The joint effects of litigation risk and regulation on non‐GAAP reporting

Abstract

AbstractWe examine the joint effects of litigation risk and regulation in shaping firms’ financial reporting decisions. Specifically, we investigate how these disciplining mechanisms influence firms’ disclosure of non‐GAAP earnings metrics, which have been at the forefront of the SEC's regulatory concerns in recent years. We employ a plausibly exogenous shock to litigation risk based on a US circuit court ruling to explore how litigation risk influences firms’ non‐GAAP earnings disclosures. We find a robust negative relation between litigation risk and both the likelihood and aggressiveness of non‐GAAP reporting. However, we find a significant attenuation in the sensitivity of non‐GAAP disclosure to litigation risk after the implementation of Regulation G (Reg G), despite evidence that aggressive non‐GAAP reporting persists in the post‐Reg G environment. Additional analyses indicate that this attenuation is actually the net result of two unique effects. First, we find that Reg G created a de facto “safe harbor” for non‐GAAP reporting among firms in circuits with higher litigation risk and a “curtailment effect” among firms in the circuit with the lowest litigation risk. Overall, Reg G led to a convergence in non‐GAAP reporting practices irrespective of firms’ circuit‐specific litigation risk. We posit that this net attenuation of litigation risk's influence on non‐GAAP reporting is likely an unintended consequence of Reg G.