non-gaap reporting. Our objective is to provide a comprehensive review focused specifically on the academic research that examines non-gaap reporting. In doing so, we aggregate the nearly two decades of academic work into one place to provide context on what we as academics have learned about non-gaap reporting. We group the literature into the most common questions examined in non-gaap studies to inform (1) regulators and practitioners interested in better understanding the practice of non-gaap reporting and (2) academics attempting to understand the scope of the extant literature. In addition, this summary of the literature provides a backdrop for our subsequent discussions on current trends in non-gaap reporting and directions for future research. Finally, in discussing the extant literature, we note that non-gaap earnings have also been labeled as pro forma earnings and street earnings. We use the label non-gaap earnings as an umbrella term to describe this type of reporting in a more general sense, while we use pro forma earnings to refer to managers non-gaap metrics and street earnings to relate to non-gaap metrics from forecast data providers (e.g., I/B/E/S, First Call). (a) Do Investors Pay Attention to Non-GAAP Performance Metrics? The early research in this area explores whether investors rely on non-gaap performance metrics or whether they focus on GAAP earnings. Critics in the financial press from this time period 10

13 expressed skepticism about the new phenomenon, where firms disclose non-gaap performance metrics to investors, arguing that these numbers were self-serving on the part of managers and misleading to investors (e.g., Derby, 2001; Dreman, 2001; Elstein, 2001; Leisman and Weil, 2001a, 2001b). Moreover, regulators during this era were extremely troubled by the growing tendency toward non-gaap disclosure. For example, Lynn Turner, the former SEC Chief Accountant, claimed that non-gaap earnings were an opportunistic way for managers to report everything but bad stuff (Dow Jones, 2001). Graham et al. (2005) survey managers and find evidence consistent with firms emphasizing non-gaap metrics when their GAAP earnings present the company as being unprofitable. To answer these questions, Hirshleifer and Teoh (2003) set the stage from a theoretical perspective by modelling firms choices between alternative means of presenting information and find that non-gaap disclosures can bias investors assessments of future cash flows upward, yet they also show that non-gaap metrics can ensure that stock prices more accurately reflect fundamental value. 7 Bradshaw and Sloan (2002) provide the first large-sample empirical evidence on non-gaap reporting in the U.S. and find that investors began to respond more to street earnings than to GAAP earnings after Moreover, Bhattacharya et al. (2003) find that investors view manager-adjusted non-gaap earnings as being more informative than GAAP operating earnings. These studies form the foundation of the horse race literature comparing investor reactions to GAAP versus non-gaap numbers. Several other studies compare market reactions to non-gaap performance metrics versus other GAAP-based numbers and, consistent with these first studies, generally conclude that non-gaap information is relevant to investors even in the more contemporary non-gaap reporting environment (Brown and Sivakumar, 2003; Johnson and Schwartz, 2005; Marques, 2006; Wieland et al., 2013; Venter et al., 2014; Bradshaw et al., 2017). 8 Finally, experimental research also finds that non-gaap metrics can influence investors decisions, primarily through an unintentional cognitive 7 Lambert (2003) expresses concerns about some of their key assumptions in the model and how the model applies to real-world situations. Specifically, he questions the assumption that the errors made by individuals do not wash out in aggregate nor are they driven out by the behavior of more sophisticated investors (Lambert, 2003, p. 388). 8 Some researchers have offered alternative explanations for investors preference for non-gaap relative to GAAP earnings such as measurement error (Bradshaw, 2003; Cohen et al., 2007) or extreme exclusion values (Abarbanell and Lehavy, 2007). We discuss research related to several of these concerns in subsequent sub-sections. 11

14 effect that influences perceived firm performance, as opposed to investors simply relying on the non- GAAP metric (Frederickson and Miller, 2004; Elliott, 2006). (b) Who Uses Non-GAAP Information? After exploring whether investors, in general, rely on non-gaap disclosures, the next logical question is: who uses non-gaap information? In other words, the somewhat surprising result from early research that investors rely more on non-gaap earnings than GAAP earnings led researchers to question which set of investors, and whether other financial statement users, react to the discretionary earnings numbers promoted by managers. Experimental researchers are the first to explore some of these questions. Frederickson and Miller (2004) and Elliott (2006) find that the existence of a non-gaap number in the earnings press release as well as the relative placement of the non-gaap and GAAP earnings figures within the press release affect the judgments of lesssophisticated investors. Although less susceptible to the influence of non-gaap reporting, experimental research also indicates that more sophisticated parties can be influenced by non-gaap reporting. For example, Elliott (2006) finds evidence that analysts view non-gaap earnings to be more reliable when firms reconcile their non-gaap metric to GAAP-based earnings, and Andersson and Hellman (2007) find that non-gaap earnings can influence analysts earnings per share forecasts. Archival studies have used trade-size-based proxies to distinguish the trading activities of lessand more-sophisticated investors and generally find evidence that complements the inferences from experimental research. These studies find evidence consistent with less- (but not more-) sophisticated investors relying on non-gaap information (Allee et al., 2007; Bhattacharya et al., 2007). More recently, Christensen et al. (2014) find that short sellers, who are generally deemed to be informed traders, trade as if non-gaap earnings disclosures generate exploitable information advantages. Their results are consistent with short sellers viewing non-gaap earnings disclosures as a signal of lower reporting quality and future underperformance and trading to take advantage of potential information asymmetries arising from the disclosures. Consistent with non-gaap reporting informing investors in different ways, Bradshaw et al. (2016) provide evidence that non-gaap earnings decrease investor consensus about future performance, and that this effect is due to different perceptions about expenses. Prior research has also explored analysts forecast revisions surrounding non-gaap disclosures (since 12

15 they are generally viewed to be sophisticated financial statement users) and find that they react to non- GAAP performance measures in revising their future earnings forecasts, but are more skeptical than investors of potentially misleading earnings exclusions (Bhattacharya et al., 2003). In addition to investors and analysts, many other stakeholders use non-gaap performance metrics. For example, Curtis et al. (2015) find that the majority of firms in the S&P 500 use adjusted earnings benchmarks to evaluate CEO performance. Other researchers find that compensation committees commonly identify non-gaap performance metrics for evaluating manager performance in determining executive compensation (Black et al., 2017a). Related studies find a strong association between compensation incentives and managers propensity to disclose non-gaap numbers to external stakeholders (Bansal et al., 2013; Grey et al., 2013; Isidro and Marques, 2013; Scheetz and Wall, 2014). Moreover, the form of their executive compensation can influence managers to have a short- or long-term focus on non-gaap disclosure as indicated by the aggressiveness of their non- GAAP reporting practices (Black et al., 2017a). In addition, creditors often frame debt covenants based on customized non-gaap performance metrics (Christensen et al., 2017b; Dyreng et al., 2017). Christensen et al. (2017b) 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 adjusted performance metrics when they are under scrutiny. Nevertheless, if they decide to report a non-gaap number, they are much less aggressive in their exclusions. (c) What Adjustments Are Commonly Used To Calculate Non-GAAP Earnings? Bradshaw and Sloan (2002) document empirical evidence that the difference between non- GAAP and GAAP earnings grew throughout the late 1980s and 1990s and that this increasing difference is largely attributable to the exclusion of special items (also known as one-time, transitory, or nonrecurring items in the extant literature). Several early studies hand collect non-gaap exclusions to provide evidence on the items that managers and analysts exclude in calculating non-gaap performance metrics. These studies find that in the late 1990s, companies often excluded one-time items (such as gains and losses on asset disposals, merger and acquisition costs, and extraordinary 13

16 items) in an effort to focus investors attention on sustainable earnings (Bhattacharya et al., 2003; 2004; Lougee and Marquardt, 2004; Entwistle et al., 2005; 2006, Nichols et al., 2005). While managers are often criticized for excluding one-time expense items (resulting in a non-gaap metric that exceeds GAAP earnings), empirical evidence indicates that some managers also exclude one-time gains, which results in a lower non-gaap performance metric (Bhattacharya et al., 2003; Curtis et al., 2014, Baumker et al., 2014). For example, Curtis et al. (2014) find that approximately one-half of firms with one-time gains report non-gaap earnings in a manner that easily allows investors to assess operating performance without the gain. However, they also find that some managers are inconsistent in their exclusion choices. For example, these managers exclude income decreasing items in quarters where they exist, but do not to exclude income increasing items in other quarters. Evidence on the current non-gaap reporting environment indicates that nonrecurring items are the most common form of non- GAAP adjustments, and that these adjustments most frequently relate to restructuring charges, tax resolutions, and acquisition related charges (Black et al., 2017b). In some cases, however, managers and analysts do not simply exclude one-time items from their non-gaap calculations, but also remove recurring transactions (also known as other exclusions in the extant literature) that they claim are non-operating or non-cash in nature. Bradshaw and Sloan (2002) document that the exclusion of amortization also contributes to the growing rift between GAAP and non-gaap earnings, while Bhattacharya et al. (2003) provide descriptive evidence that the frequency of depreciation, amortization, and stock compensation exclusions dramatically increased in 2000, as compared to 1998 and Doyle et al. (2003) find that firms with non-gaap metrics exclude an average of two cents per share of expenses related to recurring items. Black and Christensen (2009), Whipple (2016), and Black et al. (2017b) look beyond Bhattacharya et al. (2003) s sample period and find that recurring item transactions remain a common non-gaap adjustment, and that these adjustments primarily relate to stock compensation, amortization, and investment gains and losses. It appears that excluding recurring items has become more common than in earlier non-gaap reporting periods. Changes in accounting standards, such as SFAS 141 (related to accounting for business combinations) and SFAS 123R (related to accounting for stock-based compensation) likely 14

17 contribute to the increase in recurring item exclusions (Barth et al., 2012, Black et al., 2017d) since these standards mandated the inclusion of these items in GAAP-based numbers. 9 (d) What Motivates Managers and Analysts to Provide Non-GAAP Performance Metrics? As non-gaap reporting became popular in the 1990s, regulators, the financial press, and researchers were often cautious about non-gaap performance metrics because these measures deviated from the prescribed standard earnings number. As a result, non-gaap research has largely focused on better understanding the motives for non-gaap reporting. Early evidence from non-gaap studies indicates that non-gaap earnings are typically more persistent than GAAP earnings (Bhattacharya et al., 2003) and more useful for valuation purposes (Bradshaw and Sloan, 2002; Brown and Sivakumar, 2003; Frankel and Roychowdhury, 2005). This evidence is consistent with non-gaap earnings being motivated by an incentive to better inform financial statement users about core operations. Bradshaw and Sloan (2002), however, also note that since non-gaap exclusions frequently relate to expenses, non-gaap reporting might actually represent an attempt by managers and analysts to report higher performance metrics to garner higher valuations. Researchers frequently focus on these two incentives, informativeness versus opportunism, when investigating motives for non-gaap reporting. Numerous studies find evidence suggesting that providing informative or value-relevant earnings information for stakeholders is a significant motivation for managers to report non-gaap earnings metrics (e.g., Entwistle, 2005; Kyung and Lee, 2015; Black et al., 2017b). For example, (1) managers can systematically exclude one-time items, including one-time gains, in calculating non- GAAP earnings to provide a more accurate depiction of core performance (Bhattacharya et al., 2003, Lougee and Marquardt, 2004, Curtis et al., 2014), (2) investors respond more to non-gaap than to GAAP metrics, suggesting greater reliance on non-gaap information than on GAAP information (e.g., Bradshaw and Sloan, 2002, Bhattacharya et al., 2003), and (3) researchers have found evidence suggesting that investors are not mislead by non-gaap reporting (Johnson and Schwartz, 2005), particularly in the post-reg G time period (Chen, 2010, Zhang and Zheng, 2011; Jennings and Marques, 9 SFAS 141 requires firms to account for business combinations using the purchase method of accounting and to amortize certain acquired intangible assets. SFAS 123R requires firms to expense stock-based compensation, which some would argue is defensible (Christensen, 2012). 15

18 2011; Huang and Skantz, 2016; Whipple, 2016). More recently, Black et al. (2017b) examine the comparability and consistency of firms non-gaap reporting since regulators and academics have long argued that non-gaap reporting likely violates these basic tenets of GAAP earnings. 10 They conclude that, on average, managers vary their non-gaap calculations over time and from other firms for informative reasons. In addition, they find that managers have expertise in determining the persistence of earnings components and use this insight to inform their exclusion choices. Finally, Andersson and Hellman (2007) use experimental evidence to offer an explanation for firms tendency toward non-gaap reporting: Managers and financial analysts both seek to create a simpler and more comprehensible mode of financial reporting. Thus, many studies conclude that managers are generally motivated by more altruistic incentives in non-gaap reporting. Despite evidence that non-gaap metrics generally seem to be motivated by an incentive to inform, prior research finds numerous examples of potentially misleading non-gaap disclosures. For example, several studies argue that, while the exclusion of one-time items creates a performance metric that better reflects sustainable performance, the exclusion of recurring items seems less justifiable (Bhattacharya et al., 2003; Black and Christensen, 2009, Barth et al., 2012). Using this same logic, several studies evaluate the quality of non-gaap exclusions based on the extent to which they are associated with future operating performance (e.g., Doyle et al., 2003; Landsman et al., 2007; Kolev et al., 2008; Bentley et al., 2016; Black et al., 2017b), finding that recurring items exclusions are the lowest quality non-gaap adjustments and that these adjustments can mislead investors. Moreover, a large number of studies focus on whether non-gaap exclusions allow a firm to move from a position of missing a strategic earnings target based on GAAP earnings to meeting the benchmark based on non-gaap earnings. These studies infer that the motivation for the exclusions is to mislead investors by convincing them that an artificial performance measure meets a desired outcome (Bhattacharya et al., 2003; Graham et al., 2005; McVay, 2006; Black and Christensen, 2009; Marques, 2010; Doyle et al., 2013; Isidro and Marques, 2015; Wang, 2014; Lopez et al., 2016; Leung and Veenman, 2016; Bradshaw et al., 2017; Brockbank, 2017). 10 Grant and Parker (2001) criticize the fact that many firms make different adjustments in calculating non-gaap earnings each period, reducing the comparability of their earnings over time. They conclude that academic research does not provide conclusive evidence to conclude whether this ad hoc form of disclosure is informative or not. 16

19 While managers are often scrutinized for providing adjusted earnings metrics that depart from GAAP, analysts are generally believed to be more informative in their exclusion choices. Consistent with this notion, analysts focus on sustainable earnings and are less likely to have a motive of misleading investors than are managers. Brown et al. (2015) survey analysts and find that they generally exclude one-time items from their earnings forecasts. 11 In addition, Gu and Chen (2004) find that analysts use their expertise in deciding which nonrecurring items to exclude in order to provide a more informative measure for valuation (also see Chen, 2010). Heflin et al. (2015) find that analysts non-gaap adjustments are informative because they reduce the conditional conservatism found in GAAP-based earnings (see also Sobngwi, 2011), and Bentley et al. (2016) directly compare managers and analysts exclusions and find that analysts exclusions are of higher quality and less aggressive. Baik et al. (2009), however, find that uninformative incentives can also influence analysts exclusions by examining a situation where analysts might report higher non-gaap performance metrics to curry favor with managers. Other examples of aggressive behavior on the part of managers and analysts include (1) the strategic emphasis of non-gaap earnings relative to GAAP earnings (Bowen et al., 2005; Elliott, 2006; Guillamon-Saorin et al. 2012), (2) the strategic timing of earnings announcements containing non- GAAP information (Brown et al., 2012a), (3) the disclosure of non-gaap information in response to general investor sentiment (Brown et al., 2012b), (4) the failure to consistently exclude one-time items (Baik et al., 2009; Hsu and Kross, 2011; Curtis et al., 2014), and (5) the use of non-gaap exclusions to influence IPO pricing (Brown et al., 2017). 12 Moreover, non-gaap disclosures can also be used as part of an overall perception management strategy in conjunction with earnings management (Guillamon-Saorin et al., 2017). Specifically, non-gaap disclosures can substitute for different forms 11 Interestingly, different kinds of analysts have non-overlapping incentives for excluding earnings components. Batta and Muslu (2016) find that credit rating agency and equity analysts make different adjustments that reflect their clienteles, with debt rating analysts making lower (more conservative) adjustments than equity analysts. 12 Chen (2015) explores a related, but different question. Specifically, he examines the pricing impact of as if reported earnings disclosed in the IPO prospectus. Most prospectuses provide as if or pro forma financials since the IPO itself will lead to material events such as the use of proceeds to repurchase bonds, invest in new business lines, etc. Thus, firms will disclose to investors what net income and the balance sheet would look like after the material event. This as if information is forward-looking, whereas Brown et al. (2017) examine the pricing impact of historical earnings information that has been adjusted for certain line items. 17

20 of earnings management and are often used as a last resort after other perception management techniques (Doyle et al., 2013; Black et al., 2017c; Lee and Chu, 2016). (e) What Roles Do Managers And Analysts Play in Determining Non-GAAP Earnings? Researchers have frequently questioned the extent to which non-gaap earnings are a manager- versus analyst-driven phenomenon (e.g., Lambert, 2004; Bradshaw and Soliman, 2007). For example, some managers claim that they provide this information because analysts prefer these modified earnings metrics for forecasting and valuation, while other managers highlight that they use these metrics for internal decision making. On the other hand, some analysts state that they use non- GAAP metrics because managers focus on them, while other analysts state that managers reporting choices have little influence on their exclusion decisions, but instead are based on the properties of the excluded items (Brown et al., 2015; Heltzer et al., 2014). Bradshaw and Sloan (2002) are the first to provide evidence on this question and conclude that managers reporting strategies play a significant role in the increased focus on non-gaap metrics during their sample period. Several other early studies provide evidence indicating that managers and analysts both play a role in non-gaap reporting, as proxies for manager and analyst non-gaap metrics differ approximately one-third of the time (Bhattacharya et al., 2003) and investors appear to respond differently to manager- or analyst-specific adjustments (e.g., Marques, 2006; Bhattacharya et al., 2007; Black et al., 2012; Brown et al., 2012a). Bradshaw and Soliman (2007) highlight the lack of compelling evidence regarding who is responsible for non-gaap reporting as hindering researchers interested in examining the motives of non-gaap reporting. Christensen et al. (2011) shed some light on this question by examining whether managers earnings forecasts influence analysts non-gaap earnings calculations, finding that managers forecasts influence analysts one-time and recurring item exclusions. Their results, however, are indirect in nature (Bradshaw, 2011). Black et al. (2017d) explore the extent to which interactions between managers and analysts in earnings conference calls influence analysts non-gaap earnings. The results suggest that managers can influence analysts exclusions through the narrative portion of the conference call. However, when analysts question managers recommended exclusions during the Q&A portion of the conference call, they are less likely to follow managers suggestions. 18