Abstract
The Sarbanes–Oxley (SOX) Act was passed in 2002 in response to various instances of corporate malfeasance. The Act, designed to protect investors, led to wide-ranging regulation over various actions of managers, auditors and investment analysts. Part of SOX, and the focus of this study, targeted the disclosure by firms of “pro forma” earnings, an alternate (from GAAP earnings), flexible and unaudited measure of firm performance. Specifically, SOX directed the Securities and Exchange Commission (SEC) to craft regulation which would reduce – and preferably eliminate – any pro forma earnings disclosure which might be “misleading”. Examining earnings press releases over a 3-year period, this study addresses three questions. Were firms disclosing pro forma in a potentially misleading manner, what was the nature of this potentially misleading disclosure, and did SOX affect the disclosure practices? We find the following. In 2001 (prior to SOX), 53 firms – over 10% of all U.S. S&P 500 firms – were disclosing pro forma earnings in a potentially misleading manner. This was being done most commonly by using traditional GAAP terminology (e.g., “net income”) in the press release headline to describe what was later in the press release revealed to be a pro forma amount (i.e., “net income excluding special items”). By 2003 (subsequent to the SEC regulation), potentially misleading disclosure practices were seen in less than 1% of the earnings press releases of S&P 500 firms. This significant reduction suggests that managers, prior to the regulation, were either careless in their pro forma reporting practice, or were intentionally – and unethically – attempting to mislead investors. Either way, we conclude that the SEC regulation was both necessary and effective.
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Acknowledgements
The authors would like to thank colleagues at the University of Saskatchewan, reviewers for the 9th Symposium on Ethics in Accounting at the American Accounting Association 2004 Annual Meeting, and two anonymous reviewers for their helpful comments and suggestions. We would further like to thank Jacqueline Woods for her diligent research assistance. Funding for this project was graciously provided by the Social Sciences and Humanities Research Council of Canada, Deloitte & Touche, and the Canadian Academic Accounting Association.
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Gary M. Entwistle, Ph.D., CA, is Professor and Meyers Norris Penny Scholar at the University of Saskatchewan. A former audit manager with KPMG, he is the author of numerous scholarly articles on financial reporting. His present research into pro forma earnings is supported by a major research grant from the Social Sciences and Humanities Research Council of Canada. His Ph.D. is from the Richard Ivey School of Business at The University of Western Ontario.
Glenn D. Feltham, Ph.D., FCMA, is Dean of the I.H. Asper School of Business and CA Manitoba Chair in Business Leadership, at the University of Manitoba. He holds a doctoral degree in accounting, specializing in taxation, from the University of Waterloo. He has published extensively in the areas of financial disclosure, tax planning, tax policy, and family business.
Chima Mbagwu, M.Sc., is Lecturer in Accounting at the School of Business & Economics at Wilfrid Laurier University. He is presently completing his doctoral studies in accounting at the University of Saskatchewan. He has published a number of scholarly and professional articles on pro forma reporting.
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Entwistle, G., Feltham, G. & Mbagwu, C. Misleading Disclosure of Pro Forma Earnings: An Empirical Examination. J Bus Ethics 69, 355–372 (2006). https://doi.org/10.1007/s10551-006-9095-4
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DOI: https://doi.org/10.1007/s10551-006-9095-4