Non-GAAP Measures: Creative Reassuring Accounting Picture (CRAP)?

Introduction: There’s Something Happening Here

When the Buffalo Springfield sang these lines from For What It’s Worth in 1968, “There’s something happening here, what it is ain’t exactly clear,” little did they realize that their observation might have application outside of the political turmoil of that era. While they were noting the divisiveness around them, just up the street, Wall Street, that is, chief financial officers (CFOs) and market analysts were grappling with just how to depict and evaluate profits, respectively. Like the old Virginia Slims commercials, we’ve come a long way, baby, especially in the proliferation of smoke and mirrors accounting ploys. Despite the founding of the Financial Accounting Standards Board (FASB) in 1973 and its 45 years of setting generally accepted accounting principles (GAAP), in this world of euphemistic explanations and irrational expectations, accrual profit and cash flow from operations seem to be so harsh and final, so why not some non-GAAP measures that reward firms for effort? When Johnny Mercer wrote and sang these words in 1944-1945, he was actually writing the theme song for non-GAAP  enthusiasts:

You've got to accentuate the positive

Eliminate the negative

Latch on to the affirmative

Don't mess with Mister In-Between

So, in the spirt of Marvin Gaye’s 1971 What’s Going on, let’s find out.

Non-GAAP Performance Measures: Participation Trophies for Losers?

In a world where helicopter parents hover over their children and cheer them on as they receive their participation trophies for losing another soccer match, why should we be surprised that the everybody-is-a-winner mantra has spread to the business world? Non-GAAP accounting converts losers into winners, don’t you know?

Non-GAAP supporters complain that U.S. GAAP is a rules-based accounting standard that is not flexible enough to accurately reflect companies’ financial performances. GAAP inflicts rigid accounting requirements on well-meaning firms just trying to earn their way through a tough world, and since unfair rules are meant to be broken, companies are increasingly including adjusted, also known as pro forma or non-GAAP, numbers in their financial statements. Companies argue that these adjusted numbers give investors and analysts a “truer” picture of their performance. However, the truer pictures painted by these adjustments has been consistently rosier than their reported GAAP numbers. Not only did you not lose, but you actually won by a margin bigger than anyone realized!

Since 2013, there has been a sharp increase in not only the percentage of publicly-traded US firms including non-GAAP numbers in their financial disclosures but also in the magnitude of the non-GAAP adjustments. In 2013, approximately 60 percent of S&P 500 companies reported at least one non-GAAP EPS figure. In 2016, this percentage shot up to approximately 72 percent of S&P 500 companies.

Mounting evidence suggests these adjustment are becoming preferred methods of distorting financial performance and misleading investors. In fact, the research firm Audit Analytics found last year that 449 of S&P 500 companies, some 88 percent, used at least one non-GAAP metric between July and September of 2015. A newer analysis by Audit Analytics found 96 percent of the S&P 500 included non-GAAP measures in their earnings releases during the fourth quarter of 2016.

Once again, the Securities and Exchange Commission (SEC) has issued yet more guidance on non-GAAP financial measures after it saw an increasing number of public companies hawking non-GAAP numbers over GAAP results in their earnings releases. The SEC followed up with comment letters to specific companies, and the drive has led to some reduction in the prominence of non-GAAP metrics in earning releases, but in spite of their dubious value, some investors still want to see the measures. The SEC’s latest guidance is not the first time it has tried to curb the abuse of non-GAAP metrics, especially in cases where the non-GAAP measures claim profits when GAAP reports losses. Like Sonny & Cher warned back in 1967, “the beat(ing) goes on.”

“These measures have been a core part of reporting,” noted Vincent Papa, interim head of financial reporting policy at CFA Institute, who authored the two-part paper, Investor Uses, Expectations and Concerns on Non-GAAP Financial Measures (NGFMs) and Bridging the Gap- Ensuring Effective Non-GAAP and Performance Reporting. “The issues around them have been longstanding. If you go back to the dotcom era, there were similar concerns raised around non-GAAP reporting. At the same time as the Sarbanes-Oxley regulations, there were also non-GAAP regulations put in place, Regulation G.”  At different junctures, the SEC has updated its guidance on these measures. So, in 2010 there was an update and this past year, there’s been similar updated guidance and enhanced scrutiny on the reporting of these increasingly pervasive measures.

CFA’s Papa also expressed concern about the widening gap between non-GAAP profits and GAAP profits. He cited a 2015 study by Jack Ciesielski of the Analyst’s Accounting Observer that saw a trend of an average increase of about 6.6 percent in the non-GAAP profits reported by S&P 500 companies, even though there was actually a decline of about 11 percent in GAAP terms. Papa reported that investors and CFA members were concerned about the increasing gap between GAAP and non-GAAP numbers and the treatment of stock option expenses and restructuring costs as one-off expenses and not recurring expenses.

Use (or Misuse) of Non-GAAP Numbers in Financial Statements

Investors claim non-GAAP numbers are useful in some circumstances. For example, if a company incurs a large one-time expense for restructuring, investors assert it may be helpful to know what a company’s earnings would have been in the period without that one-time expense. As such, the company should be able to include in its financial statements adjusted earnings that exclude the restructuring cost. In theory, the adjusted earnings present a more accurate depiction of the company’s underlying profitability because they exclude special, one-time costs that are not a part of the company’s normal operations. Consequently, many companies are now emphasizing their earnings per share on a non-GAAP basis over their EPS on a GAAP basis.

While non-GAAP numbers may be useful for adjusting out one-time, non-recurring items, some companies can use adjustments to falsely inflate earnings. As noted in Warren Buffet’s 2016 shareholder letter: “Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, ‘adjusted earnings’ that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of ‘restructuring costs and ‘stock-based compensation’ as expenses . . . a management that regularly attempts to wave away very real costs by highlighting ‘adjusted per-share earnings’ makes us nervous.”     

Bridging the Gap between GAAP & Non-GAAP Earnings—Massage the Measure?

Analysts critical of the rise in reported non-GAAP earnings blame it on  companies’ limited earnings power. A May 2017 study found that from 2009 to 2014 companies nearly doubled the amount of one-time costs excluded from non-GAAP reporting.  A July 2017 study of the six largest publicly traded social media companies found an increased divergence between the companies’ non-GAAP and GAAP measures over time, noting an increase in the magnitude of non-GAAP adjustments over time as well. In Q3 2017, the average difference between non-GAAP and GAAP EPS for 70 percent of the companies in the Dow Jones Industrial Average was 284.1 percent. A 2017 survey of nearly 400 CFOs revealed that 20% of companies intentionally distort earnings even while adhering to GAAP. The bigger the better, but what if bigger isn’t necessarily better, and better is not necessarily good?

So what can we users of financial statements do about it? First, we need to admit that distortion and manipulation exists. Second, what the big guys do tends to flow downhill, so expect that your privately held borrowers are likely to embrace non-GAAP measures, too. Third, be prepared to explain to your borrowers why we lenders make credit decisions on GAAP numbers, not non-GAAP adjustments. So, do your homework and be ready to provide a lesson. Let me offer the poster child for non-GAAP measures, EBITDA, and why it will never spell cash flow.

You’ve asked your borrower Beatid Corporation to discuss its financial performance. Now, suppose Beatid brags about its earnings by showing how it has increased EBITDA over the past 3 years to $68MM:

Beatid Calculations ($MM)                     2014             2015             2016

PAT                                                            20                12               32

+T                                                              10                  3                 2

+I                                                                  7                 11               16

+D&A                                                           8                 14               18

EBITDA                                                     45                 40               68

Now you have an opportunity to bring your borrower back to planet Earth. Begin by explaining to him that while you appreciate thinking of the bank first by adding back the taxes, interest expense, and depreciation and amortization to come up with a number to pay the bank ahead of all these expenses, you think Beatid’s priorities might be just a little different than it thinks. The IRS probably expects to be paid ahead of other creditors, your shareholders may feel some need for gratification, and the depreciation & amortization is really meant to provide capital expenditure funding to maintain Beatid’s fixed asset base. After all, let’s not forget more working capital investment for expanding inventory to attract more customers and increasing receivables to accommodate more credit customers. If Beatid wants to increase sales, surely it needs more fixed asset and working capital investment. But these uses suck up cash, too, so you need to show Beatid the consequences of its choices. When taking them into account, Beatid’s free cash flow (FCF) available to pay both current and new prospective lenders is actually negative:

Beatid Calculations ($MM)                     2014             2015             2016

PAT                                                            20                12               32

+T                                                              10                  3                 2

+I                                                                  7                 11               16

+D&A                                                           8                 14               18

EBITDA                                                     45                 40               68

-T                                                                -10                      -3                -2

-Div                                                               -3                 -4                -8

-Capex                                                        -37              -102             -91

-DWC                                                            -2               -38              -35 

FCF available to service debt                     -7              -107             -68

Further, when you then add existing debt service, the plot sickens as Beatid discovers it can neither pay its existing lender nor any additional lender:

Beatid Calculations ($MM)                     2014             2015             2016

PAT                                                            20                12               32

+T                                                             10                  3                 2

+I                                                                  7                 11               16

+D&A                                                           8                 14               18

EBITDA                                                     45                 40               68

-T                                                                -10                      -3                -2

-Div                                                               -3                 -4                -8

-Capex                                                        -37              -102             -91

-DWC                                                            -2               -38              -35 

FCF                                                              -7              -107             -68

+P                                                              -10                 -5              -14

+I                                                                 -7                 -11             -16

Existing Debt Service (DS)                       -17                 -16             -30

Cash flow available for new lenders           -24                -123             -98

I have changed the name of the borrower to protect the innocent but failed firm in order to offer readers an example to share with borrowers who delude themselves into thinking non-GAAP measures reflect reality. The reality is that non-GAAP measures are unrealistic and that they can be harmful to the companies themselves by deluding them into thinking that they are financially stronger than they really are.

Closing and Summary: Just Say No?

Both providers and users of financial statements have good reason to be wary of non-GAAP measures. Sure, they offer an alternative view of reality, e.g., what if we hadn’t incurred one-time costs? After all, they won’t happen again. But they did, and they were real. As Ayn Rand wrote, You can avoid reality, but you cannot avoid the consequences of avoiding reality." Earth to non-GAAPers, come back soon; your notes are past-due.