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

Abstract

While non-GAAP reporting is under debate as managers may 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 revisions upon the release of material restatements are most pronounced for firms that frequently inflated non-GAAP earnings through the exclusion of recurring expenses before the restatement announcement. 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 see through the quality of non-GAAP exclusions.

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

JEL Classification: G1, K4, M4