Non-GAAP earnings and board independence

Pursuant to Regulation G, managers are required to reconcile non-GAAP earnings to the closest GAAP earnings figure in the press release. We examine how this affects our results in Sect. 4.2.1. Regulators remain concerned about non-GAAP reporting, however; for example, in January 2010, the SEC stated that it will inquire about significant differences between what firms disclose in their SEC filings and what they disclose in press releases (PwC 2010).

Effective March 2003, Regulation G requires that firms disclosing non-GAAP earnings measures (1) provide a comparable GAAP measure, (2) reconcile the non-GAAP measure to the GAAP measure, and (3) file, within five days, a Form 8 K that explains why management believes the non-GAAP measure to be useful to investors.

Unlike Yi (2007), Kolev et al. (2008) base their analysis on analysts’ determinations of core earnings, which they use to proxy for non-GAAP earnings issued by managers in the press release (see also Doyle et al. 2003, among others).

Meeting the analyst consensus forecast might be in the best interests of existing shareholders. However, Richardson et al. (2004) find that managers manage analysts’ expectations downward in order to meet the analyst forecast before selling their personal shares in the company. Similarly, McVay et al. (2006) find evidence that managers manipulate working capital accruals to meet the analyst forecast before selling their personal shares.

This result may seem counterintuitive as insiders would likely want to avoid seemingly opportunistic behavior around the time they trade their shares. However, shareholders would have difficulty proving opportunism given the lack of specific regulatory requirements associated with disclosure of non-GAAP earnings. Thus, the benefits of a higher selling price can exceed the expected costs of detection.

We focus on the alignment of interests between shareholders and managers, but efficient organizational design would minimize contracting costs between all factors of production (e.g., Jensen and Meckling 1976).

For example, the July 27, 2004, earnings release of BMC Software included the following language: “This press release includes financial measures for net earnings, earnings per share (EPS) and operating expenses that exclude certain charges and, therefore, have not been calculated in accordance with U.S. generally accepted accounting principles (GAAP). A detailed reconciliation between the GAAP results and results excluding special items (non-GAAP) is included with the financial tables accompanying this press release. BMC Software has provided these non-GAAP measures in its press releases reporting historical financial results because the Company believes these measures provide a consistent basis for comparison between quarters, as they are not influenced by certain non-cash or non-recurring expenses and are therefore useful to investors in helping them understand the financial condition of BMC Software by focusing on the performance of its core operations. Management uses these non-GAAP financial measures internally to evaluate the Company's performance and as a key variable in determining management compensation. These non-GAAP measures should not be considered an alternative to GAAP, and these non-GAAP measures may not be comparable to information provided by other companies.” (emphasis added).

Following much of the prior literature, we treat board structure as exogenous. However, to the extent that board structure and disclosure policy are jointly determined, our inferences may be biased. As Hermalin and Weisbach (2003) note, theory and evidence on the determinants of board structure are limited. Research suggests that firm size and growth are related to board independence. Thus, following prior studies, we control for these characteristics in our tests (Klein, 2002b; Lehn et al., 2003; Boone et al., 2007). We also include lagged performance as an additional control in untabulated results. Finally, we use the natural experiment of Regulation G to help mitigate concerns related to endogeneity.

Along these lines, Christensen et al. (2010) find that short sellers target stocks with earnings announcements containing pro forma earnings disclosures and that they short stocks more that exclude recurring items and those that use pro forma exclusions to meet analysts’ expectations.

Of course excluding these expenses may be optimal if their persistence is significantly lower than that of core earnings. Absent opportunism, however, we should not find that the level of permanence varies with board independence, that this relation changes around Regulation G, and that these exclusions are associated with meeting the analyst forecast preceding insider trading.

GAAP earnings is earnings per share before discontinued operations and extraordinary items (data item #9). Operating income is earnings per share before special items, discontinued operations, and extraordinary items on a diluted basis (data item #177 × #54/#171).

The SEC’s cautionary advice stated that “companies need to describe accurately the controlling principles [and] the particular transactions and the kind of transactions that are omitted” (Securities and Exchange Commission, 2001). The SEC also said that it would not deem a non-GAAP figure misleading if the company disclosed in plain English how it deviated from GAAP and the amount of each of those deviations. Following the dictates of Congress in the Sarbanes–Oxley Act, the SEC promulgated Regulation G (see also footnote 3). As previously noted, regulators remain concerned about non-GAAP reporting. For example, in January 2010, the SEC stated that it will inquire about significant differences between what firms disclose in their SEC filings and what they disclose in press releases (PwC 2010).

Brown et al. (2009), using a more comprehensive dataset find that, although there was an initial dip in the frequency of non-GAAP earnings disclosures after SOX and Reg. G., the frequency of non-GAAP earnings reports has continued to increase in recent years.

Preliminary History is a dataset (accessible via WRDS) that contains the as-first-filed financial statement figures. Quarterly Compustat routinely overwrites the original values to reflect subsequent discontinued operations and mergers and acquisitions (Standard and Poor’s 2003, Ch. 2, p. 9). This “as originally reported” data corresponds to the actual earnings reported in a given 10Q or 10 K, rather than a subsequently adjusted number.

We thank Ted Christensen and Erv Black for the use of their hand-collected non-GAAP earnings data.

Doyle et al. (2003) scale exclusions by assets per share, while Gu and Chen (2004) scale exclusions by price. Following Doyle et al. (2003), we scale our variables by assets per share. Results are similar, though weaker, if we scale using price per share.

For NYSE firms, independence is defined as follows: the director (1) cannot have a material relationship with the company, (2) cannot have been an employee for 5 years, (3) cannot have been an employee of the company’s auditor for 5 years, (4) cannot have been an interlocking director (i.e., an executive of company A serves on the compensation committee of B, and an executive of company B serves on the board of company A), and (5) cannot have an immediate family member who would be disqualified for any of these reasons. The NASDAQ and NYSE rules are similar.

The consensus from these papers is that corporate governance is multifaceted. However, the data used in both of these studies are new and the analyses are thus limited to the years 2002–2004. Alternatively, Bowen et al. (2008) use the G-Score developed in Gompers et al. (2003) as their main corporate governance metric. We do not use a metric of “shareholder rights” but rather focus on financial reporting oversight.

While we focus on board independence, this variable is likely correlated with other governance features (e.g., a CEO who is also the chairman of the board).

Doyle et al. (2003) also consider future cash flows and future abnormal returns as dependent variables. With respect to cash flows, as noted by Easton (2003) and Kolev et al. (2008), this dependent variable is less desirable as current liabilities have future cash flow implications. Consider, for example, expenses that are incurred but not paid. These expenses are paid in future quarters, resulting in a mechanical relation between exclusions from permanent earnings and future cash flows. With respect to returns, unlike our earnings measures, returns are also affected by investors’ treatment of the exclusions. Because our focus is on the permanence of the exclusions, we focus on the variables that can speak most directly to the quality of the exclusions (i.e., whether they recur in earnings). Moreover, as noted in Bowen et al. (2005), the placement of non-GAAP earnings within the press release has changed over time; thus, investor treatment may also have changed over our sample period.

We replicate each of our results using each of the growth factor’s inputs individually; results are similar. We also consider the age of the firm as a potential correlated-omitted variable. Results are not sensitive to the inclusion of the age of the firm, defined as the number of years the firm was listed on Compustat.

We also interact both non-GAAP earnings and each of the control variables with non-GAAP exclusions; results are similar (not tabulated).

An alternative explanation for this result is that some types of firms tend to exclude expenses that are more persistent (e.g., amortization expense) and that these firms are systematically related to board independence (i.e., there is a correlated omitted variable that explains our result). In unreported tests, we check whether the autocorrelation of exclusions varies with board independence and find no significant correlation. In other words, it is the “quality” of the exclusion, not simply the existence of an exclusion, that varies with board independence.

Recall that our definition of non-GAAP exclusions assigns excluded losses a positive sign and excluded gains a negative sign.

We select this cutoff following Kolev et al. (2008). Results, however, are not sensitive to the cutoff selected. Though it limits the number of observations in the “post” sample, parsing by the first quarter of 2003 following Heflin and Hsu (2008) produces qualitatively similar results, as does excluding all quarters from 2001 and 2002.

Results are similar for future GAAP earnings (not tabulated).

Results continue to hold if we interact each of our control variables with Met with Exclusions (not tabulated). Note that Jennings and Marques (2010) find no evidence that their measure of opportunism (meeting an earnings benchmark with exclusions) varies with governance. As previously mentioned, however, using exclusions to meet an earnings benchmark may be in the best interest of the firm. Thus, we condition on more direct evidence of managerial opportunism, meeting the benchmark using exclusions immediately followed by managers selling their personal shares.