Take a look at almost any earnings press release and you’ll see that standard accounting numbers—for net income, earnings per share, and even revenue—are buried under an avalanche of alternative takes. Companies often say these alternative numbers, rather than those required under generally accepted accounting principles, the regulatory standard for US-listed companies, provide a broader perspective of a company's performance.
To ensure that companies aren’t misleading investors, the Securities and Exchange Commission regulates how alternative metrics may be presented. But research by Chicago Booth’s Charles McClure and Anastasia A. Zakolyukina suggests these non-GAAP numbers may serve a useful function for investors: managers use the dual presentation of GAAP and non-GAAP numbers to support decisions to invest more, which in turn can increase fundamental firm value.
The effort to rein in the proliferation of misleading alternative numbers is in its third decade. The 2002 Sarbanes-Oxley Act created Regulation G, and in May 2016 the SEC published updated guidance. Since then, a slew of companies have received SEC comment letters, and in some cases the SEC’s enforcement division filed regulatory sanctions.
Yet companies still report non-GAAP results, which adjust for nonrecurring items that may distort investors’ perceptions. According to data provider Calcbench, most large publicly traded companies use non-GAAP disclosures, which almost always tell a more positive story than comparable GAAP figures. Media outlets also tend to compare the adjusted earnings to analyst non-GAAP estimates.
McClure and Zakolyukina sought to assess the pros and cons of non-GAAP reporting. Unable to observe managers’ choices directly, they estimate a dynamic model that explicitly incorporates managers’ optimal choices and investors’ pricing decisions. The model examines the trade-off between noisy GAAP earnings and less noisy but potentially biased non-GAAP earnings, attempting to answer “what if” questions and evaluate the consequences of prohibiting non-GAAP earnings entirely or precluding opportunistic bias in non-GAAP earnings. When answering these questions, the model considers, for example, how much managers’ incentives rely on current stock prices and how much weight investors put on GAAP versus non-GAAP earnings. This approach could help regulators understand the effects of possible rule changes and regulatory enforcement, the researchers write.
While Sarbanes-Oxley improved financial reporting, there’s still room to increase disclosure regulation.
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Research is uncovering messages that managers may not be intending to send—and that investors should listen for.
How to Listen for the Hidden Data in Earnings CallsTheir study finds a positive relationship between non-GAAP disclosure and the level of corporate investment into intangible assets such as research and development and brand capital. According to the model, when companies disclose GAAP earnings only, managers tend to underinvest. But with GAAP and non-GAAP earnings, managers overinvest in intangibles. The managers’ ability to opportunistically twist non-GAAP earnings to tell a positive story exacerbates this further.
The overinvestment destroys just under 1 percent of firm value. This provides an upper bound of the benefit for a regulation aimed at completely eliminating misleading non-GAAP disclosures. However, supplementing GAAP earnings with (biased) non-GAAP earnings increases firm value by 3.4 percent relative to GAAP-only reporting, according to the model.
“The manager’s myopia and investors’ imperfect knowledge about his actions imply underinvestment when the stock price depends on GAAP earnings only,” write McClure and Zakolyukina. “The underinvestment pattern changes when the stock price depends on both GAAP and non-GAAP earnings. Non-GAAP earnings can encourage higher investment.”
The only source of the manager’s bias, though, is pressure from short-term price movements, write the researchers. Because the manager cares about market reaction to reported earnings, he invests less when GAAP earnings get hit by negative transitory items such as write-offs and restructuring charges. The non-GAAP earnings that exclude transitory items can resolve this underinvestment problem but allow for managerial opportunism.
Either way, the researchers conclude that the ongoing, widespread reporting of adjusted metrics alongside standard ones could ultimately be efficient—and good for investors.
Charles McClure and Anastasia A. Zakolyukina, “Non-GAAP Reporting and Investment,” Accounting Review, forthcoming.
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