The valuation impact of reconciling pro forma earnings to GAAP earnings

Regulation G requires all companies to quantitatively reconcile pro forma earnings with GAAP earnings. This paper provides three findings related to the impact of reconciliations on mispricing of pro forma earnings. First, prior to Reg G, we find that mis-pricing of pro forma earnings is limited to firms with low reconciliation quality. There is no evidence of mispricing for firms with high reconciliation quality. Second, we find no evidence of mispricing after Reg G. Third, there is a cross-Reg G reduction of mispricing for firms whose reconciliation quality improves, and there continues to be no-mispricing for firms that have high reconciliation quality both before and after Reg G. Together, our results support the notion that better reconciliations reduce the extent of mispricing. *Corresponding author. Tel: +65-6790-4097. Email: [email protected]. Zhang is from Nanyang Technological University and Zheng is from the University of Hong Kong. We are grateful to an anonymous reviewer and to Ross Watts, the editor, for suggestions that substantially improved the paper. We also received helpful comments from Qiang Cheng, Ted Christensen, Xiaohui Gao, Weili Ge, Christo Karuna, Bin Ke, Clive Lennox, Jing Liu, Hai Lu, Rujing Meng, Mort Pincus, Charles Shi, James Vere, Siyan Wang, Jianguo Xu, Pai Xu, participants at the 2005 American Accounting Association Annual Meeting, and seminar participants at Chinese University of Hong Kong, City University of Hong Kong, Georgia State University, Hong Kong Polytechnic University, Hong Kong University of Science and Technology, London Business School, Nanyang Technological University, University of California at Irvine, and University of Hong Kong. We thank Cui Cui, Henry Yuen, Kelsey Xia, Oisum Li, Li Jiang, Gary Liu, Jason Tong, Zil Yau, Huifang Ying and Lavender Xu for their able research assistance. Zheng acknowledges funding support from the Research Grant Council of the Hong Kong Special Admistrative Region, China (HKU 7429/06H).