Who Trades on Pro Forma Earnings Information?

In recent years, many companies have emphasized adjusted-GAAP earnings numbers in their quarterly press releases. While managers use different names to describe these nonstandard earnings metrics, the financial press frequently refers to them as ‘‘pro forma’’ earnings. Managers and other advocates of pro forma reporting argue that these disclosures provide a clearer picture of companies’ core earnings. On the other hand, regulators, policymakers, and the financial press often allege that managers’ pro forma earnings disclosures are opportunistic attempts to mislead investors. Recent evidence suggests that while many pro forma earnings disclosures are altruistically motivated, some may represent managers’ attempts to portray overly optimistic financial performance. If this is the case, then less wealthy, less sophisticated, individual investors are arguably the most at risk of being misled. Consequently, this study investigates who trades on pro forma earnings information. Our intraday investigation We thank Steve Baginski, Linda Bamber, Hank Bessembinder, Cal Boardman, Christine Botosan, David Hirshleifer, Karl Lins, Mike Lemmon, Srinivasan Sankaraguruswamy, Kay Stice, Beverly Walther, workshop participants at Brigham Young University, Duke University, Emory University, Mellon Capital Management, University of Notre Dame, Southern Methodist University, the Batten Forum at the College of William & Mary, and participants at the 2005 FARS Midyear Meeting for helpful suggestions. We are grateful to two anonymous reviewers and Patricia Dechow (editor) for their many constructive suggestions. We appreciate the valuable research assistance of Chad Larson, Kris Allee, Joe Bartlett, Dirk Black, Bryant Blanchard, Brandon Buhler, Leo Ebbert, Jonathan Fife, Josh Gagon, Kirk Gibb, Bryan Graden, Alicia Ingalls, Robert Judd, Jon Liljegren, Sam Mautz, Greg Packer, Heidi Prescott, John Prete, Willis Pueblo, Rob Shaw, Jacob Smith, Scott Tandberg, Patrick Walsh, Adam Ward, Chris Williams, and Devin Williams. We are also grateful to Thomson Financial for providing earnings forecast data, available through the Institutional Brokers Estimate System. These data have been provided as a part of their broad academic program to encourage earnings expectation research. Professors Christensen and Black express appreciation to Brigham Young University for funding that made this research possible. Professor Bhattacharya acknowledges financial support provided by Cox School of Business at the Southern Methodist University. Editor’s note: This paper was accepted by Patricia Dechow. Submitted July 2004 Accepted September 2006 582 Bhattacharya, Black, Christensen, and Mergenthaler The Accounting Review, May 2007 of transactions around earnings announcements containing pro forma earnings information reveals that less sophisticated investors’ announcement-period abnormal trading is significantly positively associated with the magnitude and direction of the earnings surprise based on pro forma earnings. In contrast, we find no association between sophisticated investors’ trading and manager-reported pro forma information. Overall, our analyses and numerous robustness tests suggest that the segment of the market that relies on pro forma earnings information is populated predominantly by less sophisticated individual investors. This evidence is particularly relevant to standardsetters and regulators given that Section 401(b) of the Sarbanes-Oxley Act of 2002 and subsequent SEC regulations are specifically designed to protect ordinary investors from misleading pro forma information.