Disclosure Prominence and the Quality of Non‐GAAP Earnings

• Published date: 01 March 2021
• Author: JASON V. CHEN,KURT H. GEE,JED J. NEILSON
• Date: 01 March 2021
• DOI: http://doi.org/10.1111/1475-679X.12344

DOI: 10.1111/1475-679X.12344

Journal of Accounting Research

Vol. 59 No. 1 March 2021

Printed in U.S.A.

Disclosure Prominence and the

Quality of Non-GAAP Earnings

JASON V. CHEN,∗KURT H. GEE,†AND JED J. NEILSON†

Received 15 January 2019; accepted 24 November 2020

ABSTRACT

The SEC prohibits the presentation of non-GAAP measures before corre-

sponding GAAP measures; however, a large proportion of non-GAAP re-

porters present non-GAAP EPS before GAAP EPS in their earnings announce-

ments. This noncompliance raises questions about whether firms use promi-

nence to highlight higher or lower quality non-GAAP information. For firms

reporting non-GAAP EPS between 2003 and 2016, prominent non-GAAP EPS

is associated with higher quality non-GAAP reporting. Further tests reveal that

nonregulatory incentives, rather than regulatory costs, explain this relation.

Specifically, prominence is associated with higher quality non-GAAP report-

ing in settings where prominence is not regulated, investors ignore promi-

nence when non-GAAP reporting quality is lower, and the minority of firms

using prominence to mislead exhibit characteristics associated with weaker

investor monitoring. Overall, we provide evidence that regulatory noncom-

pliance can reflect an intent to inform, and that most firms use prominence

∗University of Illinois at Chicago; †Penn State University.

Accepted by Rodrigo Verdi. We acknowledge helpful comments from Kris Allee, Mary

Barth, Dirk Black, Sam Bonsall, François Brochet (AAA discussant), Bryan Brockbank, Gary

Chen, Ted Christensen, Edith Leung, Henock Louis, Charlie McClure, Karl Muller, Richard

Sloan, Kevin Standridge, Mary Tokar, Laura Wellman, Ben Whipple, Hal White, and work-

shop participants at the 2018 BYU Accounting Research Symposium, the Financial Account-

ing Standards Board, Penn State University, University of Illinois at Chicago, the 2019 Col-

orado Summer Accounting Research Conference, the 2019 Yale SOM Summer Accounting

Conference, the 2019 AAA Annual Meeting, and the 2019 Carnegie Mellon University Sum-

mer Slam. We are grateful for the financial support provided by Penn State University and

the University of Illinois at Chicago. An Online Appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

163

© University of Chicago on behalf of the Accounting Research Center, 2020

164 j. v. chen, k. h. gee, and j. j. neilson

to highlight higher quality non-GAAP information despite prohibitive regu-

lation.

JEL codes: G18, G41, M40, M41, M48

Keywords: non-GAAP earnings; disclosure prominence; reporting quality;

disclosure regulation; regulatory compliance; voluntary disclosure

1. Introduction

Prior research on the use of non-GAAP earnings suggests that firms may

report non-GAAP earnings to either inform or mislead investors. Concerns

about firms using non-GAAP to mislead prompted the U.S. Securities and

Exchange Commission (SEC) to prohibit the presentation of non-GAAP

financial measures more prominently than comparable GAAP measures in

certain firm disclosures (SEC [2003], Castillo, Eiger, and Pinedo [2017]).1

Despite this prohibition, 36% of non-GAAP reporters in recent years (2015

and 2016) presented non-GAAP EPS before GAAP EPS in their earnings

announcements, an ordering that the SEC identifies as noncompliant.2

When deciding whether to present non-GAAP EPS prominently, firms

likely consider potential regulatory and nonregulatory costs and benefits

(e.g., SEC scrutiny, reputation loss, capital market reaction). Prominence

may signal informative non-GAAP reporting if firms with lower quality re-

porting are less willing to bear potential regulatory or nonregulatory costs

(Gigler [1994]). Alternatively, firms might present lower quality (and more

favorable) information prominently if potential costs are low and/or in-

vestors naively use prominent information without regard for its quality

(e.g., Hirshleifer and Teoh [2003]). Because firms’ expectations of poten-

tial regulatory costs and nonregulatory incentives (i.e., costs and benefits)

are difficult to ascertain ex ante, we examine (1) whether firms that present

non-GAAP EPS prominently have higher or lower quality non-GAAP re-

porting and (2) the extent to which regulatory or nonregulatory costs and

benefits explain this behavior.

Our measure of prominence is based on the SEC’s requirement that

firms accompany non-GAAP financial measures with “a presentation, with

equal or greater prominence, of the most directly comparable financial

measure calculated and presented in accordance with GAAP” (17 CFR §

229.10(e), “Item 10(e)” hereafter). SEC guidance and comment letters fur-

ther indicate that “a non-GAAP measure that precedes the most directly

comparable GAAP measure” is considered more prominent by the SEC

(SEC [2016]; see example comment letters in appendix C). Accordingly,

1For example, in prepared remarks given in October 2000, Lynn E. Turner,then Chief Ac-

countant of the SEC, conveyed concern about non-GAAP earnings numbers presented promi-

nently in press releases and advised investors to “be wary of such disclosures and the story

being presented” (SEC 2000).

2See, for example, SEC [2007, 2010, 2015, 2016], as well as additional detail in appendix C.

disclosure prominence and the quality of non-gaap earnings 165

we measure non-GAAP prominence based on the ordering of non-GAAP

EPS and GAAP EPS in firms’ quarterly earnings announcements—if non-

GAAP EPS appears before GAAP EPS in the earnings announcement, we

classify the announcement as presenting non-GAAP EPS prominently. Our

measure of non-GAAP prominence is objective, easily measured over large

samples, and matches the SEC’s guidance.3We use a large sample of non-

GAAP EPS disclosures from Bentley et al. [2018] for the years 2003–16

to examine non-GAAP prominence. Approximately 26% of earnings an-

nouncements in our sample present non-GAAP EPS prominently, that is,

before GAAP EPS.

To understand firms’ motives for presenting non-GAAP EPS prominently

(i.e., to inform or mislead), we test the association between non-GAAP

prominence and non-GAAP reporting quality using several measures of

non-GAAP reporting quality from prior academic research. Four results

indicate that prominent non-GAAP EPS is associated with higher quality

non-GAAP reporting. Firms presenting non-GAAP EPS prominently (1) are

more likely to have transitory items but not more likely to exclude recurring

items, (2) are less likely to exclude more expenses than analysts deem ap-

propriate when defining non-GAAP EPS, (3) exclude items with a less pos-

itive relation with future operating earnings and cash flows, and (4) have

non-GAAP EPS that is more positively related to future operating earnings

and cash flows than GAAP EPS. Thus, prominent non-GAAP EPS is, on av-

erage, associated with higher quality non-GAAP reporting, both across non-

GAAP reporting firms (cross-sectionally) and relative to GAAP EPS (within

firm).4Assuming that firms reveal their motives for reporting non-GAAP

EPS via their reporting practices, our results suggest that, on average, firms

use prominence to inform rather than mislead.

Given that we find that non-GAAP prominence is associated with higher

quality non-GAAP reporting, we next examine whether non-GAAP promi-

nence reflects firms’ weighing of potential regulatory costs and nonregula-

tory incentives (i.e., costs and benefits). We infer the existence of potential

regulatory costs by comparing the prominence of non-GAAP EPS in the

earnings announcement to its prominence in the concurrent conference

call, in which prominence is not regulated. Given that the earnings an-

nouncement and associated conference call occur contemporaneously, dif-

ferences in non-GAAP prominence between the disclosure media for the

3In section 3.2, we compare our measure of prominence to additional dimensions of promi-

nence of interest to the SEC. These additional dimensions of prominence are rare and, when

they do occur, are significantly more likely when our measure identifies non-GAAP EPS as be-

ing prominent. Thus, the SEC’s definition of prominence is largely reflected by the ordering

of non-GAAP and GAAP information.

4Although the relative distance between the GAAP and non-GAAP earnings metrics is not

a component of prominence that is regulated by the SEC, academics may be interested in this

alternative measure. Our finding that non-GAAP prominence is associated with higher quality

non-GAAP reporting also holds using this alternate measure of prominence.