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SYNOPSIS:
A primary objective of the Sarbanes-Oxley Act is to bolster public confidence in the U.S. capital markets. The SEC aims to achieve this objective in part by regulating the use of alternate earnings measures (colloquially referred to as "pro forma" earnings) that differ from generally accepted accounting principles. This paper examines whether firms change their reporting practice in response to pro forma regulation. Specifically, it examines whether the use, calculation, and presentation of pro forma measures by S&P 500 companies changes between 2001 and 2003. We document three significant shifts in pro forma reporting in this period. First, the proportion of firms reporting pro forma earnings declines from 77 to 54 percent. Second, by 2003, pro forma is used in a less biased manner. Not only is the proportion of firms using pro forma earnings to increase reported income smaller than in 2001, but also the magnitudes of these increases are reduced. Third, in 2003, firms present pro formas in press releases in a much less prominent and less potentially misleading manner. These results suggest a strong impact of the recent regulation of pro forma reporting and provide important empirical evidence for policy makers.
Keywords: pro forma earnings; regulation; Sarbanes-Oxley.
Data Availability: Data are available upon request from Gary Entwistle at [email protected].
INTRODUCTION
The last five years have been turbulent for U.S. public companies, investors, and the stock markets. Aggressive accounting practices, earnings restatements, and weak corporate governance have raised questions about the quality of financial reporting. In response, the U.S. Congress enacted the Sarbanes-Oxley Act (SOX) to improve the accuracy and reliability of corporate disclosures and to restore public confidence in the stock markets.1 To help achieve its objectives, Section 302(a)(3) of SOX mandates the certification by senior management of the overall fairness of their company's financial statements. Section 401 (b) of SOX also instructs the Securities and Exchange Commission (SEC) to introduce regulation governing the reporting by companies of non-GAAP financial information-colloquially termed "pro forma" reporting. While the SEC regulation does not prohibit pro forma reporting, it does attempt to ensure that such reporting is useful and not done in a misleading manner. The regulation also serves to focus attention on a reporting activity that has been questioned in the financial...