The association between pro forma earnings and earnings management

Abstract

Purpose – The purpose of this paper is to examine the association between investor perception management through reporting aggressive pro forma (PF) earnings and earnings management through real activities or by manipulating accruals. Design/methodology/approach – A sample of PF earnings announcements over 2001-2007 was manually collected from Lexis Nexis, consisting of 4,285 firm-quarter observations; the aggressiveness of PF earnings reporting was measured by the difference between GAAP earnings and PF earnings. Findings – The paper finds that managers report more aggressively calculated PF earnings numbers 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 is smaller 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 by explaining firms' PF earnings reporting behaviours. It also has policy implications for capital market regulators regarding the PF earnings reporting rules. Originality/value – This paper is the first study to provide evidence that the opportunistic reporting of PF earnings is associated with managerial inability to meet earnings targets through earnings management. It advances our understanding on the PF earnings reporting behaviour.

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