No. 215: The Economic Role of Non-GAAP Earnings

This study provides a theoretical framework to explain the economic role of Non-GAAP earnings as an efficient, equilibrium response to conflicting demands from capital providers. I model a firm whose conservative GAAP earnings serve as a `hard,’ verifiable signal for the contracting needs of creditors but become increasingly uninformative for valuing intangible-intensive firms in the equity market. This creates a demand for a second, valuation-relevant signal: Non-GAAP earnings.  The model demonstrates that while Non-GAAP disclosures reduce the cost of equity by lowering information asymmetry, they simultaneously increase the cost of debt by revealing asset volatility and default risk to creditors. Consequently, firms sort into reporting regimes based on their capital structure. For high-intangible firms with leverage below a critical informational capacity, a dual-reporting strategy minimizes the weighted average cost of capital. In contrast, highly levered firms optimally rely on GAAP-only reporting to mitigate the cost of debt. My analysis provides a structural explanation for why dual reporting emerges _endogenously in modern capital markets and why regulatory attempts to suppress Non-GAAP reporting may be value-destroying  for high-growth, intangible-intensive firms.