Are Investors Misled by Exclusions of Recurring Expenses from Non-GAAP Earnings?

Abstract

While non-GAAP reporting is under debate as managers might opportunistically inflate non-GAAP earnings, analytical research by Hirshleifer and Teoh (2003) proposes that limited attention causes mispricing when inappropriate items are excluded from non-GAAP earnings but will be reversed subsequently. Addressing this proposition empirically, we find that market revisions upon the release of material restatements (a proxy of heightened investor attention) are more negative for firms that ex-ante excluded recurring expenses frequently (a proxy for inappropriate non-GAAP adjustments). This finding suggests that investors may fail to detect less salient, yet available, public information. Further, we document that investors reward aggressively reported non-GAAP earnings before the restatement announcement, but punish the same reporting choices in the post-restatement period. Overall, our findings suggest that investor attention, which increases after the restatement, enhances investors’ ability to disentangle aggressive from non-aggressive non-GAAP reporting choices. Findings hold for the pre- and post-Regulation G period.

Keywords: Non-GAAP reporting, investor attention, financial restatements, information content of earnings, firm value, overvaluation

JEL Classification: G1, K4, M4