When companies adjust their earnings reports to make profits look better than they really are, investors usually see through it. That’s the main takeaway from research by John McInnis, an accounting professor at the University of Texas at Austin’s McCombs School of Business. His findings suggest that existing accounting rules already give investors enough information to make sound decisions, even when firms try to put a positive spin on their results.

McInnis examined how firms often release two versions of their earnings. The first, based on generally accepted accounting principles (GAAP), is filed with regulators and includes all expenses. The second, known as non-GAAP earnings, appears in press releases and investor calls and often excludes certain costs. These adjustments make profits look stronger, but they can also obscure the accurate financial picture. A 2024 report found that 80% of companies in the Dow Jones Industrial Average used non-GAAP reporting, showing profits about 31% higher than under GAAP.

GAAP standards, established by the Financial Accounting Standards Board, ensure that all companies report earnings in a consistent, transparent way. They require that every expense — from depreciation to stock-based pay — be included. However, companies argue that some of these costs are temporary or unusual. By excluding one-off items such as restructuring costs, executives say they can better show the business’s underlying strength. McInnis notes that most non-GAAP reporting isn’t meant to mislead but to provide context.

The more contentious issue arises with recurring costs, especially stock-based compensation (SBC), which includes bonuses paid in shares or stock options. SBC can be huge — Alphabet, Google’s parent company, reported $23 billion in 2024 alone. Although GAAP rules require companies to recognise these costs, many firms still exclude them from their non-GAAP figures, effectively boosting their reported earnings. This practice raises the question: Do investors notice?

To find out, McInnis and co-author Laura Griffin analysed more than 70,000 quarterly earnings announcements by U.S. public companies between 2003 and 2021. They used automated text analysis to identify when companies excluded SBC from their reports and studied how their stock prices responded. The results showed that firms with unexpected increases in SBC experienced slightly lower short-term stock returns — about 1 to 2 percentage points — whether or not they excluded those expenses.

The study concluded that adjusted numbers don’t fool investors. They factor in recurring costs such as SBC and amortisation, even when companies exclude them from non-GAAP earnings. McInnis argues this is encouraging for regulators and accounting standard-setters: investors appear to understand what really drives a firm’s profitability. “The belief that excluding these costs earns a higher valuation,” he says, “is a myth.”

More information: Laura Griffin et al, Gone but not forgotten: Investor reaction to “excluded” recurring expenses, Journal of Accounting and Economics. DOI: 10.1016/j.jacceco.2025.101799

Journal information: Journal of Accounting and Economics Provided by University of Texas at Austin