Do Non-GAAP Financial Metrics and Forward-Looking Information Better Reflect Economic Realities?
In accounting, the rules say that financial statement information should be prepared under generally accepted accounting principles (GAAP). GAAP numbers are the holy grail of financial report information because they represent standards of practice that have been sanctioned by the Financial Accounting Standards Board and, generally speaking, the Securities and Exchange Commission (SEC).
In reality, an increasing number of companies are turning to non-GAAP measures to show "the company's side" of the financial statement story. According to a recent study by Audit Analytics, just 29 companies in the S&P 500 index (5.7%) closed their books for 2015 exclusively using GAAP, a sharp decline from 25% in 2006. The majority of companies now disclose non-GAAP numbers along side GAAP numbers creating confusion in the minds of the readers of financial reports.
Corporate America used non-standard accounting metrics in 2015 to publicize profit numbers above the true net income companies must report according to GAAP rules, a new study from Calcbench and Radical Compliance has found. In its analysis of 816 U.S. public companies, Calcbench found common adjustments yielded a $94 billion improvement on top of the $214 billion in GAAP net income they reported for the year.
Traditional GAAP numbers present the results of past periods instead of forward-looking information that better reflects the "economic realities" of the business. In recent times investors have questioned the usefulness of GAAP numbers that do not measure future-oriented data such as customer acquisition costs; additions and churn rate for the internet, telecom and media companies; and the progress and risk diversification of the product pipeline of pharma and biotech firms. The problem with using this information is to develop accurate and reliable amounts that are comparable across companies.
One way companies "spin" the numbers to make them better reflect economic realities, at least in their minds, is to report earnings using non-GAAP measures such as EBITDA – earnings before interest, taxes, depreciation and amortization. Still other companies report earnings with only recurring amounts so that non-recurring and/or unusual items are deleted from GAAP earnings. One joke making the rounds is the best number to report is EBE -- earnings before "expenses."
Using non-GAAP measures of earnings does not solve the economic realities problem. It is a troublesome development because it makes it more difficult for financial analysts and other users of financial reports to make sense of the already sometimes confusing numbers.
So why do companies turn to non-GAAP measures? First, let me make it clear that these numbers cannot be used for quarterly and annual reporting to the SEC. Typically, non-GAAP measures are used in reporting to analysts and/or when companies publish results on a monthly basis. Also, postings are allowed under certain circumstances on social media.
The reason given by companies for using non-GAAP numbers is they better portray operating results. They argue that amounts like interest and taxes do not directly reflect operating expenses. Indeed, they are categorized in an “other” section of the earnings statement. Items such as depreciation and amortization are non-cash expenses so that is why they are omitted.
I’ve heard other arguments such as non-GAAP financial measures provide an additional tool for investors to use in understanding and evaluating ongoing operating results and trends similar to the way top management and the board of directors use such information. To me this is a rationalization for using non-GAAP numbers and does not meet the dual tests of transparency and comparability that underlie sound financial reporting practices.
The real reason companies use non-GAAP numbers in periodic earnings reports is they reflect higher numbers and make the company look like it is doing better than it really is. The problem is most users of the financial statements are incapable of transitioning from non-GAAP to GAAP numbers. One suggestion is to require a reconciliation from the reported non-GAAP numbers to GAAP amounts. This could be accomplished by having a schedule accompany every report of non-GAAP results. After all, companies must know their GAAP numbers so that they are able to pare them down to non-GAAP results.
The SEC is cracking down on the use of non-standard financial reporting in earnings releases. More SEC comment letters to companies will soon be released in which the commission’s staff questions the companies’ use of the customized metrics. The SEC issued new guidance last month that clarifies some of the issues surrounding non-GAAP measures and emphasized some of the circumstances in which the SEC would take issue with them.
Comments are being received and analyzed prior to releasing final rules. The reconciliation approach is one possible end result of its deliberations. Others might be to restrict the use of non-GAAP numbers and dictate specific disclosures. Either way the SEC must meet its burden to protect the investing public or be relegated to a back seat in insuring that the financial statements present fairly operating results and financial position.
Purpose of Financial Reporting
The purpose of financial reporting is to assist users to understand the results of operations and financial position and to be able to rely on those numbers for decision-making. Investors and creditors need accurate and reliable GAAP-based results to decide whether to buy, hold or sell stock. Creditors need such information to decide whether to make loans to companies. Future-oriented data may be quite useful in this regard.
The public needs to know the GAAP results because they have been sanctioned by the regulators and represent “best practices.” Still, the accounting regulators should look at whether these measurements are out of touch with what businesses need today to better manage results and whether investors would be better served with new kinds of forward-looking information. One caveat is that accountants must provide assurance that companies using non-GAAP measures do not do so solely to tell a different story than what really happened.
Blog posted by Steven Mintz on June 30, 2016. Dr. Mintz is Emeritus Professor from Cal Poly San Luis Obispo. He also blogs at www.ethicssage.com.