“How does non-GAAP reporting alter the incentives to manage GAAP earnings?” by Dr. Andrew Bauer
Dr. Andrew Bauer
Canada Research Chair in Taxation, Governance and Risk
School of Accounting and Finance, The University of Waterloo
Earnings management and non-GAAP exclusions are two tools that firms use to achieve performance targets, which prior literature argues are substitutes. We conjecture that these tools are not substitutes, rather firms fall into two types: “GAAP-only” (disclose no non-GAAP performance metrics) and “non-GAAP” (disclose non-GAAP performance metrics in addition to GAAP). We believe that GAAP-only (non-GAAP) firms contract on GAAP (non-GAAP) measures; thus, GAAP-only firms have an incentive to manage GAAP earnings, while non-GAAP firms have incentives only to manage non-GAAP earnings. Using data collected from earnings announcements for U.S. firms from 2002-2015, we find that non-GAAP firms demonstrate significantly less GAAP earnings management than GAAP-only firms using either accruals or real activities. Our conclusions are supported by analyzing firms that move from one type to the other and by using propensity score matching, entropy matching, and correcting for self-selection. Using discontinuity analysis, we find evidence that non-GAAP firms manage non-GAAP earnings to avoid losses and decreases in earnings, while demonstrating no such associations for GAAP earnings. Our paper provides evidence that contracting concerns limit the choice set for earnings management activities, which helps to explain managers’ actions under performance management pressures. We also demonstrate a positive effect of allowing non-GAAP disclosures—namely that GAAP earnings quality is higher for these firms.