The use of non-GAAP measures (i.e., pro forma earnings) is a widespread phenomenon. More than 97% of Standard & Poor’s (S&P) 500 elected to disclose non-GAAP metrics in 2017 (Audit Analytics, Long-Term Trends in Non-GAAP Disclosure: A Three-Year Overview, 2018). Companies disclose pro forma earnings after excluding temporary items (e.g., restructuring charges) from GAAP earnings in an effort to provide users with core earnings that are useful to predict future performance and estimate value. Critics claim, however, that companies often utilize pro forma reporting to achieve their financial reporting goals; that is, they opportunistically exclude recurring expense items (e.g., stock compensation expense and amortization) in calculating pro forma earnings to make their performance look better. Compared to GAAP earnings, pro forma earnings are more prone to manipulation, partly because they are not audited. Unfortunately, it is not easy to distinguish “informative” disclosures of pro forma earnings where managers disclose sustainable core earnings from “opportunistic” ones, where managers overstate their operating performance. Consequently, investors—especially less sophisticated investors—may be misled by such opportunistic pro forma reporting.

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Regulators consistently seek ways to enhance the quality of pro forma reporting. Effective March 2003, Regulation G under the Sarbanes–Oxley Act of 2002 (SOX) requires companies to provide a comparable GAAP measure and reconcile the non-GAAP measure to the GAAP measure. Since then, regulators have adjusted restrictions on the disclosure rule of non-GAAP reporting. In 2010, the SEC relaxed the disclosure rule, which led to a substantial increase of non-GAAP measures. In 2015, SEC Chair Mary Jo White expressed a concern that pro forma earnings were being used to improve the appearance of financial performance. In 2016, SEC Chief Accountant of the Enforcement Division Howard Scheck called non-GAAP metrics a fraud risk factor. These warnings were followed by strengthened restrictions on non-GAAP reporting in 2016. Despite these efforts, the quality of non-GAAP earnings continues to be questionable. According to Ernst &Young (EY)’s 2020 SEC Reporting Update, pro forma reporting became the first most common reason for the issuance of a comment letter in 2020, jumping from the second most common reason in 2019.

Earnings Trends

To examine whether non-GAAP earnings are aggressive—and thus opportunistic—this article analyzes a sample of companies disclosing pro forma earnings during the 2004–2019 period. Non-GAAP earnings, a type of voluntary disclosure, are often presented in quarterly earnings press releases, but can also be disclosed in SEC 10-K or 10-Q filings. This article utilizes pro forma earnings hand-collected by Jeremiah Bentley et al (“Disentangling Managers’ and Analysts’ Non-GAAP reporting,” Journal of Accounting Research, vol. 56, no. 4, 2018).

Exhibit 1 presents the means of three measures of earnings per share (EPS) by year: pro forma non-GAAP earnings (EPS-PF), GAAP operating income (EPS-OPER), and GAAP continuing operations (EPS-CON). A total of 49,532 observations were used for this analysis. The average values of non-GAAP EPS and GAAP EPS-operating income over the research period are 0.503 and 0.404, respectively; that is, non-GAAP EPS, on average, is greater than GAAP EPS-operating income by 25%. If the non-GAAP EPS average of 0.503 is compared with the GAAP EPS-continuing operations average of 0.307, the difference is 64%. These results suggest that management opportunistically exercised its discretion in calculating non-GAAP EPS to boost the company’s performance.

Exhibit 1

Means of Earnings Per Share, by Year

Year; N; Non-GAAP; GAAP EPS-PF; EPS-OPER; EPS-CON 2004; 1,125; 0.300; 0.259; 0.192 2005; 1,378; 0.344; 0.301; 0.250 2006; 1,992; 0.395; 0.341; 0.307 2007; 2,089; 0.408; 0.330; 0.275 2008; 2,623; 0.360; 0.184; -0.139 2009; 3,007; 0.338; 0.236; 0.118 2010; 3,031; 0.423; 0.370; 0.318 2011; 3,162; 0.463; 0.399; 0.335 2012; 3,427; 0.496; 0.422; 0.338 2013; 3,651; 0.521; 0.442; 0.383 2014; 3,809; 0.567; 0.481; 0.396 2015; 4,132; 0.573; 0.376; 0.240 2016; 3,912; 0.604; 0.446; 0.348 2017; 4,046; 0.663; 0.553; 0.477 2018; 4,711; 0.797; 0.659; 0.503 2019; 3,437; 0.800; 0.667; 0.567 All years; 49,532; 0.503; 0.404; 0.307 EPS-PF: Pro forma non-GAAP earnings per share provided by management EPS-OPER: Diluted earnings per share from operations-GAAP operating income EPS-CON: Diluted earnings per share before extraordinary items and discontinued operations-GAAP continuing operations

Exhibit 2 illustrates trends of the three measures of earnings based on the data reported in Exhibit 1. Although two drops are observed in 2008–2009 (Great Recession) and 2015 (earnings recession), in general the results show an upward trend over time. For the whole period, non-GAAP earnings (EPS-PF) are the largest and smoothest (least fluctuated) of the three earnings measures. The finding that non-GAAP earnings, which are intended to disclose recurring and core operation performance, are always larger than GAAP operating income (EPS-OPER) suggests the possibility of opportunistic (i.e., aggressive) non-GAAP reporting.

Exhibit 2

Trends of Three Measures of Earnings Per Share

Reference Group

To evaluate the quality of non-GAAP reporting for the general population, a reference group was sought. Regulated industries were selected for this purpose because the need for monitoring and compliance of regulatory provisions could make entities in those industries less likely to pursue aggressive pro forma disclosures. Thus, this study examines whether differences in aggressive non-GAAP reporting exist between regulated and nonregulated industries. Finding a significant difference in the quality of non-GAAP reporting between these two groups would suggest opportunistic involvement of management in the non-GAAP earnings, based on an assumption that management opportunism declines with monitoring. This study follows Laura Field et al (“Does Disclosure Deter or Trigger Litigation?,” Journal of Accounting and Economics, vol. 39, no. 3, 2005) to define the regulated industries, mostly utilities and financial institutions.

Exhibit 3 compares the characteristics of earnings between two groups. In the pooled sample, non-GAAP earnings (EPS-PF) are greater than GAAP continuing operations (EPS-CON) in most cases (81% of observations). In addition, 84% of entities in non-regulated industries report higher pro forma non-GAAP earnings than their GAAP earnings, much higher than 55% of entities in regulated industries. Given that analysts forecast both non-GAAP earnings and GAAP earnings, this study also examines the percentages of companies beating these analysts’ forecasts (often used as a proxy for the market expectation). Although GAAP earnings (EPS-CON) exceed the GAAP forecasts (PRED-GAAP) in 60% of the pooled sample, the pro forma non-GAAP earnings (EPS-PF) beat the corresponding forecasts (PRED-PF) in 72% of the sample. In the comparisons of such cases between two groups, entities in nonregulated industries exceeded the market predictions of non-GAAP earnings by 73%, much higher than 65% of their counterparts. By contrast, there is no statistical difference in the percentages of companies surpassing the market predictions of GAAP earnings between the two groups (61% vs. 59%).

Exhibit 3

Mean Differences in Characteristics of Earnings between Nonregulated and Regulated Industries

Pooled (49,532); Nonregulated industries (45,625); Regulated industries (3,907) Pro forma non-GAAP earnings (EPS-PF) exceed GAAP continuing operations (EPS-CON); 0.812; 0.835&&&; 0.552 Pro forma non-GAAP earnings (EPS-PF) exceed analyst forecasts (PRED-PF); 0.724; 0.730&&&; 0.646 GAAP continuing operations (EPS-CON) exceed analyst forecasts (PRED-GAAP); 0.604; 0.606; 0.591 PRED-PF: Mean of analysts' non-GAAP forecasts PRED-GAAP: Mean of analysts' GAAP forecasts &&& The mean difference between two groups is statistically significant at the 1% level.

In summary, non-GAAP earnings were generally larger than GAAP earnings, and these findings were more pronounced in nonregulated industries than in regulated industries. Although nonregulated industries were more likely than regulated industries to report non-GAAP earnings that beat the market expectations, such opportunistic reporting was not documented in GAAP earnings. All of these results suggest that management, especially in nonregulated industries, opportunistically discloses non-GAAP metrics.

Aggressive Pro Forma Reporting

Following the generally accepted method indicated in the academic literature, this article defines aggressive pro forma reporting by comparing pro forma non-GAAP earnings (EPS-PF) and GAAP earnings (EPS-CON and EPSOPER). For example, reporting positive non-GAAP earnings when GAAP earnings are negative is an example of aggressive non-GAAP reporting. Given that pro forma earnings are claimed to capture operating performance, reporting pro forma non-GAAP earnings (EPS-PF) greater than GAAP operating income (EPS-OPER) is also considered aggressive reporting. Admittedly, not all of these cases represent a fraud risk factor, but disclosure of such pro forma earnings increases the possibility that management exercises its discretion to distort the appearance of performance.

Exhibit 4 shows the analysis result of aggressive reporting. The first measure is CASE 1 where GAAP earnings (EPS-CON) miss analysts’ forecasts (PRED-GAAP), but pro forma non-GAAP earnings (EPS-PF) meet or beat analysts’ forecasts (PRED-PF); such instances comprise 18% of the pooled sample. For CASE 1, nonregulated industries have a mean of 18%, significantly higher than the mean of 14% in regulated industries. CASE 2 is the second measure of aggressive reporting practice where pro forma non-GAAP earnings (EPS-PF) are greater than GAAP operating income (EPSOPER); this situation is evident in 66% of the pooled sample. For CASE 2, nonregulated industries report a mean of 68%, higher than the mean of 47% in regulated industries. The last measure of aggressive reporting is CASE 3, where pro forma non-GAAP earnings (EPS-PF) are zero or positive while GAAP earnings (EPS-CON) are negative. Although this result appears in 9% of the pooled sample, the difference in means between two groups (9% versus 5%) is statistically significant. This finding—that, in all three cases, entities in nonregulated industries report more frequent cases of aggressive reporting—implies that non-GAAP reporting is associated with management opportunism.

Exhibit 4

Mean Differences in Aggressive Pro forma Reporting between Nonregulated and Regulated Industries

Pooled (49,532); Non-regulated industries (45,625); Regulated industries (3,907) CASE 1: GAAP earnings (EPS-CON) miss analyst forecasts (PRED-GAAP), but pro forma non-GAAP earnings (EPS-PF) exceed analyst forecasts (PRED-PF); 0.179; 0.183&&&; 0.143 CASE 2: Pro forma non-GAAP earnings (EPS-PF) exceed GAAP operating income (EPS-OPER); 0.664; 0.681&&&; 0.467 CASE 3: GAAP earnings (EPS-CON) is negative, but pro forma non-GAAP earnings (EPS-PF) is zero or positive; 0.087; 0.090&&&; 0.051 &&& The mean difference between two groups is statistically significant at the 1% level.

Final Thoughts

Non-GAAP earnings, management’s view about core operations, are outside of the scope of the auditor’s report, which may provide management with an incentive that opportunistically utilizes its discretion in determining non-GAAP earnings. Management can cherry-pick numbers to achieve its reporting purpose. The above analysis implies that aggressive non-GAAP reporting is present to a certain degree, which can pose fundamental challenges for policy makers. Despite attempts at greater regulation, opportunistic reporting has not been deterred.

Some contend that non-GAAP reporting (focusing on forward information) largely results from shortcomings of GAAP reporting (providing retrospective information). The increasing use of non-GAAP earnings may be considered a potential red flag, given evidence of aggressive non-GAAP earnings and auditors’ limited role on non-GAAP reporting. A discussion on the expanded responsibility of auditors as a governance mechanism may be warranted in order to enhance the overall quality and decision-usefulness of non-GAAP reporting. Above all, investors should be careful when interpreting companies’ performance based on non-GAAP metrics.

Myungsoo Son, PhD, CPA (Korea), is a professor in the school of accountancy at California State University, Fullerton.