۱- Introduction

۲- Institutional framework

۳- Literature review, contribution, and expectations

۴- Methodology

۵- Results

۶- Conclusions

References

Abstract

This study benefits by a special feature of the UK information environment which allows UK firms to disclose non-GAAP earnings on the face of the income statement to examine two interrelated questions. First, we ask whether the decision to disclose non-GAAP earnings on the face of the income statement is related to the firm’s financial performance and corporate governance characteristics, and second, we investigate the effect of this disclosure decision on market liquidity. Using a dataset of 1227 hand-collected firm-year observations during the period 2006–۲۰۱۳, we show that better governed firms and firms with weaker financial performance are more likely to disclose non-GAAP earnings. Our evidence also suggests that this disclosure is associated with increased levels of market liquidity and the results hold after controlling for self-selection bias. We conclude that firms’ decision to disclose non-GAAP earnings on the face of the income statement is more consistent with the incentive to provide information than to mislead the market.

Introduction

Prior research provides evidence that non-GAAP earnings disclosures are becoming more prevalent as an increasing number of firms choose to disclose pro forma earnings in a number of forms and different venues. Extant literature though has not yet settled on what drives the decision to disclose non-GAAP earnings and how it affects the firm’s information environment. Non-GAAP earnings capture the “core” or “permanent” part of earnings by excluding components of GAAP earnings that are deemed exceptional or nonrecurring. However, given their discretionary and voluntary nature, the disclosure of non-GAAP earnings falls within the realm of positive accounting theory (Watts & Zimmerman, 1978), and it centers around the question of whether such choice is made to benefit managers against the interests of investors or to increase firm value (Bowen, Rajgopal, & Venkatachalam, 2008). Choi and Young (2015) define the former incentive as strategic and the latter as informative. That said, extant literature has been inconclusive as to which of the two incentives can better explain a firm’s decision to disclose non-GAAP earnings. In essence, the issue of whether nonGAAP earnings disclosures provide new and value relevant information to the market or whether they are merely intended to mislead capital market participants is still an open research question. Thus, the aim of this paper is to provide more evidence on this debate by examining the determinants of non-GAAP earnings disclosures and their effects on market liquidity, a market characteristic that is especially affected by changes in the firm’s information environment, making it a better indicator of information quality. Specifically, we examine these questions using a sample of UK firms which choose to make non-GAAP earnings disclosures on the face of the income statement. Even though in recent years a number of studies examined the economic consequences of non-GAAP earnings, there is only scant research in the UK, since the majority of related studies employ US data (Young, 2014). Nevertheless, research on non-GAAP disclosure in the UK is of particular importance, because the corresponding European legislative framework is very different from that of the US. First, the UK is a country with strong legal enforcement and developed capital markets, characteristics that set it apart from other European countries. More importantly though, UK financial reporting is based on IFRS, which is mandatory for the consolidated accounts of public companies across Europe. In sharp contradiction to the requirements regarding non-GAAP earnings in the US, IFRS allow such disclosures to be shown on the face of the income statement. Given their more prominent place in the financial statements, the incentives and effects associated with disclosures of non-GAAP earnings on the face of the financial statements may be fundamentally different from those associated with disclosures which are sparsely incorporated in the notes or which are made in venues other than the financial statements.