Sarah E. McVay

Non-GAAP Earnings and Board Independence

We examine the association between board independence and the characteristics of non-GAAP earnings. Our results suggest that companies with less independent boards are more likely to opportunistically exclude recurring items from non-GAAP earnings. Specifically, we find that exclusions from non-GAAP earnings have a greater association with future GAAP earnings and operating earnings when boards contain proportionally fewer independent directors. Consistent with the association between board independence and the permanence of non-GAAP exclusions reflecting opportunism rather than the economics of the firm, we find that the association declines following Regulation G and that managers appear to use exclusions to meet earnings targets prior to selling their shares more often in firms with fewer independent board members. Overall, our results suggest that board independence is positively associated with the quality of non-GAAP earnings.

Analysts’ Incentives to Overweight Management Guidance when Revising Their Short-Term Earnings Forecasts

We document that, when revising their short-term earnings forecasts in response to management guidance, analysts wishing to curry favor with management weight the guidance more heavily than predicted based on the credibility and usefulness of the guidance. This overweighting of guidance is present prior to equity offerings and other events that could lead to investment banking business. Although analysts sacrifice their forecast accuracy by overweighting management guidance, they appear to benefit, on average, by subsequently gaining the underwriting business for their banks. Thus, while analysts wishing to please managers are optimistic in their long-term earnings forecasts, they take their cue from management when determining their short-term earnings forecasts.

The Disclosure of Non-GAAP Earnings Information in the Presence of Transitory Gains

We examine the disclosure of non-GAAP earnings information in quarters containing transitory gains to investigatewhether the primarymotivation for thesemanagers to disclose non-GAAP earnings is to inform or mislead. In this setting, non-GAAP earnings aremore informative thanGAAPearnings, even though they are lower thanGAAPearnings. Thus, managers motivated to inform stakeholders about sustainable earnings will disclose non-GAAP earnings information excluding the gain, whereas managers motivated to report higher earningswill obscure the transitory nature of the gain by focusing onGAAPearnings. We find evidence that managers’ disclosure choices vary widely across firms, and these choices affect investors’ perceptions of core operating earnings. We then contrast how the same firm discloses non-GAAP earnings in the presence of transitory losses to provide additional evidenceon themotivesof individual firms’disclosures.Weconclude that themost pervasivemotivation to disclose non-GAAP earnings in the presence of transitory gains is to inform. An economically significant proportion of firms, however, appear opportunistic in that they only disclose non-GAAP earnings information when it increases investors’ perceptions of core operating earnings.Our evidence is important becausewespeak to the influence that eachmotive has on the choice to disclose non-GAAP earnings and we provide evidence on the underlying motives behind specific firms’ disclosures.

The Changing Implications of Research and Development Expenditures for Future Profitability

Research and development (R&D) expenditures have grown dramatically over time. We examine how R&D profitability has changed as a result, hypothesizing that the sharp increase in spending might lead to diminishing marginal returns on R&D investments and thus a decline in average profitability. Consistent with this, we estimate that the profitability of R&D has declined by over 70 percent (on average) and 62 percent (in aggregate) between the early and later parts of our sample period. This decline does not appear limited to any particular subset of our sample and is robust to alternative model specifications. We provide evidence of diminishing marginal returns to R&D investments (as higher aggregate amounts of R&D spending are associated with lower profitability). We also provide evidence of a decline in R&D investment risk across time, which could contribute to the decline in profitability. Despite the pervasiveness of the decline, we provide evidence that analysts do not fully incorporate this decline into their growth forecasts and that investors appear to revise their long-run expectations when anticipated future profits are not realized. Our results inform market participants and researchers assessing the implications of R&D for future earnings.

Why Do Firms Defer Internal Control Assessments and Does It Matter? Evidence from M&A Transactions

To inform the debate on the merits of internal control audits, we examine managers’ decisions to temporarily exempt newly acquired businesses from Section 404 of the Sarbanes-Oxley Act. We provide evidence that managers are more likely to elect the exemption when expected compliance costs are higher, such as when acquisitions are larger and occur later in the year. We find only modest evidence that managers use the exemption to avoid scrutiny of value-destroying deals. Exemption use, however, is associated with negative post-acquisition outcomes, including lower return-on-assets and higher likelihoods of goodwill impairments and financial statement restatements. These results are consistent with compliance providing benefits by facilitating timely identification and correction of control problems in the newly acquired business. Finally, we document negative abnormal stock returns at the time exemption use is announced and over the subsequent three years, suggesting that investors view exemption use negatively and that their initial price reactions are incomplete.

When Does Internal Control Over Financial Reporting Curb Resource Extraction? Evidence from China

We examine whether internal control over financial reporting (internal control) reduces the expropriation of resources from the firm by managers and controlling shareholders. Although we have ample evidence from prior literature that internal controls reduce errors in financial reports, it is less clear that they can curb resource extraction, as management may simply override these controls. We exploit a rich Chinese dataset to distinguish between the design and implementation of internal controls. On average we find some evidence that internal controls curb resource extraction, but further investigation reveals that many firms with documented internal controls fail to implement these controls, or simply override them (i.e., form over substance), and these firms’ controls do not curb resource extraction. We find that internal controls are most likely to be form over substance when they are policy-driven instead of voluntarily adopted, and also when there are more severe agency problems (and thus an increased likelihood of control override). Although the analysis is conducted with Chinese data, the spirit of our findings should generalize to all settings. In particular, our findings suggest that management can use the “form” of internal control procedures while still engaging in the undesirable behavior.