Non-GAAP Disclosure and Classification Shifting

Abstract

I investigate two discretionary reporting strategies used by managers to highlight core performance – non-GAAP disclosure and classification shifting. Non-GAAP disclosures represent managers’ voluntary disclosure of GAAP earnings that exclude certain non-recurring or non-cash expenses. Managers claim that non-GAAP disclosures better inform investors of underlying core performance. However, such disclosures have been heavily criticized by investors and regulators as an attempt by managers to opportunistically inflate performance. Classification shifting is a reporting strategy that represents managers’ recognition of certain core expenses as special items. The literature provides mixed conclusions as to whether classification shifting reflects managers’ opportunistic actions to inflate core performance or an informative signal of core expenses more likely to persist. I document that managers tend to use non-GAAP disclosures and classification shifting as a joint reporting strategy, especially when external monitoring from institutional investors, analysts, and auditors is high. In addition, firms engaging in both reporting strategies exhibit more persistent earnings, help analysts form less disperse and more accurate expectations, and show higher earnings response coefficients both around the earnings announcement and during the quarter. Collectively, the findings suggest that managers use both strategies jointly as an informative signal of performance rather than as an opportunistic strategy to overstate core performance.