Passive Ownership and Aggressive Non-GAAP Reporting

The rise of passive index funds has fueled an ongoing debate about the governance of their portfolio firms. Recent theoretical work suggests that governance quality may increase or decrease depending on whether passive ownership crowds out active ownership. We explore this theoretical implication in a broad sample of U.S. corporations, using financial reporting choices as a proxy for governance quality. We find that passive ownership increases (i) the magnitude of non-GAAP exclusions, (ii) managers’ use of non-GAAP reporting to avoid losses and meet analyst expectations, and (iii) the transitory nature of non-GAAP EPS in the subsample where passive ownership likely crowds out active ownership. We find no such effects where crowding out does not occur. Our results provide evidence that governance improves when passive funds replace retail investors but not active investors