Do Non-GAAP Expense Exclusions Mislead Investors?

A firm has two options when reporting its quarterly and annual earnings: It can report earnings based on generally accepted accounting principles (GAAP), or it can report non-GAAP earnings by excluding (adding) certain expenses that will increase (decrease) its non-GAAP earnings relative to its GAAP earnings. As the rate of non-GAAP reporting has increased, the Securities and Exchange Commission (SEC) has expressed concern that this practice has the potential to mislead investors. In line with this, the academic literature is also mixed when it comes to the usefulness of non-GAAP reporting. In our paper, we further examine firms’ use of non-GAAP reporting and the possibility of investors being misled when non-GAAP earnings are used to beat analysts’ quarterly earnings forecasts.

When reporting quarterly earnings, some managers argue that non-GAAP earnings metrics better reflect core earnings that will persist into future quarters. Unlike the exclusion of one-time gains, which is more likely aimed at highlighting recurring core earnings, it is more difficult to assess managers’ motivations when they decide to exclude expenses in the calculation of non-GAAP earnings. Although managers may argue that non-GAAP earnings are a more accurate view of sustainable future earnings, the exclusion of recurring operating expenses is far less defensible. In addition, if a manager excludes certain expenses, and thereby moves from a position of missing the analysts’ forecast to one of beating it, the exclusion is more likely to be opportunistic. Consistent with these competing views of managers’ motivations, the academic literature provides evidence for both the opportunistic view and the contrasting informative view. To determine whether investors are misled by firms that use non-GAAP exclusions opportunistically, we examine firms’ non-GAAP exclusion persistence, future performance, and earnings announcement-related market returns.

One reason for researchers’ mixed opinions on the opportunism of non-GAAP exclusions is the data previously used in academic studies. Recent studies suggest that relying on the data from the Institutional Brokers’ Estimate System may lead to a significant measurement error. This error may, in turn, lead to the misclassification of whether a firm beats or misses its earnings target. Additionally, researchers have shown instances where the type of reporting (GAAP versus non-GAAP) was misclassified. To more accurately measure firms’ reporting, we use both a programmatic search of earnings announcements along with a hand collection of earnings directly from the firms’ earnings-announcement press releases.

To identify the aggressive or opportunistic use of exclusions, previous researchers have used the exclusion of recurring items or exclusions to beat earnings targets. We combine these two measures and classify a firm’s non-GAAP use as opportunistic when it misses its GAAP earnings forecast but beats its non-GAAP forecast solely by the use of exclusions. We use this definition because it describes  arguably the most egregious behavior and the situation in which investors are most likely to be misled.

An example of our setting can be explained as follows: A firm with GAAP earnings per share (EPS) of $1.00 and a GAAP EPS forecast of $1.10 will have a negative ($0.10) GAAP forecast error. Assuming the firm has $0.30 of non-GAAP exclusions, then non-GAAP EPS will be $1.30. If the analyst accurately forecasts the $0.30 of non-GAAP exclusions, the non-GAAP forecast would be $1.40, and the firm will miss the non-GAAP forecast by the same $0.10 ($1.30 – $1.40). In contrast, if the analyst forecasts only $0.10 of non-GAAP exclusions, then the non-GAAP forecast will be $1.20 ($1.10 GAAP EPS forecast + $0.10 exclusion forecast). In this event, the unanticipated exclusion of $0.20 (the $0.30 total exclusion reported by the firm less the exclusion forecast by the analyst, $0.10) allows the firm to move from missing the GAAP forecast by $0.10 to beating the non-GAAP forecast by $0.10 ($1.30 non-GAAP EPS less non-GAAP forecast of $1.20).

To get a sense of the frequency of this opportunistic non-GAAP reporting, we present the following summary statistics. Overall, a firm is more likely to beat its analysts’ forecast than it is to miss it. We find that 60 percent of the companies in our sample beat their forecast, while 12 percent matched and 28 percent missed. Of the firms that beat their non-GAAP forecast, we find that 17 percent missed their GAAP forecast (opportunistic firms). Unconditionally, we find that this opportunistic use of non-GAAP exclusions represents 13 percent of our total sample. Because earnings announcements are an extremely important event for firms, this high rate of opportunistic use of non-GAAP reporting seems to support the SEC’s concern over opportunistic non-GAAP reporting.

The argument in favor of non-GAAP reporting is that it better represents core earnings and avoids the effects of one-time or non-recurring items. To examine this, we start by comparing the persistence of opportunistic non-GAAP exclusions for firms that did not rely on non-GAAP exclusions to beat forecasts. Here we find that the persistence of opportunistic exclusions exceeds that of exclusions not used to beat earnings. Additionally, the persistence of the opportunistic exclusions is indistinguishable from ordinary operating expenses. Taken together, this is initial evidence that the exclusions used to beat non-GAAP forecasts are more likely to be part of core earnings and not one-time expenses.

If the opportunistic use of non-GAAP earnings misleads investors, then it should have implications for future performance. To test this, we examine four measures of future performance: loss frequency, EPS, return on equity, and return on assets. Examining these measures over four quarters following the earnings announcement, we find a significant underperformance for firms that opportunistically use non-GAAP exclusions. To better understand the magnitude of this underperformance, we find that the future performance of these opportunistic firms is the same as that of firms that missed their earnings targets. Our performance results suggest that firms’ use of opportunistic non-GAAP exclusions is associated with future performance similar to that of firms that miss their earnings forecasts.

If investors see through a firm’s opportunistic use of non-GAAP exclusions, we would expect the market response to its earnings announcement to be similar to that to firms that miss rather than beat their earnings forecast. Inconsistent with this, we find that firms avoid the penalty that would normally be associated with missing their earnings forecast. Similar to the persistence results, we find that firms are rewarded for their opportunistic use of exclusions at a level that is more similar to firms that beat their earnings target, suggesting that investors do not see through the opportunistic use.

Our results, taken together, suggest that opportunistic non-GAAP exclusions used to beat earnings forecasts mislead investors. Even though firms exclude persistent recurring expenses, and their future performance is similar to that of firms that miss their earnings forecast, the market rewards these firms for beating their forecasts via a premium and a positive earnings response coefficient. These results suggest that the SEC is justified in its concern that investors are misled by the non-GAAP earnings of firms that opportunistically use expense exclusions to beat their non-GAAP earnings forecasts.

This post comes to us from professors Thomas J. Lopez at the University of Alabama, Christopher McCoy at William & Mary, Gary K. Taylor at the University of Alabama, and Michael Young at the University of Virginia. It is based on their recent article, “Are Investors Misled by Non-GAAP Expense Exclusions Used to Beat Analysts’ Earnings Forecasts?,” available here.

1 Comment

  1. Serge Pattyn

    Astonished by the message “that investors do not see through the opportunistic use”.
    I myself am a great believer of fundamental analysis and though the way the numbers are presented or phrased is not always straigthforward, the information is there to do your homework.
    But seemingly markets are more and more short term oriented and “believe” what is communicated in the morning.
    Still, I stick to my believe : as an investor, do your homework.
    Thanks for the article.

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