Non-Gaap Earnings Disclosure And IPO Pricing
Nerissa C. Brown
University of Delaware – Alfred Lerner College of Business and Economics
Theodore E. Christensen
University of Georgia
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University of Padua
Thomas D. Steffen
Yale University School of Management
July 1, 2016
The disclosure of customized (non-GAAP) earnings measures is increasingly common among firms undergoing initial public offerings (IPOs), but the effects of this disclosure practice are heavily debated. We investigate the underlying determinants of non-GAAP disclosure by IPO firms and the role of these metrics in IPO price formation. Using a sample of 696 book-built IPOs completed between 2003 and 2012, we find that firms disclosing non-GAAP earnings figures exclude an economically significant amount of income statement line items in calculating their non-GAAP metrics. Our manual inspection of IPO prospectuses reveals that the majority of these exclusions pertain to recurring expenses. We find that the disclosure of non-GAAP earnings in IPO filings is largely influenced by (1) GAAP-based earnings and cash flow performance, (2) industry-peer effects, (3) litigation risk, and (4) the presence of venture backing. Our pricing tests indicate that non-GAAP IPOs exhibit greater underpricing and post-issue return volatility, and that these effects increase with the magnitude of recurring exclusions. These results point to greater information uncertainty surrounding the disclosure of nonstandard earnings. We also find that underwriters tend to lowball the initial offer price when issuers exclude large amounts of recurring expenses. Additional analyses suggest that this lowballing partly reflects agency conflicts between issuers and underwriters. Taken together, our results extend the non-GAAP earnings literature to the IPO setting and provide evidence on the role of adjusted earnings information in IPO price formation.
Non-Gaap Earnings Disclosure And IPO Pricing – Introduction
In recent years, companies undergoing initial public offerings (IPOs) have increasingly disclosed nonstandard performance measures that do not conform to Generally Accepted Accounting Principles (GAAP), often referred to as non-GAAP earnings. For example, during the 2012?2014 period, 59% of companies going public disclosed a customized earnings measure that departs from traditional GAAP accounting (Rapoport 2015).1 This frequency of disclosure represents an increase of roughly 11% compared to the disclosure rate for IPOs completed during 2010 and 2011. Even more striking is that the non-GAAP disclosure rate for IPO firms is higher than that observed for already-public firms (Bentley, Christensen, Gee, and Whipple 2015).2 Recent survey evidence also indicates significant variety in the earnings adjustments made by IPO firms. For instance, PwC (2014a) reports that 80% of IPO prospectuses containing non-GAAP earnings numbers have at least one adjustment not generally excluded by public companies. These uncommon adjustments include income statement line items such as consulting fees, accretion charges, add-ins of deferred or unearned revenues, stock-symbol acquisition costs, and store opening costs (Raice and Wingfield 2011; PwC 2014a; Rapoport 2015).
Despite the increasing occurrence of non-GAAP earnings measures in IPO prospectuses, the academic literature has yet to investigate this phenomenon. We explore this emerging type of disclosure by investigating (1) the factors influencing the discretionary disclosure of non-GAAP earnings in IPO filings and (2) how these disclosures affect the IPO price formation process with specific focus on first-day returns, upward price revisions, and post-issue return volatility. We also examine the line items IPO firms exclude when recasting GAAP earnings on a non-GAAP basis and whether the magnitudes of these exclusions are economically significant. Finally, using proxies for the informational position of issuers relative to underwriters, we assess whether the relation between non-GAAP earnings and IPO pricing partly reflects agency conflicts between underwriters and issuers (Loughran and Ritter 2002; Willenborg, Wu, and Yang 2015).
Our focus on the disclosure of non-GAAP earnings in IPO prospectuses and its pricing implications is timely in light of the considerable debate about the informativeness of nonstandard performance measures in IPO filings. On the one hand, managers argue that adjusted earnings metrics present a more transparent view of the company’s current earnings performance, enhancing investors’ ability to forecast future performance and thereby value the firm. On the other hand, critics contend that adjusted earnings portray an inflated view of future performance and IPO value, with regulators and standard setters expressing concern about (1) the complexity and lack of comparability of these measures across firms, (2) their undue prominence in prospectuses, and (3) their potential to mislead investors (Usvyatsky 2015). This debate has generated extensive media coverage as a result of SEC scrutiny of customized earnings reported by high-profile IPOs (e.g., Groupon and Twitter), along with recent SEC warnings (not restricted to IPO firms) of possible regulatory actions to rein in non-GAAP abuses (e.g., Teitelbaum 2015; Michaels and Rapoport 2016; Shumsky 2016).
We base our investigation on a sample of 696 book-built IPOs completed during the 2003-2012 period as reported in the Thomson Financial SDC Platinum New Issues database. For each IPO, we retrieve the final prospectus from SEC EDGAR and hand-collect GAAP and non-GAAP earnings information. We also manually classify the various income statement items firms exclude when arriving at the non-GAAP earnings figure. Using textual analytics, we also construct a measure of non-GAAP emphasis based on the frequency of non-GAAP keywords appearing in the prospectus. Our data reveal that roughly 36% of IPO firms disclose an adjusted earnings metric in the final prospectus. However, this disclosure practice increases dramatically over our sample period—61% of the 2012 filings report non-GAAP earnings compared to 22% in 2003. The adjusted earnings in IPO filings are almost always higher than GAAP earnings and primarily exclude significant recurring expenses such as depreciation and amortization costs, interest-related charges, and stock-based compensation. Some firms also undo GAAP revenue recognition rules by adding deferred or unearned revenues to net income. Interestingly, we find that an economically significant proportion of firms’ earnings exclusions pertain to line items that fall outside of common classifications, consistent with anecdotes in the business press.
Using logit analyses, we investigate the influence of several factors on non-GAAP earnings disclosure and the emphasis placed on these metrics in IPO prospectuses. We find that the propensity to disclose non-GAAP earnings decreases with litigation risks and increases with peer-firm disclosure rates, venture backing, and the use of adjusted metrics in debt covenant restrictions. More importantly, we find that the disclosure and emphasis of non-GAAP earnings in IPO filings are uniquely related to GAAP operating performance, compared to the evidence documented in prior research on non-GAAP reporting by public firms. Specifically, IPO firms are less likely to disclose and emphasize adjusted metrics when GAAP earnings are extremely good or poor, suggesting an inverted U-shaped relation between GAAP earnings performance and non-GAAP reporting. We also find that firms tend to disclose and emphasize non-GAAP earnings when they report weak GAAP earnings, but strong GAAP cash flows. This result is consistent with positive cash flows providing firms with more flexibility to recast poor GAAP earnings into better “nearcash” performance. Overall, these results highlight that inferences based solely on the direction of GAAP earnings do not provide a complete picture of firms’ non-GAAP disclosure choices.
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