Views on the integrity of global capital markets
29 January 2015

In the Black, or in the Red? Bottom Line Can Depend on Performance Measure Used

Posted In: Financial Reporting
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The Wall Street Journal reported recently that 40 companies with initial public offerings (IPOs) in 2014 showed losses under standard accounting rules (i.e., GAAP, generally accepted accounting principles), but they reported profits using customized performance measures, known as “non-GAAP” measures.

Is this information misleading to investors?

Non-GAAP earnings, generally speaking, tend to be higher than GAAP earnings. Some, therefore, are concerned with the proliferation of the use of non-GAAP measures that they believe corporate managers could use to overstate earnings and ultimately mislead investors.

Companies often supplement GAAP information with non-GAAP measures, which have been used for many years, to provide users with information they believe will put them in a better position to understand a company’s performance, financial statements, or management’s point of view. For example, non-GAAP earnings are usually preferable when they remove one-time events or charges that are unlikely to recur because they may obscure a firm’s operating performance within a specific reporting period. In such a case the non-GAAP measure may also provide a better indication of the future earnings power of a company. Similarly, another expense that is often stripped out of GAAP earnings is executive stock compensation — on the basis that it is a noncash expense.

There are, of course, rules governing the use of non-GAAP measures. The SEC’s Regulation G that sets out the conditions for the use of non-GAAP financial measures, for example, prohibits:

  • Adjusting a non‐GAAP performance measure to eliminate or “smooth” items identified as nonrecurring, infrequent, or unusual, when the charge or gain is reasonably likely to recur within two years, or there was a similar charge or gain within the prior two years.
  • Excluding from non-GAAP liquidity measures charges or liabilities that required, or will require, cash settlement, or would have required cash settlement absent an ability to settle in another manner.

The question is: Have companies gone too far in stripping out such items? The WSJ article argues that they have.

Companies have long used such metrics, often omitting costs like interest, taxes and employee stock compensation, and thus boosting their results. But now, more companies are taking out more types of costs that would seem to belong in earnings calculations. During the past year, some companies going public have excluded from their nonstandard measures costs like regulatory fines, “rebranding” expenses, pension expenses, costs for establishing new manufacturing sources, fees paid to the board of directors, severance costs, executive bonuses and management-recruitment costs.

Let’s look at stock compensation. Although often a routine expense, the argument for adding it back to earnings is that it doesn’t represent a future cash outlay. But The Analyst’s Accounting Observer in its article, “Non-GAAP Earnings: Nothing Succeeds like Excess,” contends: “It’s an outlay of the firm’s own currency, and giving that currency to managers takes it away from shareholders.” The article goes on to say that it makes sense to “exclude genuine nonrecurring items, but just tossing out one item after another because it’s noncash is to jump onto the slippery slope with both feet. It can make sense to include those noncash items, and to listen to the story the earnings tell.” The question is: Does adding back stock compensation detract from what the earnings figure can tell you?

The Financial Accounting Standards Board (FASB) is undertaking a research project on “financial performance reporting” that will look to find ways to improve the relevance of information presented in the performance (income) statement for public and private companies. Specifically, the research is developing a framework for defining operating activities and distinguishing between recurring and infrequent items.

This is an opportunity for investors to make their views heard. We need to ask ourselves: Have the use of non-GAAP measures gone too far? Is this misleading for investors? And if so, what should be done about it?

Please share your views with us.


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Image credit: iStockphoto.com/yuum

About the Author(s)
Mohini Singh, ACA

Mohini Singh is director of financial reporting policy at CFA Institute. She represents membership interests regarding financial reporting and disclosure proposals issued by the FASB, the IASB, and others. Singh holds the Associate Chartered Accountant (ACA) designation.

5 thoughts on “In the Black, or in the Red? Bottom Line Can Depend on Performance Measure Used”

  1. Gerard Hallaren says:

    Ultimately, a company’s financial reports are management’s representation to shareholders. Accounting complexity has multiplied. This has reduced the informational value of financial statements.

    Looking beyond conventional measures is a natural response of both shareholders and managements. It seems that many shareholders disregard stock-based compensation and various non-cash amortization expenses.

    We need to consider elegant solutions and simplicity in our efforts to address the current situation.

  2. Ignacio says:

    To me, there is no question that non-GAAP measures are being abused by corporate managers in their continued attempt to boost their own earnings, at the expense of shareholders and other stakeholders in the company (particularly other employees, who have never suffered a higher level of inequality relative to their bosses in terms of pay).

    The idea of “maximising shareholder value” may have come to vogue in the roaring 80s, but these days the goal has been reinterpreted as to “maximising top management value”.

    Despite some headline-grabbing actions by some investors in recent years, the reality remains one in which institutional investors and regulators alike continue to enable corporate managers to get away with looting corporate coffers at the expense of owners and other financial backers.

    How long are we going to allow this trend to continue for?

  3. Tony Paine says:

    If you compare S&P-500 EPS “as-reported” vs “operating” or with other adjustments, the “as-reported” (i.e. GAAP) EPS are usually about 10-15% lower. That shows how systematic the “fudging” of EPS is. Some firms have 10 different items to adjust GAAP to something else, MANY of which are recurring nearly every period.

    A particularly bad example is pharmaceutical firms habit of ignoring acquisition costs (as non-cash) when the only way they can keep growing the company is by acquiring other companies with new drugs. Those non-cash costs dilute the rest of the shareholders.

    Even big writeoffs get the “extradordinary item” treatment in spite of the fact they represent management decisions to keep a business going for longer than made sense. It may or may not be current management, so adjustments may be necessary for executive compensation, but GAAP tells the truth.

    I only trust GAAP earnings. I will make my own adjustments, sometimes spreading a big write-off over a few years – especially as they frequently recur with some companies. As a result, I distrust companies reporting and basing executive compensation on “fudged” earnings.

    The solution I would suggest is that GAAP earnings results have to be given the same (or greater) exposure in any report as “adjusted earnings” and that GAAP earnings must be the sole headline number.

    “Extraordinary” should mean “recur less than once every business cycle of 5-7 years” not the two years used by the SEC.

  4. Wolfgang Lickl says:

    Over the last decade I have argued and written intensively about the proliferating use of Non-GAAP earnings measures. I work as portfolio manager at a German asset management company and I am covering healthcare stocks as sector specialist.

    Within (European) pharma companies the use of Non-GAAP earnings measures (also referred to as ‘pro-forma’, ‘adjusted’ or ‘Core’ earnings) is wide spread. Two UK pharma companies are on the forefront of using Core Earnings to ‘help’ the market participants better understand the ‘true’ earnings of their firms. They exclude restructuring charges, legal costs, impairments and amortization of intangible assets from their earnings numbers. In some quarters IFRS earnings have been less than a third of their Core earnings or put it another way Core earnings have been three times as high as reported earnings.

    Now, is it appropriate to excludes these charges ? Restructuring charges and legal costs are excluded by these companies because they are called ‘one time charges’ even though they reoccur quarter after quarter. I can’t find any better explanation for excluding these items other than increasing or smoothing the earnings numbers.

    What about impairments and intangibles amortization ? I think this is a slightly more complex issue and in some rare instances a case can be made for adjusting for intangibles amortization. But nonetheless in most cases these expenses should be accounted for in the P&L statement. What are the companies’ arguments for excluding these charges ? The most often cited reason for the adjustment is that these charges are ‘non-cash’. But we are not talking about the cash flow statement, we are talking about earnings and the P&L statement, and accrual accounting aims to show expenses in the time period when the related revenues are booked and not when the cash outflow occurs. So, in a world of accrual accounting the criteria to book an expense is not the question whether there is a cash outflow in the same period or not. And in the past there has been a related cash outflow when these intangibles were bought or established. So the argument that there is no cash flow related to these expenses in the reporting period is not really convincing. Let’s compare intangibles amortization with depreciation of tangible assets. Consider a car manufacturer that buys a machine and depreciates the purchase price over the following ten years. Would you accept the firm’s argument that depreciation is a ‘non cash’ charge when the company would exclude these expenses from the ‘Core’ P&L statement. I certainly would not.

    Pharma companies are not developing all drugs internally in which case the salaries of scientists would be booked as labor expenses. Purchasing a drug in late stage development and amortizing the capitalized intangible asset over a future time period turns salaries into intangibles amortization. This amortization should be accounted for in the same manner as the salaries would be. The same is true for impairments of intangible assets in the case the drug never reaches the market.

    So why has the use of these non-GAAP earnings measures proliferated so much ?
    First of all it allows the management of a company to show higher earnings. (Interestingly the vast majority of items that is excluded from the earnings number are expenses not income. ‘Extraordinary’ income is regularly included in the earnings number even if the nature of the item is one-time. One big UK pharma company included the gain on the sale of an equity stake in an unrelated company in its Core earnings whereas it excluded items such as restructuring and legal charges in the same period).

    It is easy to understand why management wants to show inflated earnings, since higher earnings should lead to higher stock prices and this increases the value of managements’ stock options. Sometimes (at least in the case of another UK pharma company) the payout threshold of management’s variable compensation is based on Core earnings which are in the discretion of management itself.

    Why do analysts and investors accept that companies are talking mainly about pro-forma earnings ? That’s more difficult to explain, but besides from giving up on arguing with management that this is not the appropriate earnings measure I guess that all human beings tend to the positive side of things and higher earnings justify higher share prices. Analysts like pro-forma earnings because ‘the system’ justifies higher price targets and makes it easier to have a buy rating on a stock. And investors like pro-forma earnings because it drives (at least for a certain period of time) share prices higher.

    Does anybody loose from pro-forma earnings. Sure, somebody must loose, otherwise it would be the perfect system to create wealth. The losers are shareholders that pay excessive management bonuses based on thin air instead of real earnings (and cash flows). Also there are times when the market focuses more on pro-forma earnings (e.g. the Tech bubble in 2000) and times when it does less so. So the loser is the shareholder who invests in companies at times when management and analysts (and of course other investors) have pushed stock prices too high relative to fundamentals. In the next downturn these shareholders loose more that they would have otherwise.

    Let’s finish with the most extreme example I have ever come across. One of the UK pharma companies acquired a product portfolio from a competitor and agreed to pay on top of the upfront purchase price annual royalties based on future sales back to the former owner (which is a typical deal structure in this industry). The company declared this (to some degree) uncertain future cash flow stream (yes, we are talking about real money flowing out of the company) as a contingent liability related to the purchase which has to be put on the balance sheet as a liability and will be amortized over time. I guess up to that point everything is in compliance with IFRS. The result is that the company has an intangible asset (in the same amount as the liability) on the balance sheet which will be amortized over the life of the asset. But now the company claims that the amortization of this asset is a non-cash charge (wasn’t there an annual related cash outflow ? see above) and it will be excluded from Core earnings in order to make it easier for investors to understand the ‘true’ fundamentals of the company. I can’t help but the share of profits that a company has to pay (as part of the purchase price) to the former owner of an asset is not part of the true profit of the new owner whether we call this profit GAAP Earnings or Non-GAAP Earnings.

    We invest in companies partly because we expect share price appreciation and partly because we expect regular dividend payments. But dividends can only be paid out of cash flows collected by the company, not out of Core earnings.

  5. Mohini Singh, ACA says:

    Thank you all for your thoughtful comments. We appreciate hearing your views so that we may share them with the standard setters.

    The argument made is that removing certain expenses from earnings makes sense if they are one-time events or non-cash charges that obscure the results of operations. Of course the flip side of that is that they are still expenses that need to be incurred to run a business. The Analyst’s Accounting Observer has some interesting examples.

    “If a company thrives by making acquisitions, then the expenses associated with making acquisitions are necessary costs of doing business. If a firm acquires intangibles that produce revenues, there was a cost associated with producing those revenues: intangibles amortization might not be perfect, but ignoring it in earnings makes less sense than including just the revenues attributable to the acquired intangibles. If a company refinances its debt to increase future cash flows, it’s a necessary cost of doing business. It’s just not convenient to acknowledge it in a quarterly earnings statement. These costs have an effect on shareholder wealth that simply isn’t exposed in looking solely at non-GAAP earnings.”

    In summary, non-GAAP earnings do not tell you the whole story of what happened in a reporting period.

    Thank you again,
    Mohini

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