Generally accepted accounting principles - or GAAP - are meant to give investors and others a more transparent picture of a company's financial position. However, companies often disclosure non-GAAP earnings in press releases by excluding a number of GAAP earnings components. While corporate managers often claim non-GAAP earnings disclosures help them convey permanent earnings, there has been much concern that managers also use non-GAAP earnings to opportunistically portray their performance. New rules have been brought in to control that problem, but are they working?

A study by Frank Heflin and Charles Hsu considers the effect of the rules, which were introduced in March 2003 by the U.S Securities and Exchange Commission. They extend other work on this subject by looking not only at the frequency of non-GAAP disclosures, but also the magnitude and the nature of items being excluded from GAAP disclosures.

The authors find that while the rules reduce opportunistic types of non-GAAP disclosures, they also reduce more informative types of non-GAAP disclosures.

They reach this conclusion after looking at the two types of non-GAAP disclosures: special items and other items. Special items tend to include information about transitory effects and thus their exclusions have the benefit of offering a better picture of permanent earnings than just GAAP earnings.

Exclusions of other items are far more vague, which may result in managers offering misleading or even fraudulent information.

"While the regulations reduced firms' use of non-GAAP disclosures to improve performance perceptions, they also reduced firms' willingness to use non-GAAP earnings to convey permanent earnings," the authors say.

The evidence is based on earnings and analyst forecast data for 2,138 U.S. firms from March 2000 to February 2005. About 21 per cent leaned to higher non-GAAP disclosure before the new rules and 28 per cent to more GAAP disclosures, with the rest fairly evenly mixed. This did not change drastically after March 2003, but there were signs of a move away from non-GAAP disclosures to more GAAP disclosures.

More significantly, the magnitude of both special- and other-item exclusions were significantly reduced after March 2003, and managers were less likely to use non-GAAP disclosures, particularly other items, to meet or beat analysts' forecasts.

However, as noted, this reduction in non-GAAP disclosures in general came at the cost of firm's being less willing to exclude transitory, or special items. This in turn resulted in a post-regulation decline in investor pricing of earnings forecasts. "This can be attributed to the change in nature of the forecast errors. Post-regulation disclosed earnings are more frequently GAAP-based and include more special items that are likely to be transitory," they say.

"Overall the regulations have reduced the opportunistic use of non-GAAP earnings disclosures which is likely consistent with the intentions of legislators and regulators. They have also interrupted an upward trend in non-GAAP reporting and a trend in meeting-or-beating forecasts, and they have increased the emphasis that managers and analysts place on GAAP earnings. However, there are results that are unlikely to be intended - the reduced use of non-GAAP disclosures when firms experience special items and the reduced investor weight on earnings forecast errors."