Do we really need non-GAAP and non-IFRS accounting? The case of share-based compensation

The convergence of US GAAP and the more broadly used IFRS principles has been a topic largely discussed.

It is difficult to say whether there is a “better” system between the two. For sure none of them is perfect and safe from frauds, manipulation and aggressive practices. Generally speaking, both IFRS and GAAP give investors an acceptable picture of the current financial situation of a business, although the degree of realism and conservativeness varies from company to company, and from industry to industry.

Despite that, many public firms still rely extensively on non-GAAP and non-IFRS figures when explaining their state of affairs to analysts and investors, even if disclosure must be given that these non-compliant numbers don’t represent an explanation as comprehensive as the one provided by standard GAAP or IFRS. So why are corporations using these practices? Citing explanations from filings of two companies, non-GAAP/IFRS figures are useful in excluding "the impact of items not directly resulting from our core operations" or to "enhance the overall understanding of past financial performance and future prospects, and to allow for greater transparency". Just by coincidence, most of the time non-GAAP/IFRS filings end up showing an apparently better situation (sometimes much better) than GAAP and IFRS ones.

I believe that, through the abuse of non-GAAP/IFRS measures, some firms are being excessively aggressive with their accounting, misleading investors and analysts. This is especially true when executives avoid referring to negative or subpar GAAP/IFRS-compliant figures in their public appearances, preferring shifting to their respective alternative performance measures when praising profitability and cash generation of the corporation they manage.?

THE CASE OF SHARE-BASED COMPENSATION

Non-GAAP and non-IFRS accounting (here also defined as “non-compliant” accounting) allow companies to produce income statements that exclude items that under GAAP and IFRS must be expensed, as well as gains that under the same rules are not recognizable.

Both GAAP and IFRS require stock-based compensation (SBC) to be expensed. But SBC can be added back, and therefore ignored, in a non-GAAP/IFRS P&L.?

There are good reasons to use share-based compensation, either in the form of stock options or restricted stock units: it is useful to align interests and can effectively represent an important mean of payment in cash-poor but high-expected-growth companies.

We will see the P&L of two technology companies, which have been largely remunerating employees through Restricted Stock Units. The two firms (the first, being based outside US, adopts IFRS accounting, the other GAAP) justify the adoption of non-GAAP/IFRS principles stating that since RSUs’ fair value is based on the companies’ current stock price, which is volatile, to give a clearer picture to investors it is better to completely exclude the SBC item from their respective P&L (instead of expensing them at fair value, which is done under GAAP/IFRS).

This is a strange statement. The value of every financial asset and liability, both listed and unlisted, experiences volatility (that’s straightforward for listed securities; unlisted assets are also subject to fair value adjustments on a regular basis). But if we use volatility as a reason to exclude an item from corporate accounts, some companies will have empty balance sheets and empty statements of income.

The change in value of RSUs closely follows the delta value of common stocks, for which marking-to-market is readily available through market quotes. Furthermore, in the last few years the first company added to its non-IFRS net income over $2000m of gains related to marking-to-market of other, more complex, OTC options (which require a larger number of inputs to be valued, some of which are arbitrary). If this corporation has no problem in valuing these options, why not marking to market much simpler RSUs?

I asked myself three questions:

-???????Is there any reason not to expense share-based compensation? No, as promising SBC to employees is clearly an economically significant transaction for a business. It doesn’t produce an immediate cash expense, but each company still needs to pay for the issuance of shares (plus the dilution for existing shareholders translates into lower EPS, at constant level of net income)

-???????Does share based compensation refer to non-core business? Generally speaking, no; in our cases is a recurring expense and is a mean of payment for every employee (and the staff members should be spending most of their time on the core business)

-???????Does removing SBC from the income statement help understanding the future prospects of each business? The accountants’ answer to this question is basically arbitrary. My answer is no, since it is a portion of the salary that these firms consistently paid, and likely will continue to pay, to everyone in the respective workforce. Ignoring it means ignoring a cost necessary for day-to-day activities

Income Statements

Follow the P&Ls, both compliant and non-compliant, of the two firms. Data in $m unless specified.

Company 1:

Company 2:

In both cases we see that the difference between GAAP/IFRS and non-GAAP/IFRS net earnings is not negligible: a combined staggering $3831m for the first firm and $590m for the second one, for the five fiscal years between 2018 and 2022.

In particular: company 1 shows a mix of high revenue growth and substantial profitability in its non-IFRS figures, while the IFRS P&L tells a totally different picture (and a cumulative IFRS net loss of over two billion dollars in five years). Company 2 remains unprofitable even in its non-GAAP income statement.

Cashflows

SBC expense is added back to operating cashflows, as a non-cash item. For this reason, almost all the companies which are abusing stock payments to employees are at the same time being marketed as cash machines by their respective managements (and by some analysts). But how would these cashflows appear if we assume SBC to be a cash item?

Company 1:

The above operating cashflows appear acceptable excluding SBC. However, the other big non-cash item (gains related to marking-to-market of derivatives used for hedging purposes) which has not been expensed in the non-IFRS income statement, hasn’t been subtracted from the figures above. Excluding these unrealized gains (which are unlikely to be ever realized, since these gains are offset by losses in the fair value of the insured asset), we come up with a cumulative cash inflows from operations of -$861m and a net change in cash of almost -$2787m for the period from FY18 to FY22.

Company 2:

Another Matter

Another problem related to the abuse of SBC is its dependency on the company’s stock. As long as its price keeps increasing, employees are happy with their Restricted Stock Units. However, if it starts reversing, the firm could fall into a dangerous vicious cycle: the company needs more shares to achieve the same nominal value of remuneration, causing more dilution and/or needing to increase cash-based payments to retain talent. Both circumstances are undesirable for shareholders.

CONCLUSION

I believe there is little reason for a company to continuously refer to Alternative Performance Measures and non-GAAP or non-IFRS accounts, if not to portrait a different reality to investors and analysts.

Stock-based compensation is a widely used and generally beneficial practice. However, its accounting is particularly prone to be abused, as this item is not expensed under non-GAAP/non-IFRS accounting. Through that, corporations with high levels of SBC can hide a non-negligible cost, while registering higher cash generation.

Current regulation, which is limited to a broad disclosure in the companies’ reports and earnings calls, may be not enough. Investors must be willing to go deeper than the surface and remember that if something seems too good to be true, it probably is.

Remogiulio Cavuto

Disclaimer: Opinions expressed are solely my own and do not express the views or opinions of others or my employer