Non‐GAAP Earnings Disclosure in Loss Firms

• Date: 01 September 2018
• Author: EDITH LEUNG,DAVID VEENMAN
• DOI: http://doi.org/10.1111/1475-679X.12216
• Published date: 01 September 2018

DOI: 10.1111/1475-679X.12216

Journal of Accounting Research

Vol. 56 No. 4 September 2018

Printed in U.S.A.

Non-GAAP Earnings Disclosure

in Loss Firms

EDITH LEUNG ∗AND DAVID VEENMAN †

Received 18 August 2016; accepted 20 April 2018

ABSTRACT

This study examines the incremental information in loss firms’ non-GAAP

earnings disclosures relative to GAAP earnings. Using a large sample ob-

tained through textual analysis and hand-collection, we posit and find that

loss firms’ non-GAAP earnings exclusions offset the low informativeness of

GAAP losses for forecasting and valuation. Loss firms’ non-GAAP earnings

are highly predictive of future performance and are valued by investors, while

the expenses excluded from GAAP earnings are not. Additional tests suggest

that loss firms disclosing non-GAAP profits have significantly better future

performance than GAAP-only loss firms and are not overvalued by investors.

∗Erasmus School of Economics, Erasmus University Rotterdam; †Amsterdam Business

School, University of Amsterdam.

Accepted by Philip Berger. Weappreciate the helpful comments and suggestions from an

anonymous reviewer. We also thank Rashad Abdel-Khalik (EAA discussant), Jannis Bischof,

Mark Bradshaw, Ulf Br¨

uggemann, Stefano Cascino, Jeffrey Doyle (FARS discussant), Peter

Easton, Lisa Goh, Peter Joos, Dennis Jullens, Thomas Keusch, Felix Lamp, Justin Leiby, Robin

Litjens, Alvis Lo, Venky Nagar,James Ohlson, Peter Pope, Sandra Schafh¨

autle, Joe Schroeder,

Harm Sch¨

utt, Anup Srivastava, M´

at´

eSz

´

eles, Jenny Tucker, Marcel Tuijn, Ben Whipple, Brian

White, brownbag participants at Erasmus University, participants of the XI Workshopon Em-

pirical Research in Financial Accounting in C´

ordoba, the EAA annual meeting in Maastricht,

the 2016 Tilburg Accounting Spring Camp, the 2017 AAA FARS midyearm eetingin Charlotte,

PhD students at the Limperg Financial Accounting course, and workshop participants at the

University of Amsterdam, University of Mannheim, ESSEC Business School, IESEG School of

Management, Hong Kong Polytechnic University, and Lancaster University for helpful com-

ments and discussions. We thank Faissal El Allaoui and Gijs van Vugt for excellent research

assistance and Thomson Reuters for providing access to I/B/E/S data. This work is part of the

research programme MaGW Veni with project number 451-16-006, which is partly financed by

the Netherlands Organisation for Scientific Research (NWO).

1083

CUniversity of Chicago on behalf of the Accounting Research Center,2018

1084 E.LEUNG AND D.VEENMAN

Comparing non-GAAP earnings of profitable firms to those of loss firms, we

find that loss firms’ non-GAAP metrics are significantly more predictive and

less strategic. We conclude that non-GAAP earnings disclosures are particu-

larly informative about loss firms and help investors disaggregate losses into

components that have differential implications for forecasting and valuation.

JEL codes: G14; M41; M48

Keywords: non-GAAP; pro forma; disclosure; valuation; loss firms; earnings

persistence; information uncertainty; textual analysis

1. Introduction

Prior research indicates that losses tend to be less persistent than profits,

because of shareholders’ option to liquidate the firm (e.g., Hayn [1995],

Lawrence, Sloan, and Sun [2017]). Moreover, loss firms are associated with

increased uncertainty about future earnings compared to profitable firms

(e.g., Konstantinidi and Pope [2016]). This uncertainty is consistent with a

wide range of factors that lead to losses, each of which has different impli-

cations for future performance. For example, losses can stem from distress,

one-time cash flow shocks, transitory accruals due to conditional conser-

vatism, as well as strategic investments that are fully expensed (e.g., R&D).

In recent years, some firms have reported losses because of the mandatory

recognition of stock-based compensation or the amortization of acquired

intangibles, expenses that are sometimes viewed as having ambiguous im-

plications for future performance (e.g., Blacconiere et al. [2011], Barth,

Beaver, and Landsman [2012], Buffett [2016]).1As a result, the aggrega-

tion of items with varying persistence can reduce the informativeness of

GAAP losses for forecasting and valuation.

Uncertainty about future performance increases investor demand for

supplemental information (e.g., Healy and Palepu [2001]), and managers

have incentives to credibly disclose salient information to alleviate mar-

ket frictions (e.g., Diamond and Verrecchia [1991], Leuz and Verrecchia

[2000]). Given the wide variation in loss persistence, investors can bene-

fit from disclosures that help them disaggregate losses into components

that have different implications for forecasting and valuation. We exam-

ine whether the disclosure of non-GAAP earnings measures in press re-

leases serves as an alternate source of information that helps investors

1For example, prior to SFAS 123R (effective for fiscal periods starting on or after June

15, 2005), Apple, Inc. reported positive annual earnings for fiscal 2002 and 2003. However,

the company also disclosed these earnings would have been negative had it been required

to expense stock-based compensation. Apple’s 2003 10-Q filings reveal the same pattern for

five of the six interim quarters in 2002 and 2003. Conversely, by May 2017, Salesforce, Inc.

had reported a loss in 20 of 25 quarterly earnings announcements since the start of fiscal

2011. In 19 of these quarters, the magnitude of the recognized stock-based compensation

expense exceeded the magnitude of the loss, implying that Salesforce’s earnings would have

been positive if it had not been required to expense stock-based compensation.

NON-GAAP EARNINGS DISCLOSURE IN LOSS FIRMS 1085

better understand the nature and implications of GAAP losses. In addi-

tion to providing what managers argue to be a better reflection of “core”

performance, non-GAAP measures are reconciled to their closest GAAP-

equivalents. These reconciliations provide investors with a disaggregation

of the items managers deem to be less persistent and irrelevant for users’

decision making.2

The results in prior research are generally consistent with the notion that

manager-disclosed non-GAAP earnings metrics provide incremental infor-

mation about future firm performance and firm value relative to GAAP

earnings (e.g., Bhattacharya et al. [2003]), particularly when the under-

lying GAAP earnings are less informative (e.g., Lougee and Marquardt

[2004]). On the other hand, prior studies also conclude that at least some

managers disclose non-GAAP earnings opportunistically, since some non-

GAAP exclusions are associated with future performance (Doyle, Lund-

holm, and Soliman [2003], Kolev, Marquardt, and McVay [2008], Frankel,

McVay, and Soliman [2011]) and some managers use these exclusions to

meet earnings benchmarks such as analysts’ forecasts or the profit–loss

threshold (Lougee and Marquardt [2004], Black and Christensen [2009],

Doyle, Jennings, and Soliman [2013]). The financial press also frequently

debates the usefulness of non-GAAP measures and questions whether these

measures are used to inflate investors’ perceptions of firm performance,

especially for loss firms (e.g., Morgenson [2016]).3Although the SEC be-

gan regulating non-GAAP reporting in 2003, it issued additional guidance

for its implementation in 2010 and 2016 due to increased concerns over

managers’ strategic presentation of non-GAAP metrics.4Thus, regulators

still view the disclosure of non-GAAP earnings to be a risk to investors.

We identify a sample of 5,174 GAAP loss-firm quarters with earnings press

releases that contain a non-GAAP earnings measure over the 2006–2014

2We use the term “non-GAAP” earnings to identify manager-disclosed earnings metrics that

deviate from GAAP,also known as “pro forma” earnings. These manager-disclosed metrics of-

ten differ from analyst-defined measures, often known as “street” earnings, because managers

and analysts have different motives for excluding items in calculating their alternative earn-

ings measures (Easton [2003], Christensen [2007], Bentley et al. [2018, BCGW]). Some of

the prior studies we reference use street earnings from I/B/E/S to proxy for management-

disclosed earnings measures (e.g., Doyle, Lundholm, and Soliman [2003], Kolev, Marquardt,

and McVay [2008], Bradshaw et al. [2018]). BCGW compare non-GAAP measures defined

by managers versus I/B/E/S and find that, on average, I/B/E/S data tend to reflect the

more informative disclosures of non-GAAP earnings provided by managers, while not cap-

turing the more aggressive disclosures. They conclude that the use of I/B/E/S data to proxy

for manager-disclosed non-GAAP earnings leads to an underestimation of the aggressiveness

of some managers’ reporting. They also conclude that I/B/E/S provides a more appropriate

proxy for managers’ non-GAAP reporting when I/B/E/S identifies non-GAAP earnings for a

firm’s peers, when more analysts follow the firm, when the firm has transitory expenses, and

when I/B/E/S excludes recurring expenses.

3See also Morgenson [2015], Rapoport [2015], Michaels and Rapoport [2016], and Shum-

sky and Francis [2016].

4https://www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm.