Chapter 2.

Literature Review
The Non-GAAP Measures
There is growing evidence that the use of non-GAAP performance measures is an increasingly
common global phenomenon, especially among large listed companies.5 In 2017, 97 percent of
S&P 500 firms in the United States used at least one non-GAAP metric. This share represents an
increase of roughly 20 percentage points compared to ten years earlier, according to Audit
Analytics (2018).6,7 In Europe, around 75 percent of a sample of 170 European issuers make use
of APMs as a measure of the financial situation or performance outside the financial statements
(ESMA [2018]). ]). Moreover, these numbers seem to be widely used in practice by investors: in
a survey conducted by the CFA Institute (Papa and Peters [2016]), 63 percent of respondents
indicated that they always or often use non-GAAP financial measures. This figure is not far
behind the 71 percent of respondents in the survey that said they always or often use
GAAP/IFRS.
Non-GAAP measures can be informative in the sense that they provide information that is
helpful for stakeholders in understanding profit numbers that managers deem important. Lev and
Gu (2016, p. 205), for example, argue that “an SEC regulation (2003) requiring the reconciliation
of non-GAAP with GAAP earnings, and empirical evidence documenting that investors respond
to non-GAAP earnings more strongly than to their GAAP brethren, conferred certain
respectability on pro forma earnings and other non-GAAP items” (emphasis in the original).
Supporters of non-GAAP measures argue that firms’ motive for reporting non-GAAP measures
is to inform investors: at least under certain circumstances, presenting non-GAAP measures
managers deem important allows them to better explain the firm’s future earnings prospects. On
the other hand, critics argue that non-GAAP measures can be misleading, opportunistic, and
reflect management self-interest. Such critics highlight that non-GAAP earnings are often higher
than GAAP earnings and meet or beat earnings benchmarks and/or analysts’ forecasts.
Moreover, it is also argued that the adjustments firms make to arrive at their non-GAAP
measures are often arbitrary. A number of studies have investigated these issues and have found
evidence consistent with both sides of the argument.10,11 This is not surprising, because both
sets of motives—to better inform investors about the firm’s future earnings prospects on the one
hand and to present earnings in a better light—are not mutually exclusive. . Firms suffering
losses or firms that are at an early stage of growth and development may be more inclined to
report non-GAAP measures. Such measures could reflect managers’ overly optimistic views, but
they could also be informative in showing the underlying profits that firms regard as recurring. In
other words, the measures can be either informative or misleading, or both at the same time.
Even the same firm may act differently depending on the situation it is facing. In response to
concerns over the potential misuse of non-GAAP measures, securities regulators around the
world, especially the U.S. Securities and Exchange Commission (SEC), have tried to limit the
potential for misuse.12 In the United States, the Sarbanes-Oxley Act of 2002 and Regulation G
imposed strict requirements for non-GAAP reporting. While the SEC loosened restrictions on
non-GAAP reporting in 2010, it again introduced tighter restrictions by updating its interpretive
guidance in May 2016.13 In the European Union, the European Securities and Market Authority
(ESMA) published its final Guidelines on Alternative Performance Measures (nonGAAP
measures) for listed issuers in October 2015, which became effective in July 2016.14 Moreover,
in June 2016, the International Organization of Securities Commissions (IOSCO) issued the
Statement on Non-GAAP Financial Measures to assist issuers not only in providing clear and
useful disclosure, but in reducing risk that such measures are presented in a way that could be
misleading. Despite these efforts by securities regulators, concerns over troubling use of non-
GAAP measures persist. Sherman and Young (2018, pp. 57–58), for instance, argue that they
have seen “a troubling trend” in the use of alternative measures, saying that “[a]lternative
measures, once used fairly sparingly and shared mostly with a small group of professional
investors, have become more ubiquitous and further and further disconnected from reality.”
Understanding Non-GAAP Reporting in the Broader Voluntary Disclosure Literature
There is only one theory paper that we are aware of that deals exclusively with non-GAAP
reporting (Hirshleifer and Teoh, 2003). Other publications codify our ideas regarding "core
earnings" (also known as "maintainable earnings" and "transitory earnings," respectively) (Stark,
1997; Ohlson, 1999). Since the majority of managers assert that they omit "transitory items" in
order to present a performance metric that truly captures their firms' core profitability, a
comprehension of these topics is essential. But over time, the larger disclosure theory literature
has changed. Disclosure theories typically try to explain why managers decide to freely reveal
information to the public (e.g., Verrecchia, 1983; Dye, 1985; Trueman, 1986; Jung and Kwon,
1988; Diamond and Verrecchia, 1991; Einhorn and Ziv, 2008). Non-GAAP earnings are an
optional disclosure that gives managers the chance to share their own performance metrics that
are derived from conventional GAAP-based statistics. Public and private knowledge have
frequently been distinguished in earlier theories. The timeliness of earnings information is also
investigated in theoretical study.
Non-GAAP earnings are an optional disclosure that gives managers the freedom to share their
own performance metrics that are derived from conventional GAAP-based statistics. Information
that is public and private has frequently been distinguished in earlier theories. Furthermore,
theoretical research examines how timely earnings information is. Most theories centre on
managers' efforts to lessen information asymmetry by giving markets information either publicly
or privately. Theoretically, the decision of managers to disclose non-GAAP performance metrics
is likely influenced by tradeoffs between the advantages and disadvantages of such disclosure
(e.g., Verrecchia, 1983). The costs and advantages of disclosure are actually assessed in an
endogenous game between managers and consumers of financial reports. The signal-to-noise
ratio of a particular disclosure signal influences both the availability and demand of information
provided by managers (e.g., performance). It is more likely that a signal will be revealed and
required by consumers of financial statements for both valuation and contracting if it is
sufficiently informative relative to its noise or variance. Managers can utilise non-GAAP
performance to deliver a better indication of performance when GAAP earnings become too
noisy and to reduce the information asymmetry brought on by a noisy GAAP statistic.
However, accurate and reliable non-GAAP disclosure is necessary for it to be effective. If not,
those who use financial information would just ignore or reject the non-GAAP disclosure. Non-
GAAP reporting also falls under a multi-period disclosure strategy, unlike some disclosure
models that concentrate on a one-period setting.
As a result, those who utilise financial statements will gain knowledge from previous firm
decisions, which suggests that managers who aggressively make non-GAAP disclosures while
misleading stakeholders will likely damage the company's reputation over time. If financial
statement users learn to recognise aggressive non-GAAP reporting and are motivated by
incentives that are aligned with them, non-GAAP disclosures should, on average, be made.
However, there may be circumstances in which corporations publish deceptive performance
indicators in order to collect rents from consumers of financial statements due to the opaqueness
of firm disclosures, investors' scant attention, or a manager's narrow focus.