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Review of Accounting and FinanceVol. 9 No. 2, 2010

pp. 139-155# Emerald Group Publishing Limited

1475-7702DOI 10.1108/14757701011044161

The association between proforma earnings and earnings

managementEssam Elshafie and Ai-Ru Yen

Department of Accounting, Business Law and Finance,Northeastern Illinois University, Chicago, Illinois, USA, and

Minna YuDepartment of Accounting, Ball State University, Muncie, Indiana, USA

Abstract

Purpose – The purpose of this paper is to examine the association between investor perceptionmanagement through reporting aggressive pro forma (PF) earnings and earnings managementthrough real activities or by manipulating accruals.Design/methodology/approach – A sample of PF earnings announcements over 2001-2007was manually collected from Lexis Nexis, consisting of 4,285 firm-quarter observations; theaggressiveness of PF earnings reporting was measured by the difference between GAAP earningsand PF earnings.Findings – The paper finds that managers report more aggressively calculated PF earningsnumbers if they do not meet their earnings targets or they have limited abilities to manage earnings.Also it was found that the gap between the value relevance of GAAP earnings and PF earnings issmaller for firms with relatively low level of discretionary accruals; this gap is decreased in the post-Sarbanes Oxley Act period.Practical implications – This paper has implications for investors and financial analysts byexplaining firms’ PF earnings reporting behaviours. It also has policy implications for capital marketregulators regarding the PF earnings reporting rules.Originality/value – This paper is the first study to provide evidence that the opportunisticreporting of PF earnings is associated with managerial inability to meet earnings targets throughearnings management. It advances our understanding on the PF earnings reporting behaviour.

Keywords United States of America, Legislation, Financial reporting, Financial management,Investors

Paper type Research paper

1. IntroductionThe market reaction to either pro forma (PF) earnings or GAAP earnings depends,in part, on the way information is processed by market participants. Fama (1970)indicates that under the efficient market hypothesis (EMH), security prices reflect allavailable information. Despite the theoretical importance of the EMH, Bloomfield(2002) indicates that the academic community has shown increasing dissatisfactionwith it. He presents an alternative to the EMH called the incomplete revelationhypothesis (IRH). Under this hypothesis, the statistics that are more costly to extractfrom public data are less completely revealed in market prices. One of the implicationsof the IRH is the managers’ financial reporting behaviour. Bloomfield indicates thatmanagers usually prefer high stock prices and high returns for the firms they managebecause of their effect on their compensation. Consistent with the IRH, ‘‘managers makemany decisions motivated, at least partly, by a desire to make it harder for investors touncover information that the managers do not want to affect their firms’ stock prices’’(Bloomfield, 2002). Among these decisions, Bloomfield identifies the announcements ofPF earnings numbers ‘‘that emphasize improvements relative to their own strategically

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chosen benchmarks, while making it more difficult for investors to observe othermeasures of performance,’’ and managing earnings by creating ‘‘cookie jar reserves tomaintain the capacity for positive accruals to boost earnings in the future.’’

PF earnings are GAAP earnings adjusted for items that managers deem unusualor non-recurring[1]. Many studies examine the value relevance of PF earnings (e.g.Bhattacharya et al., 2003; Brown and Sivakumar, 2003) and their effect on investors’decisions (e.g. Frederickson and Miller, 2004; Elliot, 2006). In the current study, weexamine whether companies use the announcements of PF earnings as an alternativeto earnings management through accruals management (Hereafter AM) and/or realearnings management (Hereafter RM). We expect that if a company does not have theability to manage earnings to a targeted level, it may manage investors’ perception byannouncing PF earnings that are more favourable (much larger) than GAAP earnings.That is, a more aggressive PF earnings announcement would be expected for acompany that missed the earnings target[2]. The reason behind this expectation is thatmanagers are motivated to hide losses or earnings disappointments and to meet or beatearnings expectations (Burgstahler and Dichev, 1997; Bartov et al., 2002); therefore, themarket penalties associated with reporting unfavourable earnings outcomes canpresumably be mitigated either by managing actual earnings or by managing readers’perception of earnings (Johnson and Schwartz, 2005). In addition to the use of PFearnings to manage perception as an alternative to the use of earnings management,the study examines the effect of the levels of AM and RM on the relative valuerelevance of GAAP earnings relative to the value relevance of PF earnings.

Sarbanes Oxley Act of 2002 (SOX) led to restrictions on disclosing PF earnings. Therestriction, namely regulation G issued by the SEC in January of 2003, defines non-GAAPmeasures and creates standards for their disclosure. Therefore, when a company reportsa PF measure, it must present the most directly comparable GAAP-based measure alongwith reconciliation between the two figures. In addition, earnings announcements mustbe filed with the SEC within five days of their public release, regardless of whether theycontain non-GAAP financial measures. Furthermore, management should justify theusefulness of providing non-GAAP financial measure to the investors (Hotlzman et al.,2003). These rules should close the value relevance gap between PF and GAAP earningsdocumented in earlier studies (e.g. Bradshaw and Sloan, 2002; Bhattacharya et al., 2003).In addition, SOX also had an effect on reporting discretion. Lobo and Zhou (2006) reportthat firms report lower discretionary accruals after SOX than in the period preceding it,which should improve the quality of GAAP earnings. Also, Cohen et al. (2008) documenta decreasing trend of AM and an increasing trend of RM after SOX. Taking these trendsinto consideration combined with the SEC requirements for reporting non-GAAPmeasures, like PF earnings, we test whether the difference between the value relevance ofGAAP earnings and PF earnings decreased in the period after SOX in comparison totheir relative value relevance during the period before SOX.

The results of the study suggest that managers report less aggressive PF earningsnumbers (a smaller difference between PF and GAAP earnings) when they achievetheir earnings objectives. Also they report less aggressive PF earnings numbers whenthey are able to mange earnings through AM or RM. The results also suggest that thelevel of discretionary accruals negatively affects the value relevance of GAAP earningsrelative to PF earnings. However, the RM level does not have the same negative effect.Finally, the results provide evidence that the gap between the value relevance of GAAPand PF earnings got smaller in the period subsequent to SOX relative to the periodbefore SOX.

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2. Literature reviewThere are several possible explanations for the management’s decision to reportPF earnings. First, GAAP rules for earnings calculations may not be ‘‘fit all’’ rules.Bhattacharya et al. (2003) find that about half of the PF earnings reporting firms arein the service industries, and approximately 31 per cent are in the manufacturingindustries. This may indicate that GAAP earnings are deemed less value relevant incertain industries. Second, the increased occurrence of transitory and non-recurringitems may prompt managers to report PF earnings. Third, managers may be actingopportunistically. Since PF earnings figures are higher than GAAP earnings figuresabout 70 per cent of the time (Bhattacharya et al., 2003), managers may report PFearnings to communicate positive information to investors in an attempt to maximizetheir compensation payments. Fourth, the decision to report PF earnings may resultfrom governance related issues. Prior research provides evidence that the board ofdirectors and investors hold management accountable for current stock performance(e.g. Weisbach, 1988; Warner et al., 1988). In response, managers may report PFearnings if doing so will reduce the likelihood of undervaluation.

The last two studies suggested reasons for announcing PF earnings that areconsistent with Watts and Zimmerman’s positive theory. Watts and Zimmerman (1986)introduced three hypotheses that explain earnings management: the bonus planhypothesis, the debt covenant hypothesis, and the political costs hypothesis[3]. Thesehypotheses reflect internal incentives for earnings management, where managementmanages earnings to improve compensation, to meet debt covenant requirements, or toavoid political costs such as taxes or government regulations.

Schrand and Walther (2000) test for the existence of strategic disclosure inearnings announcements, which is related to earnings management, but the managermanages the perception of earnings rather than actual earnings. They provideevidence on strategic reporting by managers and some evidence that investors aremisled by the reports. Entwistle et al. (2005) provide evidence that suggest thatmanagers use PF earnings strategically to affect users’ perceptions of firmperformance. Also, Johnson and Schwartz (2005) indicate that market penalties for notachieving expected earnings can presumably be softened by either earningsmanagement or perception management where PF earnings announcements come intoplay. Several studies examine how firms manage earnings to meet or beat marketexpectations. Many of these studies focus on using AM as a means of managingearnings (e.g. Bartov et al., 2002; and Matsumoto, 2002). Also recent studiesdocumented trends of managing real business activities as a mean of managingearnings (e.g. Lobo and Zhou, 2006; Cohen et al., 2008). However, to the best of ourknowledge, no prior study examines the alternative use of AM, AR, and PF earningsannouncements.

Therefore, in this study we examine using PF earnings as an alternative tool tomanage perception in the case of managers’ limited ability to manage earnings; we alsoexamine the association between earnings management, both AM and RM, and therelative value relevance of GAAP earnings and PF earnings, and finally the effect ofSOX on the relative value relevance of GAAP earnings and PF earnings.

3. Hypotheses developmentThe asymmetry of price reaction to small negative earnings surprises relative to smallpositive earnings surprises induced corporate managers to avoid reactions to negativesurprises by adopting different strategies such as earnings managements, expectation

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management, or earnings pre-announcements. Bradshaw and Sloan (2002) indicate thatPF earnings is another potential technique for reporting earnings news to investors,whereby the reported earnings are modifications of GAAP earnings such that certainexpenses deemed to be ‘‘non-recurring’’ or ‘‘non-cash’’ are excluded. In addition, Bloomfield(2002) identifies announcing PF earnings as a decision to avoid uncovering ‘‘informationthat the managers do not want to affect their firms’ stock prices’’. On the basis of thosestudies, we expect that managers use PF earnings announcement as a way to manipulateinvestors perception about the firm, as an alternative way of managing earnings. To testthis expectation, let us assume that disclosing earnings before any management will resultin investors making decision A that has negative stock return consequences undesired bythe managers, and that the managers prefer that investors make decision E, that reflectspositively on firm stock prices; then the managers may use a combination of AM, RM, andPF earnings announcement and other methods such as strategic earnings disclosure[4] toinfluence the investors to change their decision from A to E (see Figure 1).

We focus in this study on the three methods: AM, RM and perception managementthrough the announcement of PF earnings. We assume that managers choose one ofthese methods based on whether they are able to achieve their earnings targets andbased on firm characteristics that make it more possible to manage accruals or realactivities. And if managing accruals and real activities is not enough to achieve thetargets, they manage the perception of investors using PF earnings announcements. Forexample, if managers of a certain firm expected that earnings numbers will not meet thetargeted numbers, they may increase production to lower the cost of goods sold, cut ondiscretionary expenses such as R&D and advertising, or lessen their credit restrictions toincrease sales. If these real activities were not enough to increase earnings to reach thetarget goal, then it depends on the firm’s characteristics. In firms where the amounts ofinventory, accounts receivable, accounts payable, and fixed assets are relatively small;the ability to manage earnings through accruals will be limited and therefore themanagers will have to turn to managing the perception of the investors by announcingaggressive PF earnings numbers. On the basis of the discussion, we expect that firmsthat achieve their earnings targets, after using AM and RM, will not aggressively reportPF earnings. We test this prediction using the following hypothesis:

H1. Firms that meet their earnings targets make less aggressive PF earningsannouncement as compared to those that fail to meet the earnings targets.

Also based on the above discussion, we expect an inverse relationship between theaggressiveness of reporting PF earnings and both AM and RM. We predict that firmsthat have the ability to manage earnings through accruals or through managerialactivities such as accelerating the timing of sales, building larger inventory to reducethe cost of goods sold, or decreasing the discretionary expenses such as R&D andadvertising, will have less need to aggressively calculate the announced PF earnings.To test these predictions, we test the following hypotheses that are postulated in theiralternative form as follows:

Figure 1.

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H2a. Firms with low AM levels make more aggressive PF earningsannouncement as compared to firms with high AM.

H2b. Firms with low RM levels make more aggressive PF earnings announcementas compared to firms with high discretionary accruals.

Sloan (1996) shows that higher accruals negatively affect (GAAP) earnings quality. Heindicates that firms with a higher accruals component in their earnings suffer from lowerearnings persistence and negative future abnormal returns. Therefore, since the qualityof GAAP earnings is negatively affected by the amount of earnings managementmeasured by the level of discretionary accruals, we expect the value relevance of GAAPearnings relative to PF earnings to decrease as the amount of discretionary accrualsincreases. Therefore, we test the following hypothesis in its alternative form:

H3a. The higher the AM levels the higher the value relevance of PF earningsrelative to GAAP earnings.

To the best of our knowledge, extant research did not examine the effect of RM on thevalue relevance of GAAP earnings. However, since it is assumed that managersmanage activities for the same purpose of managing accruals we expect that RM willhave effects on the GAAP value relevance similar to those of AM. Therefore, wepostulate the following hypothesis to test this prediction:

H3b. The higher the RM levels the higher the value relevance of PF earningsrelative to GAAP earnings.

Managers claim that PF earnings numbers are calculated after excluding transitory andnon-cash items, making PF earnings figures better measures for future cash flows.Standard setters, on the other hand, are concerned that the alleged incomplete andselective information conveyed by PF earnings reports is likely to be misleading toinvestors (Bhattacharya et al., 2003). In response to these concerns, SOX, section 401 (b)directed the SEC to issue rules providing that PF earnings shall be presented in a mannerthat is not misleading, and to be reconciled with GAAP measures. As directed by theSOX, the SEC adopted new disclosure regulation, regulation G, effective 28 March 2003.This regulation requires public companies that disclose or release non-GAAP financialmeasures to include in that disclosure or release a presentation of the most directlycomparable GAAP financial measure and a reconciliation of the disclosed non-GAAPfinancial measure to the most directly comparable GAAP financial measure. In addition,earnings announcements must be filed with the SEC within five days of their publicrelease, regardless of whether they contain non-GAAP financial measures. Furthermore,management should justify the usefulness of providing non-GAAP financial measure tothe investors (Hotlzman et al., 2003). We expect that all of these rules that were meant toprotect investors from being misled by non-GAAP measures, also led to having the twomeasures: PF and GAAP earnings side by side for investors’ decision-making purposes,which should close the gap between the value relevance of both measures. In the meantime, papers such as Lobo and Zhou (2006) document that SOX results in firms reportinglower discretionary accruals, which should increase the value relevance of GAAPearnings. The decline in the level of discretionary accruals after SOX is also documentedin Cohen et al. (2008), who documented an accompanied increase in level of RM after SOX.

The research that addresses the relative informativeness of PF earnings relative toGAAP earnings before Sarbanes Oxley documented that PF earnings were more valuerelevant then GAAP earnings (e.g. Bradshaw and Sloan, 2002). However, after the

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effect of SOX on both PF earnings disclosure and on discretionary accruals, we expectthat the difference in value relevance between GAAP and PF earnings will decrease.Our expectation is examined by testing the following hypothesis:

H4. The difference between the value relevance of GAAP earnings and PFearnings decrease after SOX.

4. Research methodsWe manually collect a sample of PF earnings announcements over the period ofJanuary 2001 to December 2007. The sample contains 4,285 quarterly observations.Data are collected from Lexis Nexis on PF earnings, GAAP earnings, and the itemsexcluded from the GAAP earnings. These items include: amortization for intangible,compensation related expenses, research and development expenses, depreciation,interest expense, gain or loss on inventory, maintenance expenses, extinguishment ofdebt, minority interest effect on the adjustments, mergers expenses, restructuringcosts, other income and charges, sales-marketing-and administrative, and income taxesexpenses. The data were collected using the following key words: PF earnings, PF netearnings, PF net loss, PF loss, PF EPS, PF net EPS, PF earnings per share, PF netincome, PF diluted earnings per share, and PF income per diluted share.

We have two measures of earnings management: AM and RM. Following Dechowet al. (1995) we use the modified Jones model to estimate the discretionary accruals asfollows:

ACCit

TAit�1¼ �0

TAit�1þ �1

ð�Revenueit ��ARitÞTAit�1

þ �2PPEit

TAit�1þ "it ð1Þ

where, for each company i and quarter t,[5] ACC is the accruals, measured as the changein current assets (� Q40) minus the change in current liability (� Q49), minus the changein cash and cash equivalent (� Q36), plus the change in short-term debt (� Q45), andminus the depreciation expense (� Q5); TA is the total asset (Q44); � Revenue is thechange in Revenue (� Q2); and PPE is the level of gross property, plant, and equipment(Q42). The residual from Equation (1) is used as the proxy for discretionary accruals. Thehigher the magnitude of discretionary accruals, the more AM suspected.

To estimate the RM we follow Cohen et al. (2008), and we focus on three methods formanipulating earnings:

(1) acceleration of timing of sales through price discounts or easier credit terms;

(2) building inventory by increasing the production to lower the cost of goods sold;and

(3) reducing the discretionary expenses such as R&D and other SG&A expenses.

Using models developed by Dechow et al. (1998), and used by both Roychowdhury(2006) and Cohen et al. (2008), we calculate the abnormal level of operating cash flowsas the residual of estimating the following regression model:

CFOit

TAit�1¼ �0

TAit�1þ �1Revenueit

TAit�1þ �2�Revenueit

TAit�1þ "it ð2Þ

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where, for each company i and quarter t, CFO is the operating cash flows (Q108–Q78),TA and the other variables are defined above.

To estimate the abnormal production levels, we model production costs, PROD, as afunction of sales, the change in sales, and the prior change in sales as follows:

PRODit

TAit�1¼ �0

TAit�1þ �1Revenueit

TAit�1þ �2�Revenueit

TAit�1þ �3�Revenueit�1

TAit�1þ "it ð3Þ

where, for each company i and quarter t, PROD is measured as the sum of cost of goodssold (Q30) and change in inventory (Q38) and the other variables are definedpreviously.

The abnormal level of the discretionary expenses, DISX, is estimated as the residualof the following model:

DISXit

TAit�1¼ �0

TAit�1þ �1Revenueit�1

TAit�1þ "it ð4Þ

where, for each company i and quarter t, DISX is measured as the sum of selling andadministrative expenses (Q1) and research and development expense (Q4).

Finally, an RM measure, RM_PROXY, is calculated as the sum of standardizedabnormal cash flows (R_CFO), abnormal production cost (R_PROD), and abnormaldiscretionary expense (R_DISX)[6]. The higher the RM measure, the more RM suspected.

To test H1, we use two tests, a t-test and a regression analysis. For the t-test, thesample is divided into two sub-samples. The first includes the firms that achieved theirearnings objectives and the second includes firms that did not. We used previous yearsame quarter earnings as a proxy for earnings targets. Therefore, firms that generatedearnings that equal or exceed the earnings of the same quarter of the previous year, areincluded in the first group, otherwise they are included in the second group. A t-testis used to see whether there is a significant difference between the mean DIFF as ameasure of PF earnings calculation aggressiveness.

In addition to the t-test, the following regression model is estimated:

DIFFit ¼ �0 þ �1Mit þ �2INDit þ �3GROWTHit þ �4SIZEit þ "it ð5Þ

where, for each company i and quarter t, DIFF is a measure of PF reportingaggressiveness. It equals PF earnings minus GAAP earnings, M is a dummy variablethat has value of 1 if a firm meets its earnings targets and zero otherwise; IND is the two-digit SIC code to control for the industry membership effect; GROWTH is measuredusing price-earnings ratio (price at the end of quarter divided by quarterly earnings pershare excluding extraordinary items) to control for growth; and SIZE is the natural logof firm’s market value (MKVALQ) to control for firm size. We control for industrymembership and size because these variables because Bhattacharya el al. (2003) find thatfirms announcing PF earnings are more concentrated in certain industries such asservices and high-tech industries, also are relatively larger than average company in theactive Compustat files. We control for growth because Entwistle et al. (2005) examine theeffect of growth on likelihood of reporting PF earnings.

To test for H2a and H2b, the sample is divided into portfolios based on the level ofthe two earnings management measures: AM and the RM measures. The first portfoliocontains firms with discretionary accruals in the highest 25 percentile, and the second

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portfolio contains the firms with discretionary accruals in the lowest 25 percentile.Then two tests of mean differences are performed. First, a t-test of the differencebetween discretionary accruals mean in the upper and lower portfolios, to examinewhether the difference between the two portfolios is significant. Second, a test of themean DIFF (PF earnings – GAAP earnings) in the upper discretionary accrualsportfolio is compared with the mean DIFF in the lower discretionary accruals portfolio.Then the same process is repeated for the RM_PROXY, to measure the effect of RM onthe aggressiveness of calculating PF earnings. For H2a and H2b to be accepted, theresults of the t-tests should show that the mean DIFF in the firms with higher AM orRM is significantly higher than that in firms with low AM or RM .

In addition, we use regression analysis to see the direction of the relationshipbetween AM or RM and the DIFF. Since H2a and H2b postulate that firms with lowAM or low RM calculate PF more aggressively, i.e. they have larger DIFF, we expectto see a negative and significant relation between the DIFF and the earningsmanagement variables, DACC and RM_PROXY. We estimate this relationship betweenthe level of earnings management and the level of DIFF as follow:

DIFFit ¼ �0 þ �1DACCit þ �2INDit þ �3GROWTHit þ �4SIZEit ð6Þþ �5ROEit þ "it

DIFFit ¼ �0 þ �RM PROXYit þ �2INDit þ �3GROWTHit þ �4SIZEit ð7Þþ �5ROEit þ "it

where in Equations (6) and (7), ROE is the quarterly rate of returns on equity (inpercentage) included to control for financial performance and all other variables aredefined as before.

H3a and H3b stipulate that the value relevance of PF earnings will be higherrelative to the value relevance of GAAP earnings in companies with higher AM or RM.To test H3a hypothesis, we follow Collins et al. (1997) and use a simplified Ohlson(1995) model and divide our sample into portfolios based on the level of AM proxied byDACC. For the upper and lower portfolios, we estimate the following two models:

Ptþ1 ¼ �0 þ �1PFt þ �2BVt þ "t ð8Þ

Ptþ1 ¼ �0 þ �1GAAPt þ �2BVt þ "t ð9Þ

where Ptþ1 is the stock price at the end of the following quarter from CRSP, PFt is the PFearnings collected from the announcement, GAAPt is the diluted earnings per shareexcluding extraordinary items (Compustat item Q9). BVt is the book value per share andcalculated by dividing the common equity over the number of outstanding shares (Q59/Q61). Then for H3b, we repeat the same process except that the portfolios are dividedbased on the level of RM proxied by RM_PROXY. We expect that R2 of Equation (8) to besignificantly higher than that of Equation (9) in the upper DACC/RM_PROXY portfolioswhile in the lower portfolios, the difference between the two R2 should not be as large.The two models are estimated with and without controlling for the book value.

Finally, to test H4, the sample period is divided to pre- and post-SOX effect (beforeand after March 2003), and we estimate Equations (8) and (9) for both periods. A largerdifference in R2 between the two equations in the pre period relative to the difference inthe post period will provide support to H4.

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5. Results5.1 Descriptive statisticsAfter removing firms with missing observations in Compustat and CRSP, removingitems with negative prices, and removing observation with extreme values of GAAPearnings, PF earnings, discretionary accruals, and real management residual, 954observations left. As shown in Table I, PF earnings are larger on average than GAAPearnings[7], which indicates that managers usually use PF earnings to provide betterpicture of the firms’ performance, especially when these firms are making GAAP losses.

Table II shows the correlation between DIFF and the accruals and RM variables.Each correlation coefficient is accompanied by the probability of zero correlation. Asshown in the table, there is a negative correlation between DIFF and DACC, also anegative correlation between DIFF and RM_PROXY. Both of these negativecorrelations are in the same direction of the H2a and H2b. We also see a negativecorrelation between DACC and RM_PROXY, which indicate the alternate use of theseearnings management strategies.

5.2 Meeting earnings targetsTable III shows the results of testing H1. The t-test results show that the differencebetween the mean DIFF for firms that are meeting their earnings targets issignificantly smaller (t-ratio ¼ �6.96). Also, the coefficient on M, the dummy variable,in Equation (5) is significantly negative (coefficient ¼ �0.30, t-value ¼ �4.89), whichmeans that firms that are meeting their earnings targets are less aggressive in

Table I.Descriptive statistics of

major variables over theperiod from January

2001 to December 2007

Variable n Mean SD Minimum Maximum

GAAP_EPS 954 �0.131 0.986 �14.000 6.860PF EPS 954 0.098 0.274 �0.930 2.880DIFF 954 0.230 0.908 �6.810 13.750DACC 954 �0.028 0.071 �0.816 0.480R_CFO 954 0.053 0.159 �0.823 1.440R_PROD 954 0.007 0.095 �0.973 0.537R_DISX 954 �0.017 0.167 �1.470 1.770RM_PROXY 954 �0.110 0.454 �1.970 1.857SALES 954 77.230 93.860 0.000 639.140MKVAL 762 356.100 258.940 4.760 995.650ROA 909 �2.330 32.860 �476.620 47.520ROE 940 �16.000 67.380 �761.520 190.340PRICE 954 15.640 16.300 0.140 267.140RETURN 954 0.059 0.442 �0.862 3.230

Notes: GAAP EPS is the diluted earnings per share excluding extraordinary items (Compustatitem Q9), PF_EPS is PF earnings collected from earnings announcement, DIFF is differencebetween PF_EPS and GAAP_EPS, DACC is the discretionary accruals estimated using modifiedJones Model (Dechow et al., 1995), R_CFO, R_PROD, R_DISX are estimations for real earningsmanagement in terms of accelerating sales, increasing production, and reducing discretionaryexpenses, respectively, RM_PROXY is the proxy of real earnings management calculated as thesum of the standardized R_CFO, R_PROD, and R_DISX, SALES is quarterly sales (Compustatitem Q2), ROA is quarterly return on assets in percentage (Compustat item ROAQ), ROE isquarterly return on equity in percentage (Compustat item ROEQ), PRICE is the share price at theend of the quarter from CRSP, and RETURN is quarterly return from CRSP

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Table II.Pearson correlation

DIFF DACC R_CFO R_PROD R_DISX RM_PROXY

DIFF 1.0000 �0.0838 �0.2032 0.1032 0.0089 �0.1277Prob. 0.0096 <0.0001 0.0014 0.7825 <0.0001DACC 1.0000 �0.2466 0.1544 �0.0899 �0.2209Prob. <0.0001 <0.0001 0.0054 <0.0001R_CFO 1.0000 �0.3645 �0.3290 0.5144Prob. <0.0001 <0.0001 <0.0001R_PROD 1.0000 �0.4648 0.2662Prob. <0.0001 <0.0001R_DISX 1.0000 0.0219Prob. 0.4978RM_PROXY 1.0000

Notes: DIFF is the difference between PF earnings and GAAP earnings, DACC is discretionaryaccruals estimated using modified Jones Model, R_CFO is abnormal cash flows estimated usingEquation (2), R_PROD is the abnormal production levels estimated using Equation (3), R_DISX isthe abnormal discretionary expenses levels estimated using Equation (4), and RM_PROXY isproxy for real earnings management and is calculated by adding up the standardized values ofR_CFO, R_PROD, and R_DISX. Each correlation coefficient is accompanied by the probability ofzero correlation

Table III.Meeting targets

Meeting target Not meeting targetn Mean SD n Mean SD

Panel AGAAP_EPS 733 �0.043 0.918 439 �0.402 1.202PF_EPS 733 0.110 0.311 439 0.048 0.223DIFF 733 0.153 0.819 439 0.450 1.163

Mean difference �0.297Difference test t-ratio �6.957

DIFFit ¼ Mit þ INDit þ GROWTHit þ SIZEit þ "it ð5Þ

Int. M IND GROWTH SIZEPanel BCoefficient 0.76** �0.30** �0.003* �0.006 �0.03(t-stat) (3.94) (�4.89) (�2.46) (�0.81) (�0.83)

Adjusted R2 (%) 3n 1,078

Notes: *, **Significant at the 0.05, and 0.01 level (two-tailed). GAAP EPS is the diluted earningsper share excluding extraordinary items (Compustat item Q9), PF_EPS is PF earnings collectedfrom earnings announcement, DIFF is difference between PF_EPS and GAAP_EPS, M is a dummyvariable ¼ 1 for meeting or beating earnings target, IND is two digit SIC code to control for theindustry effect, GROWTH is measured using PE ratio, and SIZE is controlled using the naturallog of firm’s market value

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calculating PF earnings, that is the difference between GAAP and PF earnings issmaller. These results provide support for H1.

5.3 Using pro forma earnings and AM/RM alternativelyPanel A in Table IV shows that there is a significant difference between the averagediscretionary accruals of the upper and lower discretionary accruals portfolios (meandifference ¼ 0.198, t-ratio ¼ 10.838). Also, it shows that in the upper discretionaryaccruals portfolio the mean DIFF (0.132) is significantly lower than that in the lowerdiscretionary accruals portfolio (0.480). The difference between the two portfolios(�0.348) is significant (t-ratio ¼ �3.851). This means that when a company does nothave the ability to manage earnings upward using accruals, they exclude moreexpenses from the calculation of PF earnings to manage the investors’ perception of thefirms’ performance. These results support H2a. Additional evidence supporting H2ais shown in Panel B, where the regression analysis shows a significantly negativerelationship between DACC and the DIFF (coefficient ¼ �0.660, t-value ¼ �2.92),which means that the more discretionary accruals used by a firm, the less aggressive itis in calculating PF earnings. As for H2b, the results in Panel A also support it. Themean difference test shows that that DIFF mean is significantly larger in firms withlow RM compared with DIFF in firms with high RM (compare 0.1852 to 0.4633,t-ratio ¼ �2.764). Additional support for H2b is shown in Panel B, where thecoefficient on RM_PROXY in Equation (7) is significantly negative also(coefficient ¼ �0.181, t-value ¼ �3.95), which shows the inverse relationship betweenmanaging real earnings and aggressively calculating and reporting PF earnings.

5.4 The effect of AM/RM on informativeness of pro forma earningsH3a postulates that the informativeness of PF earnings will be higher relative to GAAPearnings in firms with high discretionary accruals. The sample is divided into fourquartiles based on the level of the discretionary accruals. Then Equations (8) and (9) areestimated for the highest and lowest quartiles. The results of estimating these twoequations are shown in Table V. The results in Panel A show that PF earnings valuerelevance is always higher than that of the GAAP earnings regardless of whether thefirms are involving in high or low AM. However, it is shown that GAAP earningsrelevance is always lower for firms with high discretionary accruals, whether wecontrolled for the book value or not. Compare an adjusted R2 of 2 and 3 per cent to 6 and 13per cent. In addition, the differences between R2s of the GAAP models and PF models aresmaller for firms with lower discretionary accruals. Compare 23 and 21 per cent to 18 and11 per cent, respectively. These results provide support to H3a, that the gap between PFearnings and GAAP earnings value relevance is smaller in firms with low AM. On theother hand, the results shown in Table V Panel B do not support H3b. Contrary to ourexpectations, the difference between the value relevance of PF and GAAP earnings islarger in firms with low RM, compare 27 and 22 per cent to 25 and 17 per cent respectively.In our sample, the value relevance of GAAP earnings is higher for firms with higher levelsof RM, though the RM does not significantly affect the value relevance of PF earnings.

5.5 The difference in PF and GAAP earnings value relevance before and after SOXH4 predicts that the gap between the value relevance of the two earnings measuresshould decrease after SOX. To test this hypothesis, we divide the sample into twogroups: before and after SOX. First, we examine whether the trend of increasing RM

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Table IV.Mean difference test

Panel AHigh 25% of discretionary accruals n 291Discretionary accruals Mean 0.063

SD 0.225Low 25% of discretionary accruals n 292Discretionary accruals Mean �0.135

SD 0.215Mean Difference 0.198Difference test t-ratio 10.838

High 25% of discretionary accruals n 291DIFF ¼ PF – GAAP Mean 0.132

SD 0.699Low 25% of discretionary accruals n 292DIFF ¼ PF – GAAP Mean 0.480

SD 1.375Mean Difference �0.348Difference test t-ratio �3.851

High 25% of real earnings management n 249Real earnings management Mean 0.791

SD 2.142Low 25% of real earnings management n 249Real earnings management Mean �0.867

SD 1.075Mean Difference 1.657Difference test t-ratio 10.910

High 25% of real earnings management n 249DIFF ¼ PF – GAAP Mean 0.185

SD 0.949Low 25% of real earnings management n 249DIFF¼PF GAAP Mean 0.463

SD 1.273Mean Difference �0.278Difference test t-ratio �2.764

Panel BThe association between AM and magnitude of PF GAAP earnings difference

DIFFit ¼ �0 þ �1DACCit þ �2INDit þ �3GROWTHit þ �4SIZEit þ �5ROEit þ "it ð6Þ

Intercept DACC IND GROWTH SIZE ROECoefficient 0.223* �0.660** �0.001 �0.002 �0.001 �0.003**(t-stat) (2.29) (�2.92) (�0.73) (�0.28) (0.10) (�8.19)Adjusted R2 (%) 10n 754

The association between RM and magnitude of PF – GAAP earnings difference

DIFFit ¼ �0 þ �1RM PROXYit þ �2INDit þ �3GROWTHit þ �4SIZEit þ �5ROEit þ "it ð7Þ

Intercept RM_PROXY IND GROWTH SIZE ROECoefficient 0.236* �0.181** �0.001 �0.002 0.002 �0.003**(t-stat) (2.45) (�3.95) (�0.95) (�0.22) (0.16) (�7.35)Adjusted R2 (%) 11n 754

Notes: *, **Significant at the 0.05, and 0.01 level (two-tailed). Discretionary accruals are estimated usingmodified Jones Model, DIFF is difference between PF_EPS and GAAP_EPS, GAAP EPS is the diluted earningsper share excluding extraordinary items (Compustat item Q9), PF_EPS is PF earnings collected from earningsannouncement, RM_PROXY is proxy for real earnings management and is calculated by adding up thestandardized values of R_CFO, R_PROD, and R_D_DISX, IND is two digit SIC code to control for the industryeffect, GROWTH is measured using PE ratio, and SIZE is controlled using the natural log of firm’s marketvalue, and ROE is the quarterly rate of returns on equity (in percentage) included to control for financialperformance

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and decreasing AM documented in Cohen et al. (2008) is evident in our sample. A t-testis shown in Table VI that compares the levels of RM and AM before- and after-SOX.The results show that, on average, discretionary accruals decreased while RMincreased after SOX, which is consistent with the findings in Cohen et al. (2008).

Table V.The relative value

relevance of PF andGAAP earnings underhigh and low levels ofearnings management

Ptþ1 ¼ �0 þ �1PFt þ �2BVt þ "t ð8Þ

Ptþ1 ¼ �0 þ �1GAAPt þ �2BVt þ "t ð9Þ

Highdiscretionary

accruals t-value

Highdiscretionary

accruals t-value

Lowdiscretionary

accruals t-value

Lowdiscretionary

accruals t-value

Panel AModel (8) pro formaIntercept 11.55** (8.04) 11.98** (7.08) 13.09** (10.35) 10.93** (5.91)a1 42.99** (8.09) 43.35** (8.58) 33.62** (8.74) 31.72** (8.06)a2 �11 (�0.51) 0.36 (1.54)

Adjusted R2 (%) 25 24 24 24n 238 232 238 233

Model (9) GAAPIntercept 17.11** (12.33) 15.34** (8.22) 17.38** (12.44) 10.51** (5.30)a1 4.9** (2.62) 4.72* (2.51) 4.03** (3.87) 5.64** (5.32)a2 0.32 (1.41) 1.2** (4.55)

Adjusted R2 (%) 2 3 6 13n 238 232 238 233

Differencein adjusted R2 (%) 23 21 18 11

High realearnings

management t-value

High realearnings

management t-value

Low realearnings

management t-value

Low realearnings

management t-value

Panel BModel (8) pro formaIntercept 15.65** (15.85) 12.68** (7.79) 10.8** (16.01) 10.35** (12.33)a1 25.5** (10.68) 23.5** (9.20) 27.35** (10.54) 25.74** (10.11)a2 0.58* (2.24) 0.04 (0.38)

Adjusted R2 (%) 32 33 32 32n 238 236 238 234

Model (9) GAAPIntercept 20.95** (21.24) 12.52** (6.89) 12.09** (14.45) 9.8** (10.22)a1 4.00** (4.28) 4.12** (4.66) 2.49** (3.71) 3.05** (4.77)a2 1.46** (5.37) 0.48** (3.50)Adjusted R2 (%) 7 17 5 10n 238 236 238 234Difference inadjusted R2 (%) 25 16 27 22

Notes: *, **Significant at the 0.05, and 0.01 level (two-tailed). Where Ptþ1 is the stock price at the endof the following quarter from CRSP, PFt is the PF earnings collected from the announcement, GAAPt isthe diluted earnings per share excluding extraordinary items (Compustat item Q9), and BVt is the bookvalue per share and calculated by dividing the common equity over the number of outstanding shares(Q59/Q61). Upper and lower 1 per cent of DACC and RM_PROXY are removed

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Second, we examine whether the difference between GAAP earnings and PE earningsvalue relevance is smaller after SOX because of the decrease in the accruals andbecause of the SEC reconciliations and other disclosure requirements. The results inTable VII show that the gap between the value relevance of PF earnings and GAAPearnings became smaller after SOX. In both models whether we are only regressing theearnings measure on the price or controlling for the book value, the R2s of the GAAP

Table VI.Changes in AM and RMbefore and after SOX

n Mean STD

Discretionary accrualsBefore SOX 437 �0.03416 0.071556After SOX 415 �0.02424 0.074193Difference �0.00992

t-test �1.98412

Real earnings managementBefore SOX 437 �0.10217 0.485104After SOX 415 �0.30735 0.487025Difference 0.205181

t-test 6.158351

Notes: AM is accrual management measured by the discretionary accruals that are estimatedusing modified Jones Model, and RM is real earnings management measured by RM_PROXYwhich is calculated by adding up the standardized values of R_CFO, R_PROD, and R_DISX asdefined above

Table VII.The difference betweenthe value relevance ofPF and GAAP earningsbefore and after SOX

Before SOX After SOXCoefficient t-stat Coefficient t-stat Coefficient t-stat Coefficient t-stat

Model (8) pro formaIntercept 10.63* (22.94) 10.41* (21.08) 14.27* (11.96) 10.55* (6.17)a1 24.28* (11.22) 23.02* (12.51) 32.54* (10.24) 29.21* (8.31)a2 0.02 (�0.31) 0.71* (2.79)

Adjusted R2 (%) 22 22 20 22n 437 431 415 401

Model (9) GAAPIntercept 11.48* (21.63) 10.65* (16.23) 19.99* (18.07) 11.97* (6.60)a1 1.8* (4.53) 1.88* (4.90) 10.35* (507) 8.51* (4.16)a2 0.13 (1.66) 1.36* (5.42)

Adjusted R2 (%) 4 5 5 12n 437 431 415 401Difference inadjusted R2 (%)

18 17 15 10

Notes: *Significant at the 0.01 level (two-tailed). Where Ptþ1 is the stock price at the end of thefollowing quarter from CRSP, PFt is the PF earnings collected from the announcement, GAAPt isthe diluted earnings per share excluding extraordinary items (Compustat item Q9), and BVt is thebook value per share and calculated by dividing the common equity over the number ofoutstanding shares (Q59/Q61)

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earnings models get closer to those of the PF models after SOX (compare 18 and 17 percent difference in R2 before SOX to 15 and 10 per cent difference in R2 after SOX). Theseresults support H4 that the difference between the value relevance of GAAP earningsand PF earnings decreases after SOX.

6. ConclusionsIn this study, we focus on the alternative ways managers use to manipulate earningsand investors’ perception. We hypothesize that managers use AM or RM to achievetargeted numbers, and that they supplement those methods by managing theperception of investors through issuing PF earnings numbers that are on averagehigher than GAAP numbers. We first predict and find that when managers are able toachieve their earnings targets, they report less aggressive PF earnings numbers.We then predict that the aggressiveness of reporting the announced PF earnings,measured by the difference between PF earnings and GAAP earnings, is negativelyassociated with the managers’ ability to manipulate earnings through AM or RM. Theresults support our prediction.

In addition, we provide evidence as expected that the value relevance of GAAPearnings relative to PF earnings is lower for firms with high AM. However,inconsistent with our expectation, the value relevance of GAAP earnings relative to PFearnings is not better for firms with low RM. Finally, we provide evidence consistentwith Cohen et al. (2008) that AM decreased and RM increased after SOX. Thesechanges in the methods of manipulating earnings together with the SEC requirementsof reporting non-GAAP measures reduced the difference between the value relevanceof GAAP and PF earnings. So the difference between the value relevance of GAAP andPF earnings is smaller in the period subsequent to SOX compared to the periodpreceding SOX. Our study provides new evidence on the alternative use of earningsand perception management as well as on the effect of SOX on financial reporting andthe value relevance of GAAP and non-GAAP earnings measures.

Notes

1. PF earnings refer to actual earnings not budgeted or forecasted.

2. We measure the degree of aggressiveness of reporting PF earnings as the differencebetween PF earnings and GAAP earnings throughout the paper.

3. Review Xiong (2006) for review of these hypotheses.

4. Schrand and Walther (2000) give examples on how managers strategically select priorperiod earnings amounts as a benchmark to evaluate current period earnings in theearnings announcement. For example, they exclude prior period gain from sales ofPPE to provide a low benchmark to evaluate current period earnings. By doing thatmanagers are able to highlight most favourable changes in earnings.

5. Compustat item numbers are in parentheses, and in case the item does not have anumber, its Compustat mnemonic is shown.

6. We standardized those variables by subtracting its mean and dividing over its SD.

7. To insure the validity of the negative GAAP_EPS, ROA, and ROE means, we calculatedthe means of these variables for all firms for all available years in Compustat. Theresults after removing the extreme upper and lower 1 per cent observations of eachvariable were in line with what we have in our sample.

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About the authorsEssam Elshafie is an Assistant Professor of Accounting at Northeastern Illinois University, Chicago.He earned his PhD in accounting at Kent State University in 2005. His research interests are in thearea of financial performance measures, earnings management, and executive compensation. EssamElshafie is the corresponding author and can be contacted at: e-elshafie@neiu.edu

Ai-Ru Yen is an Assistant Professor of Accounting at the Northeastern Illinois University. Sheearned her PhD in accounting at the University of Maryland in 2007. Her research interests coverearnings management, intangibles valuation, financial reporting and corporate governance.

Minna Yu is an Assistant Professor of Accounting at Ball State University, Indiana. Sheearned her PhD in Accounting at Kent State University in 2007. Her research interests are in thearea of international accounting and earnings management.

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