In recent years, non-GAAP earnings disclosures reported by public companies, also known as “street earnings,” have increased. The financial press and investor community have criticized the practice as opportunistic. “Regulators have become increasingly concerned because they believe companies may be portraying a rosier picture of their earnings,” says Associate Professor Neil Bhattacharya. With his co-authors, Bhattacharya explores how managers react to short sellers’ or sophisticated investors’ actions, owing to their non-GAAP reporting practices.

Public companies are required to report their earnings under the accounting standard GAAP (Generally Accepted Accounting Principles). However, according to Bhattacharya, GAAP numbers or earnings have “noise” connected to them. Thus, companies sometimes voluntarily provide alternative earnings numbers alongside their mandatory earnings called “non-GAAP.” Companies that release non-GAAP earnings figures often claim that they are closer to their core earnings. For example, there could have been a significant one-off expense skewing the numbers.

“Regulators have become increasingly concerned because they believe companies may be portraying a rosier picture of their earnings.”

This research finds a new twist—there may be a market mechanism at play that curbs the reporting practice. Enter the short sellers, the sophisticated investors who try to identify overvalued firms. “Their game is to identify overvalued firms before the market is aware of it,” notes Bhattacharya. “Short sellers use many signals to figure out which firms are overvalued. In our research, we show that they are using non-GAAP reporting as a signal, or one of their criteria.”

“A short seller may notice a non-GAAP figure that is higher than GAAP, even egregiously so,” explains Bhattacharya. “If exclusions (often expenses) in non-GAAP figures seem frivolous, they will surmise that these companies are having trouble maintaining a higher GAAP earnings amount and consider that as a cue for over-valuation.” Not all non-GAAP reports are bad or opportunistic, says Bhattacharya. Some firms are trying to provide less noisy numbers to GAAP.

In essence, the study investigates whether short sellers help discipline the managers of publicly traded firms. The paper “Can Short Sellers Constrain Aggressive Non-GAAP Reporting?” provides robust evidence that the threat of short-selling pressure acts as a disciplining mechanism. “We provide evidence of a market-based mechanism and show that it may diminish the need for costly regulations, which is important from a public policy perspective,” says Bhattacharya.