Non-GAAP Earnings for Contracting and Financial Disclosure

We explore how the internal use of non-GAAP performance metrics in compensation contracting relates to the disclosure of non-GAAP earnings to external stakeholders. Ex ante, it is unclear why information useful in contracting would be informative for valuation purposes unless a firm’s compensation and financial disclosure processes are related. We explore this relation using a large hand-collected sample of non-GAAP earnings numbers from firms’ proxy statements and annual earnings announcements. We find that the use of a non-GAAP performance measure in compensation contracting is positively associated with the likelihood that managers will disclose a non-GAAP metric in the earnings announcement, and that these two numbers are often exactly equivalent. We also find that the quality of non-GAAP reporting is higher when the firm uses nonGAAP performance metrics for both compensation contracting and financial disclosure, and that investors find non-GAAP earnings to be more credible when compensation committees corroborate the externally-disclosed non-GAAP number by relying on it internally. Finally, using non-GAAP earnings for compensation contracting appears to reduce the likelihood that managers will report non-GAAP earnings aggressively. Overall, our results suggest that the dual use of nonGAAP earnings for internal performance evaluation and external performance disclosure improves non-GAAP reporting quality. JEL Codes: G34; M12; M41; M48; M52