Dirk E. Black

Has the Regulation of Pro Forma Reporting in the US Changed Investors’ Perceptions of Pro Forma Earnings Disclosures?: REGULATION OF PRO FORMA REPORTING IN THE US

We explore whether investors’ perceptions of pro forma earnings numbers have changed following the regulation of pro forma reporting imposed by the Sarbanes�?Oxley Act of 2002 (SOX). First, we find that investors appear to pay more attention to pro forma earnings disclosures in the post�?SOX period, consistent with the notion that they perceive that regulation generally renders these disclosures more credible. Second, the results indicate that investors discount aggressive pro forma earnings reports in both periods. However, they appear to discount at least some potentially misleading pro forma earnings disclosures more in the post�?SOX period. Finally, our results imply that the regulation of pro forma reporting has increased the average quality of pro forma earnings disclosures by filtering out those that are most likely to be misleading. These results are consistent with the conclusions that (1) the quality of pro forma reporting has improved following SOX, and (2) investors’ perceptions of pro forma earnings metrics have changed in the post�?SOX regulatory environment.

The Effects of Executive Compensation Contracts and Auditor Effort on Pro Forma Reporting Decisions

We investigate two potential deterrents of aggressive pro forma reporting. First, the design of compensation contracts can encourage managers to adopt either a short- or a long-term focus. While it is difficult to observe whether compensation contracts are tied directly to pro forma earnings numbers, we posit that managers with a short-term horizon are more likely to make aggressive pro forma exclusions than managers with a long-term focus. Second, auditor effort can discourage potentially misleading pro forma earnings adjustments. Consistent with our predictions, we find that when compensation contracts include a long-term performance plan, managers are less likely to make potentially misleading pro forma earnings adjustments. Similarly, we find some evidence of a negative association between auditor effort (as proxied by higher-than-normal audit fees) and potentially misleading earnings adjustments. Taken together, this evidence is consistent with the notion that the design of compensation contracts and auditor effort can significantly influence managers’ pro forma reporting decisions. The results also suggest that investors discount earnings information when opportunism is likely to motivate managers’ earnings adjustments. Moreover, when managers make aggressive earnings exclusions in the presence of safeguards that limit opportunistic behavior, investors appear to react even more negatively.

SFAS 123R and the CEO Contracting Use of Relative Performance Evaluation

This paper examines how changes in CEO risk-taking incentives are associated with changes in the use of relative performance evaluation (RPE) in CEO contracts. Using a shock to the accounting for executive stock options (SFAS 123R), I confirm that risk-taking incentives and option grants declined following SFAS 123R using a within-firm design, but not a within-CEO-firm-design. Decreased risk-taking incentives lead executives to invest in projects with lower systematic risk and can result in reduced incentives to hedge exposure to systematic risk in CEO compensation contracts via RPE. However, CEO relative risk-aversion increases with decreases in risk-taking incentives, potentially increasing incentives to protect CEO wealth from systematic performance via RPE. Testing these competing predictions, I find modest evidence consistent with reduced RPE surrounding SFAS 123R, suggesting that when CEO risk-taking incentives are reduced, so are incentives to shield CEO pay from systematic performance.

Peer Group Composition, Peer Performance Aggregation, and Detecting Relative Performance Evaluation

We study S&P 500 firms’ disclosure of relative performance evaluation (RPE) details in their first proxy statement filing after the effective date of an SEC rule mandating expanded executive compensation disclosures. Using theoretically-developed implicit techniques to detect RPE use, we compare inferences from the explicit disclosures with inferences from the implicit tests. In our hand collection of each firm’s first proxy statement after the expanded disclosure mandate, we identify 17.32% of the S&P 500 firms as explicit RPE disclosers. In the subsample of RPE disclosers, we find consistent implicit evidence of RPE as long as the peer group is composed either of firms in the same industry/size quartile or of firms named as peers in the explicit RPE disclosures. More importantly, in the subsample of explicit RPE non-disclosers, we also detect the use of RPE, using industry/size peer groups and weighting each peer’s performance by each peer’s correlation with systematic risk relative to each peer’s idiosyncratic risk. Our inferences depend on assumptions about the choice of peers and the weights on those peers, suggesting important implications for RPE researchers. These findings also imply that relying on explicit mandated disclosures of RPE may understate the prevalence of RPE in practice.

CEO Compensation Incentives and Non-GAAP Earnings Disclosures

We examine the relation between compensation incentives and non-GAAP earnings disclosures. Specifically, we focus on the extent to which bonus plan incentives and long-term performance plan incentives are associated with the aggressiveness of non-GAAP reporting, controlling for CEO sensitivity to stock price. Using a large hand-collected sample of non-GAAP earnings disclosures, we find that long-term plan incentives are negatively associated with the likelihood and magnitude of aggressive non-GAAP reporting, suggesting that they act as a deterrent to potentially opportunistic behavior. For a sub-sample of firms for which compensation contracts in proxy filings explicitly state that managers will be evaluated based on non-GAAP metrics, we find less opportunistic non-GAAP reporting, consistent with boards defining adjusted performance metrics in compensation contracts in order to limit CEOs’ ability to define their own non-GAAP numbers. However, when boards of directors have discretion to use non-GAAP metrics when evaluating managers, we find more opportunistic non-GAAP earnings reporting, consistent with managers using the flexibility in contracts to influence their performance evaluations.

A New Measure of Managers' Intentional Income Smoothing

The purpose of our study is to further understand managerial incentives that affect the volatility of reported fiscal-year earnings. We do this by examining income smoothing based on pseudo fiscal years. For each firm, we create pseudo-year earnings using four consecutive quarters other than the reported fiscal year. We then compare earnings volatility of pseudo years to the earnings volatility of the firm’s own reported fiscal year. To the extent managers use accruals to reduce annual earnings volatility, we expect the volatility of reported fiscal-year earnings to decrease relative to the volatility of pseudo-year earnings. We find that this measure of income smoothing behaves as expected in a variety of cross-sectional tests. Moreover, we find that cash flow and accrual patterns for firms with high values of our smoothing measure are more consistent with intentional income smoothing than with the integral approach to accounting. Our evidence is consistent with income smoothing being primarily driven by accruals rather than cash flows. Overall, we contribute to the literature exploring alternative explanations for the differential volatility of fiscal-year and fourth-quarter earnings.

The Information Content of Analysts' Book Value Per Share Forecasts

We investigate the information content of analysts’ book value per share (BVPS) forecasts. We test whether analysts’ BVPS forecasts are informative about future realizations of other comprehensive income (OCI) and special items controlling for analysts’ EPS forecasts. Our results suggest that analysts’ BVPS forecasts generally incorporate upcoming realizations of OCI and special items, especially for financial firms. We also find evidence that BVPS forecasts provide expectations of non-EPS income, and that the market responds to BVPS innovations, especially BVPS forecasts misses. Finally, we find evidence that analysts provide more BVPS forecasts for financial firms that 1) have greater absolute levels of accumulated other comprehensive income (AOCI) from securities and derivatives, 2) report higher levels of OCI from securities, and 3) hold more opaque financial assets, and for non-financial firms with high absolute levels of pension-related AOCI.We investigate the information content of analysts’ book value per share (BVPS) forecasts. We test whether analysts’ BVPS forecasts are informative about future realizations of other comprehensive income (OCI) and special items controlling for analysts’ EPS forecasts. Our results suggest that analysts’ BVPS forecasts generally incorporate upcoming realizations of OCI and special items, especially for financial firms. We also find evidence that BVPS forecasts provide expectations of non-EPS income, and that the market responds to BVPS innovations, especially BVPS forecasts misses. Finally, we find evidence that analysts provide more BVPS forecasts for financial firms that 1) have greater absolute levels of accumulated other comprehensive income (AOCI) from securities and derivatives, 2) report higher levels of OCI from securities, and 3) hold more opaque financial assets, and for non-financial firms with high absolute levels of pension-related AOCI.