The Relation between Earnings Management and Pro Forma Reporting
May 8, 2013 Leave a comment
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
Abstract:
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.
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