Non-GAAP Reporting and Investment

Abstract

When investors use GAAP earnings to value firms’ shares, managers’ investments into intangible assets become sensitive to transitory earnings. Non-GAAP earnings can remove these transitory earnings, 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. We find the manager’s ability to bias non-GAAP earnings creates inefficient investment choices and destroys firm value. We estimate the magnitude of overinvestment at 6% and the corresponding loss in the average firm value at just under 1%.

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