Litigation Risk and the Regulation of Non-GAAP Reporting

The SEC has recently raised renewed concerns about firms’ reporting of adjusted (non-GAAP) earnings metrics. Regulators have significant interest in understanding the factors that help constrain non-GAAP reporting. We first provide evidence on the relation between securities litigation risk and firms’ propensity to report non-GAAP earnings. We then provide evidence on how this relation is moderated by the regulation of non-GAAP disclosure under Reg G. Using a plausibly exogenous litigation shock based on a U.S. circuit court ruling, we find a robust negative relation between litigation risk and non-GAAP reporting prior to the passage of Reg G. This negative relation suggests that, in the absence of rules-based regulation of non-GAAP reporting, litigation risk helps to constrain non-GAAP disclosure. However, our evidence suggests that the subsequent regulation of non-GAAP disclosure has decreased the sensitivity of non-GAAP disclosure to litigation risk. Specifically, we find that differences in non-GAAP reporting across judicial circuits are diminished and the negative association between litigation risk and non-GAAP reporting is significantly attenuated following the implementation of Reg G. Our results are consistent with claims that Reg G has had the unintended consequence of shielding firms’ non-GAAP disclosures from litigation risk by creating a de facto “safe harbor” for non-GAAP disclosure. Finally, we use our quasi-natural-experimental setting to validate a new proxy for circuit-specific litigation risk that future researchers can employ in any setting.