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