The Relation between Earnings Management and Pro Forma Reporting

The Relation between Earnings Management and Pro Forma Reporting

Ervin L. Black Sr. Brigham Young University – Marriott School of Management

Theodore E. Christensen Brigham Young University – Marriott School of Management

T Taylor Joo University of Arkansas – Department of Accounting

Roy Schmardebeck University of Arkansas

May 1, 2013

We investigate the association between past and current earnings management and the likelihood that companies will disclose pro forma earnings. Specifically, we investigate how prior earnings management, current-period operating performance, real earnings management, and accruals management influence the probability that a company will disclose an adjusted earnings metric in its earnings press release. We also explore how these same factors influence the likelihood of aggressive pro forma disclosures. We define aggressive disclosures as those that exclude recurring items, use earnings exclusions to convert a Generally Accepted Accounting Principles (GAAP) loss to a pro forma profit, or convert a GAAP earnings metric that falls short of earnings expectations to a pro forma earnings number that meets or exceeds expectations. The results indicate that companies with more constrained balance sheets (i.e., those that have used up their accruals in prior periods) and less current-period earnings management (i.e., those with lower abnormal accruals) are more likely to disclose pro forma earnings and do so aggressively. Moreover, we find some evidence that companies using more real earnings management and with better operating performance are less likely to report aggressive pro forma numbers. These results suggest that while more past earnings management is consistently positively associated with aggressive pro forma reporting, we find evidence of a substitute relation between aggressive pro forma reporting and both abnormal accruals and real earnings management. In sum, managers are more likely to disclose aggressive pro forma earnings when they (1) have a more constrained balance sheet, (2) are less able to manage earnings with accruals or real earnings management, and (3) have less profitable operations. Finally, we find evidence that investors appear to understand these tradeoffs as they discount pro forma disclosures in the presence of higher levels of prior earnings management.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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