Executive Summary:
Lawmakers and regulators have become increasingly concerned about the proliferation of a non-standard profitability measure (known as “pro forma” earnings) that some earnings press releases report along with the audited income number calculated according to the generally accepted accounting principles (GAAP). Regulators, policymakers, and the financial press allege that managers' pro forma earnings reports are often opportunistic attempts to mislead investors. Managers, on the other hand, contend that they provide pro forma numbers because those numbers are closer to their core earnings than audited GAAP figures. The investors who are arguably the most vulnerable to managerial manipulations are the less sophisticated, individual investors (small investors). Consequently, this study investigates who trades on pro forma earnings information. Our intraday investigation of transactions around pro forma announcements reveals that small investors’ announcement-period abnormal trading volume is significantly positively associated with earnings surprise based on pro forma earnings. In contrast, we find that large, sophisticated investors either do not trade on pro forma information, or they take the position opposite to that of small investors (e.g., while small investors predominantly buy following a pro forma good news announcement, large investors sell). Collectively, our results indicate that the segment of the market that relies on pro forma earnings information is populated almost entirely by small investors. Given preliminary evidence from recent research that a segment of the market is misled by pro forma information, and in the backdrop of sweeping regulatory and disclosure policy changes introduced by the Sarbanes-Oxley Act of 2002 and subsequent SEC regulations (SEC Regulation G) to protect ordinary investors, our results are particularly timely and relevant to standard setters and regulators. |
