Non-GAAP Reporting and Investment

Abstract

Managers’ incentives depend on their firms’ stock prices, which are often determined by investors using earnings. When investors use GAAP earnings, managers’ investment decisions into internally generated intangible assets become sensitive to the transitory items in these earnings. Non-GAAP earnings can remove these transitory items, and thus improve investment efficiency, but also introduce opportunistic bias, and thus hide inefficient investment. We quantify this trade-off by estimating a dynamic model in which a manager makes investment and non-GAAP disclosure decisions and where investors rationally anticipate his incentives. We find the manager’s ability to distort non-GAAP earnings creates inefficient investment choices and destroys firm value. We estimate the magnitude of the loss in the average firm value at just under 1%.

Keywords: Non-GAAP, pro-forma, investment, intangible assets, real effects, structural estimation