The Effects of Executive Compensation Contracts and Auditor Effort on Pro Forma Reporting Decisions

Abstract

We investigate two potential deterrents of aggressive pro forma reporting. First, the design of compensation contracts can encourage managers to adopt either a short- or a long-term focus. While it is difficult to observe whether compensation contracts are tied directly to pro forma earnings numbers, we posit that managers with a short-term horizon are more likely to make aggressive pro forma exclusions than managers with a long-term focus. Second, auditor effort can discourage potentially misleading pro forma earnings adjustments. Consistent with our predictions, we find that when compensation contracts include a long-term performance plan, managers are less likely to make potentially misleading pro forma earnings adjustments. Similarly, we find some evidence of a negative association between auditor effort (as proxied by higher-than-normal audit fees) and potentially misleading earnings adjustments. Taken together, this evidence is consistent with the notion that the design of compensation contracts and auditor effort can significantly influence managers’ pro forma reporting decisions. The results also suggest that investors discount earnings information when opportunism is likely to motivate managers’ earnings adjustments. Moreover, when managers make aggressive earnings exclusions in the presence of safeguards that limit opportunistic behavior, investors appear to react even more negatively.