The Relation Between Earnings Management and Pro Forma Reporting

The Relation Between Earnings Management and Pro Forma Reporting
Ervin L. Black
Theodore E. Christensen
Brigham Young University
T. Taylor Joo
New Mexico State University
Roy Schmardebeck
University of Arkansas
March 2014
We appreciate helpful comments from Michael Drake, Adam Esplin, Bret Johnson, Jeff Wilks, Chris
Williams, Shankar Venkataraman, and workshop participants at the University of Arkansas, Brigham
Young University, the 2013 BYU Accounting Research Symposium, and the 2014 AAA Financial
Accounting and Reporting Section Midyear Meeting. We also express appreciation to Brigham
Young University for student mentoring grants that made the collection of the pro forma earnings
data possible, and to the many students who have read thousands of press releases to hand-collect the
data.
Electronic copy available at: http://ssrn.com/abstract=2259379

The Relation Between Earnings Management and Pro Forma Reporting
Abstract
Managers have a variety of tools at their disposal to influence stakeholder perceptions. Earnings
management and the strategic reporting of non-GAAP (pro forma) performance metrics are just two
of the many choices on the menu. We investigate how managers use of other menu items can
influence the likelihood that they will disclose pro forma earnings. Specifically, we explore how (1)
prior earnings management, current-period (2) operating performance, (3) real earnings management,
and (4) accruals management influence the probability that a company will disclose an adjusted
earnings metric in its earnings press release and the likelihood that it will do so aggressively. Based
on a sample of hand-collected pro forma earnings disclosures, we find that companies that have used
up their accruals in prior periods and that engage in less current-period earnings management are
more likely to disclose pro forma earnings and to do so aggressively. Moreover, we find some
evidence that companies using more real earnings management and with better current 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. 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.
Keywords: pro forma earnings, accruals, real earnings management, earnings management constraints
Electronic copy available at: http://ssrn.com/abstract=2259379

1. Introduction
We explore various perception management techniques commonly used by managers. One of
these techniques is the disclosure of non-GAAP (pro forma) earnings. In particular, we investigate the
relation between the disclosure of pro forma earnings and (1) past earnings management, (2) current
operating performance, (3) current real earnings management and (4) current accruals management.
Prior research debates whether pro forma earnings provide investors with a clearer picture of future
operating performance (not conveyed by GAAP earnings) or whether they portray an overly
optimistic depiction of current performance (Bhattacharya et al. 2003; Curtis et al. 2014). For more
than a decade, the Securities Exchange Commission (SEC) has expressed concern about the potential
for pro forma earnings disclosures to mislead investors (Dow Jones 2001; SEC 2001a, 2001b). In
2010, Howard Scheck, Chief Accountant at the SECs Division of Enforcement identified non-GAAP
earnings metrics as a fraud risk factor (Leone 2010). Most recently, the SEC formed a taskforce in
July of 2013 to scrutinize companies non-GAAP earnings metrics that could potentially be
misleading with an eye toward possible enforcement cases (Rapoport, 2013). This skepticism about
pro forma earnings stems from the fact that these non-GAAP earnings disclosures are not audited and
therefore allow managers discretion in providing non-standard and potentially misleading
performance metrics.
Prior research finds that managers use discretion allowed within GAAP to meet or beat
strategic earnings targets (e.g., Bartov et al. 2002; Kasznik and McNichols 2002; and Graham et al.
2005). However, within-GAAP earnings management is only one tool that managers can use to
manage shareholder perceptions. Prior research finds that managers sometimes disclose adjusted
earnings numbers to appear to meet strategic earnings targets on a pro forma basis when GAAP
earnings fall short (Black and Christensen 2009; Brown et al. 2012; Doyle et al. 2013), suggesting that
meeting strategic earnings targets on a non-GAAP (pro forma) basis when GAAP numbers fall short
is one reason managers may decide to disclose pro forma earnings metrics.
We propose that managers likely have a menu of choices from which they can choose to
influence shareholder perceptions, and their selection in a given period depends on the relative costs
1
and benefits of each menu choice. While individual managers may have different menu choice
preferences, we believe most would prefer to simply meet or beat strategic targets with strong
operating performance. If managers can meet their strategic objectives based on neutral reporting of
strong operating performance, then they have no need to manage earnings or report non-GAAP
earnings. However, when operating performance alone does not allow companies to meet or beat
earnings targets, then managers can use the discretion allowed within GAAP to influence the reporting
of current performance with several other menu choices such as real earnings management (e.g.,
decreasing discretionary spending), accruals management (e.g., managing reserves), classification
shifting (McVay 2006), and expectation management (Matsumoto 2002). However, sometimes
managers best efforts to manage earnings cannot produce GAAP earnings that meet or beat strategic
earnings goals.
We predict that managers are more likely to turn to pro forma reporting when their efforts to
manage perceptions via other menu choices fall short. In other words, if managers cannot meet
strategic targets with current-period operating performance or within-GAAP earnings management
techniques (real earnings management, accruals management) then, they are more likely to resort to
the disclosure of a non-GAAP (pro forma) earnings number that achieves their objective. While real
earnings management may still be possible when the balance sheet is constrained due to past accruals
management, undertaking real activities to manage earnings is costly relative to other tools for
meeting earnings targets. All else equal, we predict that companies with (1) more past earnings
management, (2) lower current period operating performance, (3) less real earnings management, and
(4) lower current period accruals are more likely to resort to pro forma reporting to meet current-
period strategic earnings targets. We also test cross-sectional settings in which the costs of real
earnings management and accruals management are high/low, because managers decision to disclose
pro forma earnings also depends on the relative costs of earnings management mechanisms for their
company (Zang 2012).
We also explore how these same factors influence the likelihood of aggressive pro forma
disclosures. We define aggressive disclosures as those that (1) use earnings exclusions to convert a
2
GAAP loss to a pro forma profit, (2) convert a GAAP earnings metric that falls short of earnings
expectations to a pro forma earnings number that meets or exceeds expectations, or (3) exclude
recurring items. While non-GAAP earnings numbers may not be credible to all users, prior research
suggests that some financial statement users rely heavily on pro forma earnings (Frederickson and
Miller 2004; Elliot 2006; Bhattacharya et al. 2007). In addition, the disclosure of pro forma earnings
may be less costly than either real or accruals management since the adjustments used to derive the
pro forma earnings number do not affect actual operations or the balances reported in the financial
statements.
While some prior studies have used I/B/E/S actual earnings as a proxy for manager-disclosed
non-GAAP earnings, we use hand-collected pro forma earnings disclosures from earnings press
releases to explore how these other perception management menu choices influence managers
propensity to disclose pro forma earnings and to do so aggressively. We begin our analyses based on a
sample of companies that report pro forma earnings at least once between 1998 and 2006 (7,101
company-year observations) and investigate whether the incidence of reporting a pro forma earnings
number is related to current performance, past earnings management, or current earnings
management. In our second set of analyses, we focus on a subset of 2,568 company-year observations
in which companies disclose pro forma earnings and investigate the relation between these aggressive
pro forma earnings disclosures and our variables of interest.
We find robust evidence suggesting that companies that have engaged in more earnings
management in prior periods (i.e., those with tighter balance sheet constraints) are more likely to
disclose pro forma earnings in the current period (and to do so in an aggressive manner). We also find
consistent evidence indicating that companies with more current period income-increasing accruals
are less likely to report pro forma earnings (or to do so aggressively). Moreover, we find some
evidence that companies using more real earnings management and with better current 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, there is a substitute relation between aggressive pro forma reporting and both abnormal
3
accruals and real earnings management. Interestingly, when we perform market reaction tests around
earnings announcements containing pro forma earnings disclosures, 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. Overall, we believe this evidence will be of interest to investors,
regulators, and other stakeholders concerned with pro forma reporting.
2. Background and Hypothesis Development
Perception Management
Managers have a variety of tools at their disposal for managing stakeholder perceptions,
including real earnings management, accruals management, and non-GAAP reporting. While most of
the same perception management menu choices are available to managers of different companies,
their menu-item preferences likely vary cross-sectionally based on each firms unique
circumstances.1 According to Graham et al. (2005), managers generally care most about GAAP
earnings, especially earnings per share (EPS). Investors, in particular, focus on whether companies
meet or beat analysts expectations (Kinney et al. 2002; Skinner and Sloan 2002). Although meeting
or beating earnings targets leads to positive stock returns, the use of earnings management to achieve
these goals is not costless. Prior research suggests that managers make trade-offs between accruals
and real earnings management because of the relative costs of these menu choices (Cohen et al. 2008;
Cohen and Zarowin 2010; Badertscher 2011). The use of real earnings management can incur real
1
McVay (2006) finds that in addition to accruals management and real earnings management, there is yet another
mechanism by which managers can manage perceptions. Managers can shift expenses out of (and revenues into)
core earnings because financial analysts are more likely to discount special items because they are considered to be
transitory. The advantage of classification shifting is that the bottom-line GAAP earnings remain the same, making
this type of earnings management less susceptible to scrutiny from auditors and regulators. The cost, however, is the
decrease in the earnings quality of the manipulated core earnings. Further research by Fan et al. (2010) finds that the
use of special items is more likely in the fourth quarter than in interim quarters. Finally, Matsumoto (2002) and
Cotter et al. (2004) find that managers can influence analyst expectations by issuing forecasts that guide analysts
forecasts down. The cost of lowering analysts expectations may be a decline in stock price because of lower
expected earnings. However, managers would still choose to lower the expectation if the benefit of meeting or
beating the expectation is still larger than the cost of the initial low expectation. While we acknowledge that
expectations management is a part of meeting or beating analyst benchmarks, we focus on earnings management
mechanisms.
4
economic penalties. For example, to perform real earnings management, managers may decide to cut
research and development or advertising expenditures. With accruals management, managers can
exercise discretion by changing accounting methods, estimates, or the timing of an accrual. However,
within-GAAP changes to accounting policies and estimates are subject to scrutiny from auditors,
investors, lenders, and other stakeholders.
Marquardt and Wiedman (2004) distinguish between detected and undetected accruals-based
earnings management and find evidence that managers use the two types of earnings management in
different settings when seeking to achieve established benchmarks.2 For example, when a company
issues equity, Marquardt and Wiedman find that managers prefer to manage earnings upward by
accelerating revenue recognition. They also find that when companies try to avoid reporting an
earnings decrease, they are more likely to employ transitory and less costly techniques.
Prior Accruals Management
When managers choose to influence stakeholder perceptions through traditional earnings
management techniques, accruals accumulate on the balance sheet as operating assets and liabilities.3
Barton and Simko (2002) find that companies with higher net operating assets at the beginning of the
period are more likely to miss analysts earnings expectations based on GAAP earnings at the end of
the period. Hirshleifer et al. (2004) call the extent of overstated net operating assets, balance sheet
bloat. Excessive balance sheet bloat limits managers future flexibility to use accruals to manage
earnings. In other words, to the extent that managers have used accruals to manage earnings in prior
periods, they may be constrained to select other menu choices in the future.
2
See Marquardt and Wiedman (2004, pp. 466-472) for a detailed discussion on the costs and benefits of earnings
management involving accruals.
3
Earnings management through accruals affects the income statement and also the assets and liabilities as reported
on the balance sheet. Inflating earnings through accruals increases both income and net operating assets. Although
income statement accounts are closed out to retained earnings at the end of each period, balance sheet accounts are
permanent. Thus, non-reversing accruals accumulate on the balance sheet. Barton and Simko (2002) suggest that net
operating assets at the beginning of a period reflect the net cumulative extent of prior earnings management through
accruals. In other words, high net operating assets can indicate prior aggressive accrual choices associated with
earnings management. Furthermore, prior research (Barton and Simko 2002; Hirshleifer et al. 2004; Ettredge et al.
2010; Badertscher 2011) finds that earnings management can use up slack in the balance sheet and, thus, a high
level of net operating assets can serve as a constraint that limits managers future reporting flexibility (i.e., their
ability to record additional income-increasing accruals).
5
Because investors penalize companies that fall short of analysts earnings forecasts (Kinney
et al. 2002; Skinner and Sloan 2002), managers have strong incentives to meet or beat expectations.
Managers can meet expectations through earnings management (Bartov et al. 2002). However, if the
ability to use earnings management in the current year is limited because of past earnings
management (as evidenced by the beginning of the year value of net operating assets), managers may
try to mitigate the negative effects of failing to meet analyst expectations based on reported GAAP
earnings through an alternative perception management menu choice: pro forma reporting.
The disclosure of non-GAAP (pro forma) earnings may be an attractive alternative for some
managers because external auditors are not required to audit non-GAAP earnings metrics disclosed in
press releases,4 giving managers discretion over how to portray their core operating performance.
Additionally, pro forma disclosures are relatively less costly than other forms of perception
management. However, since pro forma earnings do not represent the official GAAP earnings
number reported in 10-Q and 10-K filings, investors may discount pro forma earnings numbers when
companies have high levels of balance sheet constraints due to prior earnings management. Rather
than manipulating accruals or managing transactions, managers can disclose pro forma earnings
metrics to appear to meet strategic earnings targets on a pro forma basis even though they fall short
based on GAAP earnings. They do so by excluding recurring items5 or altering the number of shares
outstanding used to calculate EPS.
Prior research on pro forma reporting examines the informativeness and persistence of pro
forma earnings (Bhattacharya et al. 2003; Doyle et al. 2003; Lougee and Marquardt 2004; Bowen el al.
2005), who trades on pro forma earnings (Frederickson and Miller 2004; Bhattacharya et al. 2007,
Allee et al. 2007), and the determinants of pro forma reporting (Lougee and Marquardt 2004; Bowen et
al. 2005). Bowen et al. (2005) find that company characteristics such as sales growth, earnings
4
We acknowledge that the SEC monitors pro forma disclosures in SEC filings (e.g., 10-K, 10-Q, and 8-K filings).
We do not know the extent to which the SEC monitors non-GAAP disclosures in press releases. However, anecdotal
evidence suggests that auditors routinely review press releases prior to their public release.
5
Examples of recurring items managers can exclude are items such as depreciation and amortization expense, stock
compensation expense, and R&D expense (Bhattacharya et al. 2003).
6
volatility, leverage, number of special items, and low informativeness of GAAP earnings are positively
related to pro forma reporting. We contribute to this literature by exploring how past and current
earnings management influences the likelihood that managers will disclose pro forma earnings.
This discussion leads to our first formal hypothesis. Prior research suggests that earnings
management bloats the balance sheet and constrains managers ability to use earnings management in
future periods. Therefore, we hypothesize that companies with more past accruals management, as
evidenced by constrained balance sheets, will have less flexibility to manage accruals in the current
period and thus will be more likely to resort to pro forma reporting to manage investor perceptions.
Hence, our first hypothesis, stated in the alternate form is:
HYPOTHESIS 1. Companies with more past earnings management (as represented by

higher balance sheet constraints) are more likely to disclose pro forma earnings and
to do so aggressively.
Current Operating Performance
Clearly, there is no substitute for solid current-period operating performance to convey a
strong perception to stakeholders. If managers can meet strategic earnings targets based on neutral
reporting of unmanaged operating performance, they have no need to attempt real or accruals
management. When operating performance alone does not portray the picture managers want to
depict, we argue that they are more likely to turn to other perception management tools. Thus, we
expect that the companys propensity to disclose pro forma earnings is higher if the company has
lower current period unmanaged operating performance. Stated in an alternative form, our next
hypothesis is:
HYPOTHESIS 2. Companies with lower unmanaged current-period operating

performance are more likely to disclose pro forma earnings and to do so aggressively.
Current Real Earnings Management
Graham et al. (2005) find survey evidence indicating that managers prefer to use real
earnings management relative to accruals management. Zang (2012) comes to a similar conclusion
based on archival data. She finds that managers use real earnings management before accruals
management because accruals management happens after the end of the fiscal year while real
7
earnings management takes place during the fiscal period. An interesting result highlighted in the
Graham et al. survey is that, in order to meet earnings benchmarks, managers prefer to use real
earnings management such as cutting R&D and other discretionary expenses, before turning to
accruals management. Even when managers decide to manage earnings using within-GAAP accruals,
they face constraints that limit the amount and timing of these earnings management accruals. This
preference for real earnings management over accruals management may also be attributable to the
increased regulatory scrutiny of accruals in the post-Sarbanes-Oxley environment (Badertscher 2011;
Zang 2012).
Gunny (2010) investigates the relation between using real earnings management and meeting
or beating earnings benchmarks. She finds that companies that use real earnings management to just
meet or beat earnings benchmarks have higher subsequent performance relative to companies that do
not engage in real earnings management and just miss earnings targets. She concludes that real
earnings management is not used opportunistically but rather as a signal from managers. However,
while real earnings management may be preferable to accruals management to some managers, real
earnings management decisions to cut discretionary expenses such as R&D, advertising, or adjust
inventory levels can affect earnings in any given period. To the extent that managers use these real
earnings management techniques, we hypothesize that they will be less likely to adjust earnings
through pro forma reporting. As such, we propose the following third hypothesis, stated in alternative
form:
HYPOTHESIS 3. Companies using less real earnings management are more likely to
disclose pro forma earnings and to do so aggressively.
Current Accruals Management
Accruals management involves using discretion allowed within GAAP to change accounting
policies or estimates. Naturally, real earnings management occurs during the fiscal year, whereas
accruals management is more likely to occur after the close of a companys fiscal year. Graham et al.
(2005) find that managers may turn first to real earnings management and then to accruals
management. If managers still have slack in the balance sheet (i.e., they have not used up their ability
8
to manipulate accruals), we hypothesize that they are more likely to manage GAAP earnings number
before using pro forma earnings. As such, our fourth hypothesis, stated in alternate form:
HYPOTHESIS 4. Companies with less current-period accruals management are more

likely to disclose pro forma earnings and to do so aggressively.
3. Methodology, Variable Measurement, and Research Design
Dependent Variables
To examine the influence of earnings management variables on managers propensity to
disclose pro forma earnings numbers and report aggressively motivated pro forma earnings metrics,
we employ a series of logit models. Prior research has proposed three proxies for aggressive pro
forma reporting: The use of pro forma exclusions (1) to convert a GAAP loss to a pro forma profit,
(2) to appear to meet analysts expectations based on pro forma earnings when GAAP earnings fall
short, and (3) exclude recurring expense items (e.g., Bhattacharya et al. 2003; Black and Christensen
2009; Brown et al. 2012). Thus, the dependent variables in these analyses are as follows:
1. PROFORMA is an indicator variable that equals 1 if a company discloses a pro forma
earnings number in any quarter during the fiscal year, and zero otherwise.
2. PROFIT is an indicator variable that equals one if a company discloses a pro forma
earnings number and the excluded items are sufficient to convert a GAAP operating
loss into a pro forma profit, and zero otherwise.
3. CONSENSUS is an indicator variable that equals one if a company discloses a pro
forma earnings number and the excluded items are sufficient to move the company
from missing analysts expectations based on GAAP earnings to meeting or beating
expectations on a pro forma basis, and zero otherwise.
4. Finally, RECUR is an indicator variable that equals one if the company discloses a
pro forma earnings number that excludes recurring items, and zero otherwise.
9
Past Earnings Management
We follow prior research and use net operating assets as a proxy for past earnings
management. Essentially, this stream of research argues that companies only have so much flexibility
under accrual accounting to change current earnings. To the extent that they have managed earnings
in prior periods, their ability to do so currently is limited.6 Thus, we follow prior research in using net
operating assets as a proxy for the extent to which past earnings management limits the companys
ability to manage earnings in the current period. We calculate net operating assets as the difference
between operating assets and operating liabilities at year t scaled by sales in year t-1:
NOAi,t = (OP_ASSETSt - OP_LIABILITIESt) / SALESt-1 (1)
where:
NOAt = net operating assets;

OP_ASSETSt = total assets (ATt) minus cash and short-term investments (CHEt)
OP_LIABILITIESt = total assets (ATt) minus short term debt (DLCt) minus long-term
debt (DLTTt), minus minority interest (MIBTt), minus preferred
stock (PSTKt), minus common equity (CEQt);
SALESt-1 = sales (SALEt) at the beginning of the year.
We follow prior research and industry-adjust NOA by subtracting the median NOA for the
industry and year from each company-specific NOA value.7 We refer to the industry-adjusted NOA
measure of past earnings management as the extent to which the balance sheet is constrained,
(BS_CONSTRAINT).
Current Unmanaged Operating Performance
We explore the relation between operating performance and firms propensity to disclose pro
forma earnings based on unmanaged operating performance. Specifically, we measure unmanaged
operating performance by subtracting abnormal accruals from earnings scaled by lagged assets.8
6
See, for example, Barton and Simko (2002), Hirshleifer et al. (2004), and Badertscher (2011).
7
For the industry-adjusted measure of NOA, if the 3-digit SIC does not have 10 observations in a particular year, we
use a 2-digit SIC, which we also require at least 10 observations per year.
8
In untabulated results, we also find our results robust to measuring operating performance as the change in
earnings, return on assets (ROA), and industry-adjusted ROA.
10
Real Earnings Management
We employ three real earnings management (REM) measures commonly used in prior
research.9 Specifically, we follow Roychowdhury (2006) in calculating abnormal cash from
operations, abnormal discretionary expenditures, and abnormal inventory production.
The first measure of REM captures sales manipulation, such as the acceleration of the timing
of sales. For example, managers accelerate revenue recognition to manage earnings upward. The
actual cash flow from operations does not match the inflated sales revenue. We calculate the
expected cash flow by estimating Equation (2) with a cross-sectional regression by three-digit SIC
code and year:10
CFO i,t / A i,t-1 = 1 (1/A i,t-1 ) + 2 (S i,t / A i,t-1) + 3 (S i,t / A i,t-1 ) + i,t (2)
where:
CFO i,t = cash flow from operations in year t.

A i,t-1 = total assets in the year t-1.
S i,t = the net sales for year t.
S i,t = the change in sales from year t-1 to t.
The abnormal cash flow from operations is the actual cash flow minus the predicted value of the cash
flow from operations. We multiply the company-specific abnormal cash flow from operations by
negative one, so the higher number indicates a higher level of real transaction management.
The second REM measure is abnormal expenditures (R&D, advertising, and selling, general,
and administrative expense). Managers can manage earnings upward by cutting or delaying a
discretionary expenditure. We estimate expected discretionary expenditures for each company-year
observation by year and for each 3-digit SIC code:
DIS_EXP i,t / A i,t-1 = 1 (1/A i,t-1 ) + 2 (S i,t / A i,t-1) + 3 (S i,t / A i,t-1 ) + i,t (3)
9
See, for example, Cohen et al. (2008), Cohen and Zarowin (2010), Gunny (2010), and Zang (2011).
10
For all three measures of real earnings management, if a 3-digit SIC does not have 10 observations in a particular
year, we use a 2-digit SIC, which we also require at least 10 observations per year.
11
where:
DIS_EXP i,t = R&D expense plus advertising expense plus selling, general, and
administrative expense in year t.
S i,t = the net sales for year t.
S i,t = the change in sales from year t-1 to t.
The abnormal expenditure is the actual discretionary expenditure minus the predicted value of the
expenditure. As with the abnormal cash flow, we multiply the company-specific discretionary
expenditure by negative one, so the higher values indicate a higher level of real transaction
management.
The third REM measure is abnormal inventory production. Managers can overproduce
inventory items, which lowers the overhead costs assigned to each unit of inventory. This decrease in
per-unit overhead costs lowers the total cost of goods sold, thereby increasing the earnings.
Following Roychowdhury (2006), we calculate the expected level of production costs for each year
and for each 3-digit SIC code:
PROD i,t / A i,t-1 = 1 (1/A i,t-1 ) + 2 (S i,t /A i,t-1) + 3 (S i,t /A i,t-1 ) + 4 (S i,t-1 /A i,t-1 ) + i,t (4)
where:
PROD i,t = cost of goods sold plus change in inventory in year t.

S i,t = the net sales for year t. S i,t is the change in sales from year t-1 to t.
S i,t-1 = the change in sales from year t-2 to t-1.
The abnormal production cost is the actual production cost minus the predicted value of the
production cost. High abnormal production costs lead to higher earnings, thus indicating a higher
level of real transaction management.
Following Badertscher (2011), we sum all three of the REM measures (abnormal cash from
operations, abnormal expenditures, and abnormal production of inventory) to create
REAL_EARNINGS_MGT, which represents a consolidated measure of real earnings management for
the company. We follow prior research and interpret larger values of REAL_EARNINGS_MGT as a
proxy for higher levels of real earnings management.
12
Accruals Management
Following many prior studies, we use discretionary (abnormal) accruals to proxy for earnings
management.11 Specifically, we follow Dechow et al. (1995) and Kothari et al. (2005) and use the
residuals from the cross-sectional modified Jones model to estimate abnormal accruals. Furthermore,
we follow Chen et al. (2008) and Francis and Yu (2009) and include operating income scaled by
lagged total assets in the model.12 Thus, we calculate abnormal accruals by estimating the following
cross-sectional regression by two-digit SIC code and year:
TAt = 0 + 1 (1/ATt-1) + 2 (REVt - ARt) + 3 PPEt + 4 NIt + t (5)
where:
TAt = total accruals for company i in year t, calculated as the difference

between income before extraordinary items (Compustat Item IBC)
and operating cash flows (OANCF);
ATt-1 = assets (AT) at the beginning of year t;
REVt = the change in total revenue (SALE) from year t-1 to t;
ARt = the change in accounts receivable from year t-1 to t;
PPEt = gross property, plant, and equipment (PPEGT) in year t;
NIt = operating income (OIADP) in year t;
t = the estimate of abnormal accruals (ABN_ACCRUALS);
TAt, REVt, ARt, PPEt, and NIt are all scaled by ATt-1. We use all available observations on
Compustat but we omit companies in regulated industries (with SIC codes 4000-4949) and financial
companies (SIC codes 6000-6999), and we require at least 10 industry-year observations in each two-
digit SIC code and year group.
Empirical Model
To test for a relation between our earnings management measures and the propensity to
disclose pro forma earnings metrics, we estimate the following general model:
Pr (PF = 1) = 0 + 1 TestVars + k Controls (6)
11
See, for example, Jones (1991), Dechow et al. (1995), Myers et al. (2003), Kothari et al. (2005), Ball and
Shivakumar (2006), Chen et al. (2008), and Francis and Yu (2009).
12
In addition, untabulated results are robust to the inclusion of other performance measures used by prior research
and suggested by Kothari et al. (2005) such as net income, return on assets (ROA), and lagged ROA.
13
where:
PF = indicator variable coded 1 if the company disclosed pro forma

earnings, zero otherwise. Depending on this specification, this
variable is measured as PROFORMA, or one of the aggressive
measures of pro forma reporting (PROFIT, CONSENSUS, or
RECUR);13
TestVars = test variables of interest including: unmanaged operating
performance (UNMANAGED_EARNINGS) or earnings
management measures, measured as past accruals
management (BS_CONSTRAINT), current period real
earnings management (REAL_EARNINGS_MGT), or current
period accruals management (ABN_ACCRUALS);
Controls = controls for company characteristics.
We estimate Equation (6) using a logit regression. We use robust standard errors, clustering at
the company level (Petersen 2009) in all of the regressions. We follow Brown et al. (2012) and control
for company-level characteristics that could influence the propensity to disclose pro forma earnings
disclosures. Specifically, we control for whether a company reported pro forma earnings in the prior
period (LAG_PF), reported earnings that did not meet the mean analyst forecasts (NEG_FE), reported
GAAP operating loss (GAAPOP_LOSS), special items (SPECIAL_CHRG). We also include controls
for company size (SIZE), earnings volatility (STDROA), leverage (LEVERAGE), consecutive earnings
increases (STRING4), issuance of management earnings forecast (GUIDANCE), debt/equity issuance
(ISSUE), future debt/equity issuance (FUTURE_ISSUANCE), institutional ownership (%INSTHOLD),
Big 4 auditors (BIGAUDIT), accruals quality14 (ACCRUALS_QUALITY), and litigious industries
(LIT).15
Sample Selection and Data
We hand-collect pro forma earnings data from quarterly earnings press releases identified by
searching on PR Newswire and Business Wire using LexisNexis from January 1998 to December
13
In untabulated analyses, we investigate the relation between the variables of interest and the reporting of pro
forma earnings (and aggressive pro forma earnings) in the fourth quarter of the fiscal year. We find that both our
main results and our aggressiveness results are robust to this alternative definition of pro forma reporting.
14
We follow Dechow et al. (2011) and calculate accruals quality as the mean-adjusted absolute value of the residual
from a regression of the change in working capital on past, present, and future cash flows.
15
In untabulated analyses, we also include industry and year indicator variables to control for differences in pro
forma reporting over time and across industries and find the coefficient signs and significance unchanged. We also
find that our results (untabulated) are robust when we use a linear probability model rather than a logit model.
14
2006 using search words pro forma, pro-forma, and proforma. We also search for other words
used by companies to describe adjusted earnings metrics. These searches identify a potential 106,638
quarterly press releases.16 We read each of these press releases carefully and narrowed the final
sample down to 24,018 press releases with quarterly pro forma earnings disclosures. We code a
company-year observation as having pro forma reporting if the company discloses pro forma
earnings in any quarter during the fiscal year. After excluding company-year observations missing
any of the required regression variables, we identify a final sample of 2,568 company-year
observations in which companies disclosed pro forma earnings. Since some of the companies in our
sample do not disclose pro forma disclosures in each year of the sample period (1998-2006), we then
include company-year observations for the years in which the sample companies do not disclose pro
forma earnings. The inclusion of these observations brings the sample up to 7,101 company-year
observations.
Descriptive Statistics and Correlations
Table 1 presents descriptive statistics for the sample. Panel A presents descriptive statistics
for all firm-year observations between 1998 and 2006 for the full sample of companies that report
quarterly pro forma earnings at least once during the sample period. Panel B presents descriptive
statistics for the subsample of company-year observations in which companies report pro forma
earnings. The descriptive statistics in Panel A indicate that 36 percent of the company-year
observations in this full sample are comprised of firm-years in which the companies disclose a pro
forma earnings metric. With respect to control variables, we note that NEG_FE indicates that 34
percent of the sample companies in Panel A miss the analyst consensus forecast based on GAAP
EPS. Additionally, GAAPOP_LOSS indicates that nearly 25 percent of the sample reports a GAAP
operating loss. We note that 61 percent of the sample companies provide management earnings
16
Additional search words include earnings excluding, net income excluding, adjusted net income, adjusted
loss, cash earnings, earnings before, free cash flow, normalized EPS, normalized earnings, recurring
earnings, distributable cash flow, GAAP one-time adjusted , and GAAP adjusted cash loss.
15
guidance before the issuance of quarterly earnings (GUIDANCE) and that nearly 19 percent of the
companies issue debt or equity (ISSUE).
We also present descriptive statistics for the company-year observations in which companies
disclose pro forma earnings during the year in Panel B. We note that 12 percent of these companies
report a pro forma earnings number that converts a GAAP operating loss to a pro forma profit
(PROFIT). Additionally, 39 percent of these companies report a pro forma earnings number that
meets or beats analysts consensus forecast while the GAAP operating earnings number falls short
(CONSENSUS) and 79 percent of these company-year observations excluded recurring items in
calculating the pro forma earnings number (RECUR).
Panel A of Table 2 presents selected Pearson (upper-right triangle) and Spearman (lower-left
triangle) correlations for the full sample of all company-year observations of companies that report
pro forma earnings at least once during the 1998-2006 sample period. The first row (Pearson
correlations) and the first column (Spearman correlations) indicate a significantly positive pairwise
relation between PROFORMA and BS_CONSTRAINT, suggesting that companies with higher
balance sheet constraints are more likely to disclose pro forma earnings (PROFORMA). We also
observe a significantly negative correlation between PROFORMA and UNMANAGED_EARNINGS,
which suggests that companies with higher unmanaged operating performance are less likely to
report pro forma earnings. Finally, we also find a negative relation between the propensity to disclose
pro forma earnings (PROFORMA) and both real earnings management (REAL_EARN_MGT) and
abnormal accruals (ABN_ACCRUALS), consistent with the notion that pro forma disclosures are a
substitute for both real and accruals earnings management. In other words, this result is consistent
with the notion that when current-period earnings management is not possible (potentially because of
balance sheet constraints), companies resort to reporting an adjusted (pro forma) earnings metric.
Panel B of Table 2 presents pairwise Pearson and Spearman correlations for the smaller
subsample of company-year observations in which companies actually disclose a pro forma earnings
metric in one of their quarterly earnings press releases. We find results similar to the correlations
presented in Panel A of Table 2, but with a focus on aggressive pro forma reporting. Importantly, we
16
find that each of the aggressive reporting variables (PROFIT, CONSENSUS, and RECUR), are
significantly (1) positively correlated with prior earnings management (BS_CONSTRAINT),
suggesting that companies with higher balance sheet constraints (i.e., more prior year earnings
management) are more likely to report pro forma metrics aggressively in the current period, and (2)
negatively correlated with current unmanaged operating performance (UNMANAGED_EARNINGS),
real earnings management (REAL_EARNINGS_MGT), and accruals management
(ABN_ACCRUALS). These correlations suggest a substitute relation between aggressive pro forma
reporting and current operating performance and earnings management. Next, we investigate the
relation between the incidence of pro forma reporting and our variables of interest using a
multivariate approach.
4. Results
Determinants of Pro Forma Reporting
Table 3 presents the multivariate results from estimating seven different specifications of
equation (6), where PROFORMA is the dependent variable (7,101 observations). The first four
specifications separately explore how past earnings management, current unmanaged operating
performance, and current real and accruals management influence a companys propensity to report a
non-GAAP earnings number. The fifth specification includes all of these factors in the same model
with control variables. Finally, in the last two specifications, we split the sample based on whether or
not the sample companies are above or below their respective industry median levels of balance sheet
constraint.17
In the first model of Table 3, we find a significantly positive relation between
BS_CONSTRAINT and the incidence of reporting pro forma earnings. This result is consistent with
H1 and suggests that companies with more past earnings management likely do not have the ability to
manage earnings further and therefore are more likely to choose to disclose pro forma earnings.
17
We find that the area under the receiver operating characteristic (or ROC) curve is above 0.70 for all of our
models, suggesting that our models have acceptable discriminatory power in classifying companies that disclosed
pro forma (or aggressive pro forma) earnings (see Hosmer and Lemeshow 2002).
17
However, in Models 2 and 3 we do not find a significant relation between unmanaged earnings
(UNMANAGED_EARNINGS) or real earnings management (REAL_EARNINGS_MGT) and the
decision to report pro forma earnings. However, in Model 4 we find a significantly negative
association between ABN_ACCRUALS and the likelihood of reporting pro forma earnings. This result
is consistent with H4 and suggests that accruals management can be a substitute for pro forma
reporting as a tool that managers use when managing shareholder expectations. Model 5 includes all
of the variables of interest in the same model, we still find a significantly positive (negative) relation
between BS_CONSTRAINT (ABN_ACCRUALS) and the decision to disclose a pro forma earnings
number. Interestingly, after controlling for the other menu choices, we also find a significantly
negative relation between UNMANAGED_EARNINGS and the likelihood of disclosing a pro forma
earnings number, consistent with the notion that when companies have strong operating results, they
are less likely to turn to pro forma reporting to manage perceptions. Finally, we still find a
significantly positive relation between ABN_ACCRUALS and the likelihood that managers will
report pro forma earnings.18
Model 6 limits our sample to observations where companies have higher balance sheet
constraints than their respective industry medians. Our main results from Model 5 hold for the
subsample of observations with high balance sheet constraints. Specifically, we find a significantly
negative relation between both UNMANAGED_EARNINGS and ABN_ACCRUALS and PROFORMA.
Model 7 limits the sample to observations where sample companies have lower balance sheet
constraints than their respective industry medians. In this model, we only find a significantly negative
relation between ABN_ACCRUALS and the incidence of pro forma reporting. Taken together, these
results suggest that the substitute relation between operating performance and pro forma reporting
only holds for firms that have exhausted their ability to manage earnings in prior periods.
18
With respect to the control variables, we find a positive relation between reporting pro forma earnings in the
current year and reporting pro forma earnings in the prior year (LAG_PF). We also find that companies that miss
analyst earnings expectations (NEG_FE), report special charges (SPECIAL_CHRG), issue management earnings
guidance (GUIDANCE), and operate in litigious industries (LIT) are more likely to report pro forma earnings. We
find that companies that have consecutive earnings increases (STRING4) are less likely to report pro forma earnings
in the current year.
18
Cross-sectional Tests of Pro Forma Reporting Determinants
We also examine how the relation between each of our menu choices and the likelihood of
disclosing pro forma earnings varies with the costs of real and accruals earnings management. To
perform these tests, we employ Zangs (2012) measures of the costs associated with real and accruals
management. Specifically, Zang (2012) suggests that the costs of real earnings management are
higher for companies with lower market share, lower financial performance, and higher institutional
ownership. She also suggests that the costs of accruals earnings management are higher for
companies with a Big 8 auditor and longer auditor tenure.19 Finally, she also suggests that the costs
of accruals earnings management are higher in the post-SOX period20, for companies with higher
levels of past earnings management, and for companies with longer operating cycles. We split our PF
sample and estimate the relation between PROFORMA and each of the menu choices in each of the
settings representing where the costs of real and accruals earnings management are high and low.
In Models 1 and 2 of Table 4, we investigate the relation between our menu choice items and
firms propensity to report pro forma earnings after splitting the sample based on market share of
sales revenue. We measure beginning-of-year market share as company-specific sales divided by
total industry sales (based on three-digit SIC code) and split the sample at the median. In Model 1 of
Table 4, we do not find a relation between any of the menu choices and the likelihood that high
market share companies will disclose pro forma earnings. However, in the low-market-share sample,
we find a significantly positive coefficient on BS_CONSTRAINT and a significantly negative
coefficient on ABN_ACCRUALS. These results suggest that when the cost of using real earnings
19
As 97 percent of our sample is comprised of companies employing Big N auditors, we do not investigate this
setting in our paper.
20
We find that ABN_ACCRUALS are significantly negatively associated with the decision to report pro forma
earnings in the pre-SOX period, but insignificant in the post-SOX period. Real earnings management is
significantly negatively associated with the decision to report pro forma earnings in the pre-SOX period and
significantly positive in the post-SOX period. We also find that unmanaged earnings are significantly negatively
associated with the decision to report pro forma earnings in the pre-SOX period, but significantly positive (one-
tailed test) in the post-SOX period. BS_CONSTRAINT is significantly positive in both samples.
19
management is high and managers are more likely to use accruals earnings management, then we
find a substitute relation accruals earnings management and pro forma reporting.
Next, we examine the relation between our menu choice items and the likelihood that a firm
will report pro forma earnings after splitting the sample based on the level of financial distress. We
follow Zang (2012) and measure financial distress using Altmans Z score at the beginning of the
period. Lower values of Altmans Z score represent higher financial distress and a higher costs
associated with real earnings management. We split our sample based on the median value of
Altmans Z for the sample companies. Model 3 presents results for the sub-sample of low financial
distress companies. We find a positive relation between BS_CONSTRAINT and the likelihood of pro
forma reporting, but we do not find a significant coefficient on any of the other menu choice
variables. In Model 4, we find a positive coefficient on BS_CONSTRAINT and negative coefficients
on UNMANAGED_EARNINGS and ABN_ACCRUALS. Thus, our main results seem to hold most for
companies in financial distress.
Zang (2012) also suggests that the costs of real earnings management are higher for
companies with higher levels of institutional ownership. Therefore, we next split our sample based
on the median institutional ownership percentage and find a positive coefficient on
BS_CONSTRAINT in both the high and low institutional ownership groups. We also find a negative
coefficient on UNMANAGED_EARNINGS in the low institutional ownership sample. Finally, we
find a negative coefficient on ABN_ACCRUALS in both the high and low institutional ownership
groups. Hence, the level of institutional following does not appear to influence the relation between
BS_CONSTRAINT and ABN_ACCRUALS and the likelihood of pro forma reporting. However, we do
find evidence that the substitute relation between unmanaged operating performance and pro forma
reporting appears to be stronger when firms have lower levels of institutional ownership.
Next, we examine the relation between our menu choice items and the likelihood of pro
forma reporting when the costs of accruals management are high. We proxy for the costs of accruals
management following Zang (2012). Specifically, we first split the sample based on the length of
auditor tenure and then using the length of the companys operating cycle. Prior research suggests
20
that longer auditor tenure is associated with higher earnings quality (Myers et al. 2003). In addition,
Zang (2012) suggests that companies with longer operating cycles have more financial flexibility and
a lower cost to accruals management. We split the sample based on the median levels of auditor
tenure and operating cycle.
Models 7 and 8 present results for the long and short auditor tenure subsamples respectively.
We find a positive relation between BS_CONSTRAINT and the likelihood of pro forma reporting in
both subsamples. However, we do not find significant coefficients on any of the other menu choices
in the long auditor tenure subsample. In the short auditor tenure sample, we find negative relations
between UNMANAGED_EARNINGS and ABN_ACCRUALS and the probability of pro forma
reporting. These negative coefficients in the low auditor tenure sample suggest that the substitute
relation between pro forma reporting and (1) unmanaged operating performance and (2) accruals
earnings management are most common when companies are less constrained by their external
auditors.
We next investigate how these relations vary relative to the length of companies operating
cycles. In Model 9, we find a positive relation between BS_CONSTRAINT and the likelihood of pro
forma reporting and a negative relation between UNMANAGED_EARNINGS and the probability of
pro forma reporting for companies with long operating cycles. In Model 10, we find a positive
coefficient on BS_CONSTRAINT and a negative coefficient on ABN_ACCRUALS for the short
operating cycle sample. These last result suggests that when the costs of accruals management are
high, managers are more likely to substitute accruals earnings management for pro forma reporting.
Finally, in Models 11 and 12, we examine how analyst following influences the relations
between the menu choices and the probability of pro forma reporting. Prior research (Yu 2008)
suggests that analysts act as an external monitor and managers are less likely to manage earnings
when analyst following is high. However, in both Models 11 and 12, we find a positive coefficient
on BS_CONSTRAINT and negative coefficients on UNMANAGED_EARNINGS and
ABN_ACCRUALS. These results suggest that the relation between each of the menu choice items and
pro forma reporting does not differ based on analyst following.

21
Model 13 provides full-sample results after including all of these constructs as control
variables. After controlling for the relative costs of both real and accruals earnings management, we
find that our main results hold. Specifically, the likelihood of pro forma reporting is positively
associated with the level of prior earnings management and negatively associated with both current
unmanaged operating performance and accruals management.
Determinants of Aggressive Pro Forma Reporting
Converting a GAAP Operating Loss to a Pro Forma Profit
We next turn our attention to investigating how the availability of other menu choices
influence the likelihood that managers will report pro forma earnings numbers aggressively. In order
to do this, we limit our analyses to observations where managers disclose a pro forma earnings figure
in at least one of its quarterly earnings announcements during the current company-year (2,568
observations) and report the results in Tables 5 through 7. Table 5 explores the likelihood that
managers will exclude income statement items to report a pro forma number that converts a GAAP
operating loss to a pro forma profit (PROFIT). Models 1-4 investigate how each menu choice
individually influences aggressive pro forma reporting. Consistent with H1, Model 1 reports a
significantly positive relation between the probability that a company will report a pro forma
earnings number that converts a GAAP loss to a pro forma profit (PROFIT) and BS_CONSTRAINT.
This result suggests that when a company has used up its ability to manage earnings in prior periods,
it is more likely to disclose a pro forma number in an aggressive manner in the current period.
Consistent with H2, we also find a negative coefficient on UNMANAGED_EARNINGS in Model 2,
suggesting that companies with poor current operating performance are more likely to report pro
forma earnings aggressively. Model 3 does not find a significant association between PROFIT and
REAL_EARNINGS_MGT, however Model 4 reports a significantly negative coefficient on
ABN_ACCRUALS, suggesting a negative association between the likelihood of aggressive pro forma
reporting and a companys ability to manage accruals.
In Model 5, when all of the menu choices are included in the model simultaneously, we still
find a significantly positive coefficient on BS_CONSTRAINT and significantly negative coefficients

22
on ABN_ACCRUALS and UNMANAGED_EARNINGS. However, we do not find a significant
coefficient on REAL_EARNINGS_MGT. These results suggest that companies that have managed
accruals in the past that have poor current operating performance, and that dont manage earnings in
the current period are more likely to report aggressive pro forma earnings. Again, these results
indicate that strong unmanaged operating performance and the ability to manage accruals in the
current period are likely substitutes for pro forma reporting.21 In Models 6 and 7, we split the sample
based on whether the balance sheet constraint is higher and lower than the companys industry
median. In both of these models, we find consistent evidence of the substitute relation between both
(1) current unmanaged earnings and (2) the ability to manage accruals this period and the likelihood
of aggressive pro forma reporting, irrespective of prior earnings management. However, the
operating performance results are much stronger for companies that have not engaged in prior
earnings management.
Using Pro Forma Exclusions to Meet Expectations when GAAP Earnings Fall Short
Table 6 investigates the relation between the menu choices and the propensity to use earnings
exclusions to report a pro forma earnings number that meets expectations when the GAAP operating
earnings number falls short of expectations (CONSENSUS). Consistent with H1 H4, Models 1-4 in
which we explore each menu choice separately, we find a significantly positive coefficient on
BS_CONSTRAINT and significantly negative coefficients on REAL_EARNINGS_MGT, and
ABN_ACCRUALS. When we include all of the variables of interest in one model, we find that all of
these relations are significant, including UNMANAGED_EARNINGS. These results indicate that
companies with higher balance sheet constraints, lower unmanaged operating performance, and less
21
Relative to controls, we find a positive relation between reporting a pro forma profit and GAAP loss in the current
year, with reporting a pro forma profit and GAAP loss in the prior year (LAG_PROFIT). We also find that
companies that operating in a highly litigious industry are more likely to report pro forma earnings that report a
profit. However, we find a negative relation between SIZE, and FUTURE_ISSUE and PROFIT. This indicates that
bigger companies and companies that will issue future debt and equity are less likely to report a pro forma profit,
and GAAP loss, in the current year.
23
real and accruals earnings management are more likely to report pro forma earnings disclosures that
meet or beat the analyst consensus when GAAP earnings do not meet the consensus forecast.22
In Models 6 and 7, we split the sample based on whether the firms balance sheet constraints
are higher or lower than the companys industry median. In Model 6, all of the results from Model 5
based on the full sample hold. Specifically, we find a substitute relation between strong operating
performance23 and both forms of earnings management and aggressive pro forma reporting when
balance sheet constraints are especially high. However, in Model 7, we no longer find a significant
coefficient on REAL_EARNINGS_MGT. This result indicates that when companies have used
extensive abnormal accruals in prior periods, they prefer to use real earnings management as a
substitute for aggressive pro forma reporting, but this is not true of companies that have not managed
earnings in the past. These companies appear to prefer current accruals management.
The Exclusion of Recurring Items
Table 7 investigates the relation between each of the perception management tools and a
companys decision to report pro forma earnings numbers that exclude recurring items. In Models 1-
4 when we introduce each variable of interest individually, we find a significantly positive coefficient
on BS_CONSTRAINT and a significantly negative coefficient on ABN_ACCRUALS. However, we do
not find a significant relation between UNMANAGED_EARNINGS and REAL_EARNINGS_MGT and
RECUR. When we include all of the variables of interest in Model 5 simultaneously, these univariate
results persist and we also find a significantly negative coefficient on UNMANAGED_EARNINGS.
Taken together, these results indicate that companies with higher balance sheet constraints, lower
operating performance, and less current-period accruals management are more likely to report pro
22
With respect to control variables, we find a positive relation between reporting pro forma earnings that meet or
beat the analyst consensus and whether the company used pro forma earnings to meet or beat analyst consensus in
the prior year (LAG_CONSENSUS). We also find a positive relation between CONSENSUS and whether the
company reported a GAAP operating loss in the current year (GAAPOP_LOSS), whether the company operated in a
litigious industry (LIT) and whether the company issued debt or equity during the year (ISSUE). We find a negative
relation between the reporting of special charges (SPECIAL_CHRG) and reporting pro forma earnings that meet or
beat analyst expectations. This result indicates that companies that have special items are less likely to report pro
forma disclosures that meet or beat analyst forecasts.
23
Doyle et al. (2013) find similar results using a sample of companies with analyst adjusted earnings metrics.
24
forma earnings numbers that exclude recurring items, consistent with H1, H2, and H4.24 In Model 6,
we find significantly negative coefficients on UNMANAGED_EARNINGS, REAL_EARNINGS_MGT,
and ABN_ACCRUALS for companies with more constrained balance sheets. In Model 7, for
companies with less constrained balance sheets, we find significantly negative coefficients on
UNMANAGED_EARNINGS and ABN_ACCRUALS. These results indicate that the substitute relation
between strong operating performance and accruals management and the exclusion of recurring items
is consistent, but managers preference for real earnings management relative to this form of
aggressive pro forma reporting is only evident among firms with more constrained balance sheets.
Market Tests
Collectively, we find robust evidence that higher levels of prior earnings management (as
denoted by higher balance sheet constraints) are positively associated with the likelihood that a
company will report pro forma earnings. Given these results, we investigate how investors react to
this tendency. Specifically, Table 8 examines whether balance sheet constraints influence the market
reaction to quarterly earnings announcements containing pro forma earnings disclosures. The sample
consists of 41,026 quarterly earnings announcements. Consistent with prior research (Black et al.
2013), we include the GAAP forecast error (FEGAAP) and an indicator variable for whether or not the
company disclosed a pro forma earnings numbers in the quarter (PROFORMA). We also calculate a
quarterly version of the balance sheet constraint used in Badertscher (2011) and create
BS_CONSTRAINTP50, which is an indicator variable set to 1 for companies with balance sheet bloat
greater than the median value for the industry-quarter, zero otherwise.25 In addition, we include
interactions between FEGAAP, BS_CONSTRAINTP50, and PROFORMA.
24
Relative to control variables, in this test, we find a positive relation between whether the company issued pro
forma earnings in the prior period that excluded recurring items (LAG_RECUR) and the dependent variable. In the
full model, we find a positive relations between the amount of institutional holdings (%INSTHOLD) and whether the
company operated in a litigious industry (LIT) and the incidence of reporting pro forma earnings after removing
recurring items.
25
In untabulated analyses, we find robust results when replacing BS_CONSTRAINTP50 with the continuous balance
sheet constraint measure, or an indicator variable set to one when a company is above the industry-year median
balance sheet bloat value. We also find robust results when we calculate the balance sheet constraint, following
Barton and Simko (2002).
25
Model 1 of Table 8 simply confirms a significantly positive earnings response coefficient on
the GAAP forecast error, FEGAAP, as a baseline measure of the markets response to reported
earnings. Model 2 also indicates a significantly positive coefficient on PROFORMA, suggesting that
the short-window market return around earnings announcements containing pro forma earnings
disclosures is systematically higher than the return around earnings announcements that do not
contain pro forma disclosures, consistent with a market premium for pro forma earnings disclosures.
Moreover, the coefficient on the FEGAAP x PROFORMA interaction term is significantly negative,
suggesting that when companies disclose an adjusted earnings metric in the earnings press release,
investors discount the GAAP earnings number. Consistent with Bhattacharya et al.s (2003) results,
these results indicate that investors pay more attention to pro forma earnings and discount GAAP
earnings when a non-GAAP number is disclosed in the same earnings press release.
In Models 3 and 4, we split the sample based on the median value of the quarterly balance
sheet constraint variable. The contrast in the results of these two regressions is striking. While the
market premium for pro forma earnings disclosures persists in the low balance sheet constraints sub-
sample (Model 4), the coefficient on PROFORMA is not significant in the high balance sheet
constraint subsample. This result suggests that investors no longer place a premium on the non-
GAAP earnings information when they suspect the company has only resorted to reporting the non-
GAAP earnings information because they no longer have flexibility in their balance sheet due to
consistent accruals management in prior periods. Moreover, we also find a significantly negative
coefficient on the FEGAAP x PROFORMA interaction term in both sub-samples, consistent with the
notion that investors generally discount GAAP earnings in the presence of pro forma earnings. Taken
together, the results indicate that investors understand the ramifications of prior earnings
management and place less weight on pro forma earnings disclosures that appear to be a substitute
for earnings management because companies have exhausted their ability to do so.
Finally, Model 5 tests these implications by controlling for the level of balance sheet
constraints (BS_CONSTRAINTP50) in the regression and interacting it with the other variables of
interest. First, we find a significantly negative coefficient on the PROFORMA x

26
BS_CONSTRAINTP50 interaction term. This result indicates that the market reaction around the
earnings announcement is lower when firms report pro forma earnings and they have high balance
sheet constraints. Thus, we conclude that high balance sheet constraints lead investors to discount
their response to press releases containing pro forma earnings. This result is consistent with the
notion that the market understands the tradeoff between past earnings management and pro forma
reporting and discounts pro forma earnings disclosures in the presence of high balance sheet
constraints. We also find marginal evidence that investors discount their reaction to GAAP earnings
in the presence of high balance sheet constraints, as evidence by the coefficient on the FEGAAP x
BS_CONSTRAINTP50 interaction term. Finally, the three-way interaction term, FEGAAP x
PROFORMA x BS_CONSTRAINTP50, is not statistically significant, suggesting that while investors
discount both pro forma earnings disclosures and the information contained in GAAP earnings in the
presence of high balance sheet constraints, there is no incremental discounting of GAAP earnings
when companies report pro forma earnings in the presence of high balance sheet constraints.
Special Items
Prior research suggests that pro forma reporting is more prevalent among companies that
report special items (Lougee and Marquardt 2004). To mitigate concerns that the results are
attributable to companies with special items, we our analyses separately after excluding all company-
year observations that report special items. Specifically, we delete observations where
SPECIAL_CHARGES equals one. Although this reduces our sample size by 4,640 observations, in
untabulated analyses, we still find a positive relation between BS_CONSTRAINT and the incidence of
pro forma reporting.
6. Conclusion
This study examines the influence of past earnings management, current operating
performance, and current earnings management on the likelihood that companies will disclose pro
forma earnings. We argue that managers have a menu of perception management choices available
that may be used in lieu of pro forma reporting. As a result, we investigate the extent to which (1)
27
past earnings management, (2) current period operating performance, (3) current-period real earnings
management, and (4) current accruals management influence managers decision to report pro forma
earnings. We also explore how these same factors influence the likelihood of aggressive pro forma
earnings disclosures.
We find consistent evidence that companies with more constrained balance sheets (i.e., those
that have more past earnings management) are also more likely to report pro forma numbers and to
do so aggressively. Moreover, we find that companies with better operating performance and higher
abnormal accruals are less likely to report pro forma numbers and to do so aggressively. Finally, we
also find some evidence of a substitute relation between real earnings management and aggressive
pro forma reporting. In sum, managers are more likely to disclose aggressive pro forma earnings
when they (1) have a more constrained balance sheet, (2) have less profitable operations, and (3) are
less able to manage earnings with real earnings management or accruals. Additionally, when we
perform market reaction tests around earnings announcements containing pro forma earnings
disclosures, 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.
Our evidence contributes to the growing non-GAAP reporting literature by documenting
additional determinants of pro forma reporting. Prior research focuses on (1) company characteristics
that serve as determinants of pro forma reporting (Lougee and Marquardt 2004) and (2) the
informativeness of pro forma reporting (Bhattacharya et al. 2003). We contribute to the list of factors
influencing pro forma reporting: past and current earnings management. Our results should be of
particular interest to investors and regulators because they provide additional evidence consistent
with the notion that managers may use pro forma earnings as a substitute for earnings management.
28
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31
Appendix
Variable Definitions
ABN_ACCRUALS = the amount of abnormal accruals calculated from the performance-adjusted modified Jones model
(Jones 1991; Dechow et al. 1995; and Kothari et al. 2005).
ACCRUALS_QUALITY = Accruals quality as calculated in Dechow et al. (2011), which is the mean-adjusted absolute value of
the residual from a regression of the change in working capital on past, present, and future cash flows.
ALTMANS Z SCORE = Altmans Z score calculated consistent with Altman (1968) and Altman (2000).
ANALYST FOLLOWING = the count of the number of analysts issuing earnings forecast for the current year.
AUDITOR TENURE = the number of years during which the company has been audited by the current auditor.
BIGAUDIT = an indicator variable, which equals one if a company is audited by a Big N auditor, zero otherwise.
BS_CONSTRAINT = the beginning of the year balance sheet constraint. The balance sheet constraint is calculated as net
operating assets divided by total sales (SALE) in year t-1. Net operating assets are equal to operating
assets minus operating liabilities. Operating assets care calculated as total assets (AT) minus cash and
short-term investments (CHE). Operating liabilities are calculated as total assets (AT) minus short-
term debt (DLC) minus long-term debt (DLTT) minus common equity (CEQ) minus minority interest
(MIBT) minus preferred stock (PSTK). BS_CONSTRAINT is then calculated as the company-
specific NOA minus the industry median NOA.
BS_CONSTRAINTP50 = an indicator variable, which equals one if the companys beginning of the quarter balance sheet
constraint is greater than the industry-quarter median, zero otherwise.
CONSENSUS = an indicator variable, which equals one if GAAP earnings does not meet analyst forecast, but pro
forma earnings does in any of the four quarters during the fiscal year, zero otherwise.
FE GAAP = the GAAP forecast error, calculated as the difference between GAAP operating EPS (OEPSXQ) and
the mean analysts earnings forecast.
FUTURE_ISSUE = an indicator variable coded one if the company issued debt or equity within one year following the
earnings announcement date, as reported in SDC platinum, zero otherwise.
GAAPOP_LOSS = an indicator variable coded one if the company reported a loss during the current fiscal year, zero
otherwise.
GUIDANCE = an indicator variable coded one if the company disclosed management earnings guidance during the
year, zero otherwise.
%INSTHOLD = the percentage of shares owned by institutional investors as reported in the Thomson Financial
CDA/Spectrum 13f institutional holdings database for the closest calendar year..
ISSUE = an indicator variable coded one if the company issued debt or equity during the year as reported in
SDC platinum, zero otherwise.
LAG_CONSENSUS = an indicator variable, which equals one if GAAP earnings did not meet analyst forecast, but pro forma
earnings did meet the consensus in any of the four quarters during the prior fiscal year, zero
LAG_PF = an indicator variable coded one if the company reported pro forma earnings during any quarter in the
prior year, zero otherwise.
LAG_RECUR = an indicator variable, which equals one if a company excluded recurring items in pro forma earnings
in any of the four quarters during the prior fiscal year, zero otherwise.
LEVERAGE = total long term debt (DLTT) divided by total assets (AT).
LIT = an indicator variable, which equals one if the company operates in a litigious industry (defined as SIC
codes 2833-2836, 3570-3577, 3600-3674, 5200-5961, and 7370), zero otherwise.
MARKET SHARE = beginning-of-year market share calculated as company-specific sales divided by total industry sales
(based on three-digit SIC code).
NEG_FE = an indicator variable coded one if the company missed analyst expectations at the end of the fiscal
year, zero otherwise.
OPERATING CYCLE = the length of the companys operating cycle.
PROFIT = an indicator variable, which equals one if the GAAP earnings is a loss, but the pro forma earnings is a
profit in any of the four quarters during the fiscal year, zero otherwise.
PROFORMA = an indicator variable coded one if the company reported pro forma earnings during any quarter of the
fiscal year, zero otherwise.
REAL_EARNINGS_MGT = following Badertscher (2011), the sum of the three measures of real earnings management (abnormal
cash from operations, abnormal expenditures, and abnormal production of inventory).
RECUR = an indicator variable, which equals one if a company excludes recurring items in pro forma earnings
in any of the four quarters during the fiscal year, zero otherwise.
SIZE = the natural log of total assets (AT).
SPECIAL_CHRG = an indicator variable coded one if the company reported special items during the fiscal year, zero
otherwise.
STDROA = the standard deviation of return on assets over the past three years.
STRING4 = an indicator variable coded one if the company reported consecutive earnings increases over the past
four years, zero otherwise.
UNMANAGED_EARNINGS = net income (NI) divided by beginning of the year total assets (AT) minus ABN_ACCRUALS.
32
TABLE 1
Descriptive Statistics
Panel A: All Company-Year Observations of Firms that Report Pro Forma Earnings at Least Once (N = 7,101 )
Mean Std Dev 25th Percentile Median 75th Percentile
Variables of Interest:
PROFORMA 0.363 0.481 0.000 0.000 1.000
BS_CONSTRAINT 0.337 1.402 -0.134 0.051 0.391
UNMANAGED EARNINGS 0.043 0.163 -0.017 0.047 0.116
REAL_EARNINGS_MGT -0.179 0.521 -0.415 -0.119 0.073
ABN_ACCRUALS -0.013 0.121 -0.057 -0.007 0.035
Control Variables:
ACCRUALS_QUALITY -0.207 0.597 -0.234 -0.127 -0.049
NEG_FE 0.344 0.475 0.000 0.000 1.000
GAAPOP_LOSS 0.246 0.430 0.000 0.000 0.000
SPECIAL_CHRG 0.652 0.476 0.000 1.000 1.000
SIZE 6.862 1.716 5.631 6.751 7.932
STDROA 0.077 0.177 0.016 0.032 0.077
LEVERAGE 0.184 0.177 0.005 0.158 0.304
STRING4 0.362 0.481 0.000 0.000 1.000
GUIDANCE 0.608 0.488 0.000 1.000 1.000
ISSUE 0.185 0.389 0.000 0.000 0.000
FUTURE_ISSUE 0.146 0.353 0.000 0.000 0.000
%INSTHOLD 0.581 0.245 0.403 0.611 0.771
BIGAUDIT 0.969 0.174 1.000 1.000 1.000
LITIGOUS 0.353 0.478 0.000 0.000 1.000
Panel B: Only Company-Year Observations in Which Firms Disclose a Pro Forma Earnings Number (N = 2,568)
Mean Std Dev 25th Percentile Median 75th Percentile
Variables of Interest:
PROFIT 0.119 0.324 0.000 0.000 0.000
CONSENSUS 0.391 0.488 0.000 0.000 1.000
RECUR 0.793 0.405 1.000 1.000 1.000
BS_CONSTRAINT 0.441 1.551 -0.119 0.099 0.515
UNMANAGED EARNINGS 0.035 0.170 -0.027 0.040 0.107
REAL_EARNINGS_MGT -0.197 0.540 -0.450 -0.138 0.053
ABN_ACCRUALS -0.024 0.132 -0.067 -0.013 0.032
Control Variables:
ACCRUALS_QUALITY -0.232 0.603 -0.298 -0.140 -0.062
NEG_FE 0.330 0.470 0.000 0.000 1.000
GAAPOP_LOSS 0.296 0.457 0.000 0.000 1.000
SPECIAL_CHRG 0.800 0.400 1.000 1.000 1.000
SIZE 6.948 1.721 5.717 6.798 8.000
STRROA 0.092 0.171 0.018 0.039 0.094
LEVERAGE 0.179 0.179 0.001 0.151 0.302
STRING4 0.334 0.472 0.000 0.000 1.000
GUIDANCE 0.670 0.470 0.000 1.000 1.000
ISSUE 0.165 0.371 0.000 0.000 0.000
FUTURE_ISSUE 0.139 0.346 0.000 0.000 0.000
%INSTHOLD 0.603 0.241 0.424 0.639 0.786
BIGAUDIT 0.971 0.167 1.000 1.000 1.000
LITIGOUS 0.396 0.489 0.000 0.000 1.000
See appendix for variable definitions
33
TABLE 2
Pearson/Spearman Correlations
Panel A: All Company-Year Observations of Firms that Report Pro Forma Earnings at Least Once (N = 7,101 )
Pearson (upper) / Spearman (lower) (1) (2) (3) (4) (5)

(1) PROFORMA 0.056 -0.037 -0.027 -0.069
<.0001 0.002 0.022 <.0001
(2) BS_CONSTRAINT 0.083 -0.124 0.005 -0.058
<.0001 <.0001 0.678 <.0001
(3) UNMANAGED EARNINGS -0.053 -0.098 -0.134 -0.523
<.0001 <.0001 <.0001 <.0001
(4) REAL_EARNINGS_MGT -0.038 -0.043 -0.193 0.143
0.002 0.000 <.0001 <.0001
(5) ABN_ACCRUALS -0.062 -0.056 -0.556 0.175
<.0001 <.0001 <.0001 <.0001
Panel B: Only Company-Year Observations in Which Firms Disclose a Pro Forma Earnings Number (N = 2,568)
Pearson (upper) / Spearman (lower) (1) (2) (3) (4) (5) (6) (7)
(1) PROFIT 0.331 0.188 0.117 -0.147 -0.061 -0.122
<.0001 <.0001 <.0001 <.0001 0.002 <.0001
(2) CONSENSUS 0.331 0.407 0.121 -0.098 -0.091 -0.092
<.0001 <.0001 <.0001 <.0001 <.0001 <.0001
(3) RECUR 0.188 0.407 0.056 -0.047 -0.044 -0.057
<.0001 <.0001 0.005 0.017 0.026 0.004
(4) BS_CONSTRAINT 0.128 0.173 0.079 -0.169 -0.004 -0.104
<.0001 <.0001 <.0001 <.0001 0.839 <.0001
(5) UNMANAGED EARNINGS -0.212 -0.129 -0.055 -0.118 -0.117 -0.461
<.0001 <.0001 0.006 <.0001 <.0001 <.0001
(6) REAL_EARNINGS_MGT -0.067 -0.099 -0.048 -0.060 -0.130 0.159
0.001 <.0001 0.015 0.003 <.0001 <.0001
(7) ABN_ACCRUALS -0.127 -0.081 -0.057 -0.077 -0.491 0.167
<.0001 <.0001 0.004 <.0001 <.0001 <.0001
See appendix for variable definitions
34
TABLE 3
Logit Model of the Probability of Disclosing Pro Forma Earnings
Model: Pr (PROFORMAi,t) = 0 + 1 BS_CONSTRAINT i,t + 2 UNMANAGED_EARNINGS i,t + 3 REAL_EARNINGS_MGTi,t

+ 4 ABN_ACCRUALSi,t + Control Variables
Dependent Variable: PROFORMA Above Below

Industry Industry
BSC BSC
Prediction (1) (2) (3) (4) (5) (6) (7)
Intercept -2.027*** -2.027*** -2.029*** -1.996*** -1.957*** -1.984*** -1.963***

(-10.580) (-10.536) (-10.546) (-10.379) (-10.112) (-7.424) (-7.184)
BS_CONSTRAINT + 0.076*** 0.070***
(3.958) (3.584)
UNMANAGED EARNINGS - 0.048 -0.563** -0.772** -0.390
(0.235) (-2.148) (-2.028) (-0.972)
REAL_EARNINGS_MGT - -0.017 -0.006 -0.062 0.063
(-0.316) (-0.108) (-0.761) (0.823)
ABN_ACCRUALS - -0.675*** -1.125*** -0.996** -1.185***
(-2.820) (-3.522) (-2.207) (-2.405)
Control Variables Included YES YES YES YES YES YES YES
Number of observations 7,101 7,101 7,101 7,101 7,101 4,021 3,080
Pseudo R2 0.109 0.108 0.108 0.109 0.111 0.120 0.097
We report t-stats in parentheses.

note: *** p < 0.010, ** p < 0.050, * p < 0.10
PRO FORMA = Equals 1 if the firm issued pro forma earnings during the year, 0 otherwise.
BS_CONSTRAINT = Balance Sheet Constraint following Badertscher (2011)
UNMANAGED EARNINGS = Net income (NI) divided by beginning of the year total assets (AT) minus ABN_ACCRUALS;
REAL_EARNING_MGT = Real earnings management measure following Roychowdhury (2006);
ABN_ACCRUALS = Discretionary accruals measure following Kothari et al. (2005);
Control Variables: See appendix
35
TABLE 4
Logit Model of the Probability of Disclosing Pro Forma Earnings in Cross-Sectional Settings
Model: Pr (PROFORMAi,t) = 0 + 1 BS_CONSTRAINT i,t + 2 UNMANAGED_EARNINGS i,t + 3 REAL_EARNINGS_MGTi,t

Dependent Variable: PROFORMA Costs of Real Earnings Management (Zang 2012) Costs of Accruals Management (Zang 2012)
High Low High Low High Low Long Short Long Short Higher Lower Full
Market Market Altman Z- Altman Z- Instituional Instituional Auditor Auditor Operating Operating Analyst Analyst Model
Share Share Score Score Ownership Ownership Tenure Tenure Cycle Cycle Following Following
Prediction (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)
Intercept -2.375*** -2.125*** -2.235*** -2.132*** -2.107*** -1.766*** -2.833*** -1.789*** -2.288*** -1.870*** -1.140*** -1.991*** -1.859***
(-7.876) (-8.163) (-8.089) (-7.306) (-6.538) (-7.339) (-8.705) (-7.171) (-7.395) (-6.766) (-2.970) (-8.231) (-8.252)
BS_CONSTRAINT + 0.050 0.067*** 0.142*** 0.050* 0.061** 0.076*** 0.104*** 0.038* 0.070** 0.101*** 0.062** 0.068*** 0.075***
(1.421) (2.807) (3.313) (1.643) (1.871) (3.156) (2.678) (1.538) (1.809) (3.356) (1.988) (2.721) (3.031)
UNMANAGED EARNINGS - -0.367 -0.365 -0.267 -0.892*** -0.729 -0.542** -0.454 -0.478* -0.904** -0.378 -0.839** -0.500* -0.669**
(-0.614) (-1.182) (-0.662) (-2.380) (-1.275) (-1.760) (-0.866) (-1.554) (-2.160) (-1.039) (-1.763) (-1.553) (-2.492)
REAL_EARNINGS_MGT - 0.101 -0.035 -0.030 0.071 -0.055 0.034 -0.061 0.058 0.037 -0.042 0.049 -0.032 -0.006
(1.220) (-0.455) (-0.422) (0.773) (-0.714) (0.429) (-0.735) (0.755) (0.390) (-0.583) (0.648) (-0.403) (-0.111)
ABN_ACCRUALS - -0.755 -1.018*** -0.546 -1.526*** -1.018* -1.321*** -0.602 -1.306*** -0.630 -1.377*** -1.424*** -0.905** -0.994***
(-1.117) (-2.608) (-1.160) (-3.345) (-1.615) (-3.348) (-1.043) (-3.329) (-1.266) (-3.039) (-2.567) (-2.230) (-3.088)
MARKET SHARE -0.253
(-1.027)
ALTMAN'S Z SCORE 0.003
(0.674)
%INSTHOLD 0.070
(0.527)
AUDITOR TENURE -0.016***
(-4.442)
OPERATING CYCLE -0.001**
(-2.527)
ANALYST FOLLOWING 0.013**
(2.435)
Control Variables Included YES YES YES YES YES YES YES YES YES YES YES YES YES
Number of observations 3,550 3,551 3,353 3,353 3,551 3,550 3,474 3,627 3,353 3,353 3,225 3,876 6,706
2
Pseudo R 0.089 0.141 0.124 0.111 0.107 0.112 0.116 0.115 0.113 0.121 0.111 0.109 0.118

note: *** p < 0.010, ** p < 0.050, * p < 0.10
PRO FORMA = Equals 1 if the firm issued pro forma earnings during the year, 0 otherwise;
BS_CONSTRAINT = Balance Sheet Constraint following Badertscher (2011);
ABN_ACCRUALS = Discretionary accruals measure following Kothari et al. (2005).
36
TABLE 5
Logit Model of the Probability of Disclosing Aggressive Pro Forma Earnings (PROFIT)
Model: Pr (PROFITi,t) = 0 + 1 BS_CONSTRAINTi,t + 2 UNMANAGED_EARNINGS i,t + 3 REAL_EARNINGS_MGTi,t

Dependent Variable: PROFIT Above Below

Industry Industry
BSC BSC
Prediction (1) (2) (3) (4) (5) (6) (7)
Intercept -1.707*** -1.895*** -1.774*** -1.676*** -1.811*** -1.853** -1.819**

(-2.902) (-3.146) (-2.978) (-2.812) (-3.063) (-2.267) (-1.981)
BS_CONSTRAINT + 0.139*** 0.091**
(3.006) (1.941)
UNMANAGED EARNINGS - -1.557*** -3.085*** -3.665*** -2.520*
(-3.526) (-4.286) (-4.922) (-1.619)
REAL_EARNINGS_MGT - -0.080 -0.123 -0.041 -0.087
(-0.715) (-0.985) (-0.251) (-0.408)
ABN_ACCRUALS - -1.765*** -3.690*** -3.883*** -3.541***
(-4.180) (-5.300) (-4.250) (-2.974)
Pseudo R2 0.079 0.081 0.072 0.080 0.112 0.120 0.117

note: *** = p < 0.010, ** = p < 0.050, * = p < 0.10
PROFIT = Equals 1 if the firm issued pro forma earnings that turned a GAAP operating loss into a pro forma profit;
UNMANAGED EARNINGS = Net income (NI) divided by beginn= Return on assets, calculated as net income divided by total assets
37
TABLE 6
Logit Model of the Probability of Disclosing Aggressive Pro Forma Earnings (CONSENSUS)
Model: Pr (CONSENSUSi,t) = 0 + 1 BS_CONSTRAINTi,t + 2 UNMANAGED_EARNINGS i,t + 3 REAL_EARNINGS_MGTi,t

Dependent Variable: CONSENSUS Above Below

Industry Industry
BSC BSC
Prediction (1) (2) (3) (4) (5) (6) (7)
Intercept -1.429*** -1.419*** -1.462*** -1.381*** -1.328*** -1.138** -1.963***

(-4.103) (-4.009) (-4.162) (-3.931) (-3.802) (-2.549) (-3.246)
BS_CONSTRAINT + 0.122*** 0.106***
(3.185) (2.787)
UNMANAGED EARNINGS - -0.178 -1.231*** -1.347** -1.342*
(-0.556) (-2.363) (-2.274) (-1.353)
REAL_EARNINGS_MGT - -0.218*** -0.220*** -0.342*** 0.014
(-2.558) (-2.512) (-2.908) (0.114)
ABN_ACCRUALS - -0.857*** -1.669*** -1.587*** -1.723**
(-2.414) (-3.125) (-2.359) (-1.843)
Pseudo R2 0.071 0.066 0.068 0.068 0.077 0.098 0.053

note: *** = p < 0.010, ** = p < 0.050, * = p < 0.10
CONSENSUS = Equals 1 if the pro forma number meets or beats the mean analyst forecast, but GAAP operating earnings do not, 0 otherwise;
38
TABLE 7
Logit Model of the Probability of Disclosing Aggressive Pro Forma Earnings (RECUR)
Model: Pr (RECURi,t) = 0 + 1 BS_CONSTRAINTi,t + 2 UNMANAGED_EARNINGS i,t + 3 REAL_EARNINGS_MGTi,t

Dependent Variable:RECUR Above Below

Industry Industry
BSC BSC
Prediction (1) (2) (3) (4) (5) (6) (7)
Intercept 0.792** 0.811** 0.781** 0.832** 1.015*** 1.376** 0.605

(2.102) (2.148) (2.070) (2.219) (2.662) (2.549) (1.102)
BS_CONSTRAINT + 0.087** 0.064*
(1.794) (1.310)
UNMANAGED EARNINGS - -0.338 -1.937*** -2.985*** -1.061*
(-1.018) (-3.267) (-3.102) (-1.395)
REAL_EARNINGS_MGT - -0.091 -0.103 -0.267** 0.067
(-0.866) (-0.994) (-1.800) (0.475)
ABN_ACCRUALS - -0.899** -2.418*** -2.795*** -1.972**
(-2.219) (-3.655) (-2.883) (-2.163)
Pseudo R2 0.036 0.035 0.035 0.037 0.043 0.058 0.034

note: *** = p < 0.010, ** = p < 0.050, * = p < 0.10
RECUR = Equals 1 if the firm issued pro forma earnings that exclude recurring items, 0 otherwise;
39
TABLE 8
Market Reaction to Pro Forma Reporting around Earnings Announcement
Dates Controlling for Balance Sheet Constraints
Model: CAR = 0+ 1 FEGAAP + 2 PROFORMA + 3 FEGAAP x PROFORMA

+ 4 BS_CONSTRAINTP50 + 5 PROFORMA x BS_CONSTRAINTP50
+ 6 FEGAAP x BS_CONSTRAINTP50 + 7 FEGAAP x PROFORMA x BS_CONSTRAINTP50 +
Above Below
Industry Industry
Dependent BSC BSC
Variable: CAR Predicted Sign (1) (2) (3) (4) (5)
Intercept 0.0042*** 0.0037*** 0.004*** 0.004*** 0.0039***
(10.937) (8.714) (6.489) (6.289) (7.992)
FEGAAP + 0.7964*** 0.8659*** 0.730*** 0.981*** 0.9082***
(19.621) (18.002) (11.772) (13.782) (15.463)
PROFORMA + 0.0028*** 0.000 0.005*** 0.0045***
(2.668) (0.360) (3.202) (3.674)
FEGAAP x PROFORMA - -0.2849*** -0.232** -0.301** -0.3031***
(-3.188) (-2.169) (-2.124) (-2.652)
BS_CONSTRAINTP50 - -0.001
(-0.850)
PROFORMA x BS_CONSTRAINTP50 - -0.0058***
(-2.544)
FEGAAP x BS_CONSTRAINTP50 - -0.1469*
(-1.439)
FEGAAP x PROFORMA x BS_CONSTRAINTP50 - 0.0407
(0.224)
Number of
41,026 41,026 21,412 19,614 41,026
observations
Adjusted R2 0.019 0.020 0.016 0.025 0.020
note: *** = p < 0.010, ** = p < 0.050, * = p < 0.10
CAR = Size-adjusted abnormal return cumulated over the 3-day window surrounding the earnings announcement;
FEGAAP = Forecast error based on GAAP earnings;
PROFORMA = Equals 1 if the firm issued pro forma earnings for the quarter, 0 otherwise;
BS_CONSTRAINTP50 = Equals 1 if the company's quarterly balance sheet constraint is greater than the median balance sheet constraint value for the industry-year, 0
otherwise.
40

The Relation Between Earnings Management and Pro Forma Reporting

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The Relation Between Earnings Management and Pro Forma Reporting

Electronic copy available at: http://ssrn.com/abstract=2259379

Electronic copy available at: http://ssrn.com/abstract=2259379

We explore various perception management techniques commonly used by managers. One of

therefore allow managers discretion in providing non-standard and potentially misleading

decreasing discretionary spending), accruals management (e.g., managing reserves), classification

strategic targets with current-period operating performance or within-GAAP earnings management

company (Zang 2012).

number is related to current performance, past earnings management, or current earnings

pro forma earnings disclosures and our variables of interest.

regulators, and other stakeholders concerned with pro forma reporting.

2. Background and Hypothesis Development

investors, lenders, and other stakeholders.

Prior Accruals Management

When managers choose to influence stakeholder perceptions through traditional earnings

outstanding used to calculate EPS.

Hence, our first hypothesis, stated in the alternate form is:

HYPOTHESIS 1. Companies with more past earnings management (as represented by

Current Operating Performance

Clearly, there is no substitute for solid current-period operating performance to convey a

HYPOTHESIS 2. Companies with lower unmanaged current-period operating

Current Real Earnings Management

increased regulatory scrutiny of accruals in the post-Sarbanes-Oxley environment (Badertscher 2011;

Current Accruals Management

HYPOTHESIS 4. Companies with less current-period accruals management are more

3. Methodology, Variable Measurement, and Research Design

To examine the influence of earnings management variables on managers propensity to

1. PROFORMA is an indicator variable that equals 1 if a company discloses a pro forma

loss into a pro forma profit, and zero otherwise.

3. CONSENSUS is an indicator variable that equals one if a company discloses a pro

from missing analysts expectations based on GAAP earnings to meeting or beating

expectations on a pro forma basis, and zero otherwise.

NOAi,t = (OP_ASSETSt - OP_LIABILITIESt) / SALESt-1 (1)

NOAt = net operating assets;

Current Unmanaged Operating Performance

forma earnings based on unmanaged operating performance. Specifically, we measure unmanaged

research.9 Specifically, we follow Roychowdhury (2006) in calculating abnormal cash from

operations, abnormal discretionary expenditures, and abnormal inventory production.

code and year:10

CFO i,t = cash flow from operations in year t.

discretionary expenditure. We estimate expected discretionary expenditures for each company-year

observation by year and for each 3-digit SIC code:

and for each 3-digit SIC code:

PROD i,t = cost of goods sold plus change in inventory in year t.

level of real transaction management.

operations, abnormal expenditures, and abnormal production of inventory) to create

REAL_EARNINGS_MGT, which represents a consolidated measure of real earnings management for

proxy for higher levels of real earnings management.

cross-sectional regression by two-digit SIC code and year:

TAt = 0 + 1 (1/ATt-1) + 2 (REVt - ARt) + 3 PPEt + 4 NIt + t (5)

TAt = total accruals for company i in year t, calculated as the difference

digit SIC code and year group.

Pr (PF = 1) = 0 + 1 TestVars + k Controls (6)

PF = indicator variable coded 1 if the company disclosed pro forma

increases (STRING4), issuance of management earnings forecast (GUIDANCE), debt/equity issuance

(ISSUE), future debt/equity issuance (FUTURE_ISSUANCE), institutional ownership (%INSTHOLD),

Big 4 auditors (BIGAUDIT), accruals quality14 (ACCRUALS_QUALITY), and litigious industries

Sample Selection and Data

Descriptive Statistics and Correlations

companies issue debt or equity (ISSUE).

(CONSENSUS) and 79 percent of these company-year observations excluded recurring items in

calculating the pro forma earnings number (RECUR).

Intercept -2.027* -2.027* -2.029* -1.996* -1.957* -1.984* -1.963***

Intercept -1.707* -1.895* -1.774* -1.676* -1.811* -1.853 -1.819**

Intercept -1.429* -1.419* -1.462* -1.381* -1.328* -1.138 -1.963***

Intercept 0.792 0.811 0.781 0.832 1.015* 1.376 0.605