This article originally appeared in our June 2016 Issue.
“We’re actually confusing people more than we were helping people understand what’s going on in the business.”
— Gregory Hayes, CEO of United Technologies, explaining the motive for shifting focus from GAAP to adjusted earnings in future SEC filings
If one Fortune 500 CEO is willing to publicly express such a dim view of his company’s audited financial statements, there must be others who feel the same. Indeed, the same article in which Hayes was quoted (Theo Francis and Kate Lineburgh, “U.S. Corporations Increasingly Adjust to Mind the GAAP,” Wall Street Journal, Dec. 14, 2015, http://on.wsj.com/1SSThWV) reports that 25% of SEC filings contain voluntary disclosures of unaudited pro forma performance metrics such as adjusted net income; adjusted sales; and adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA). In at least one case, a quarterly earnings announcement did not even mention earnings as reported in accordance with GAAP.
One of the more striking aspects of the non-GAAP metrics that management evidently favors is the absence of the putative hallmarks of GAAP’s relevance, transparency, and comparability. But before condemning non-GAAP metrics as less useful, or perhaps even misleading, CPAs should consider why they are increasingly being used. Even a seemingly straightforward adjustment like the depreciation addback to derive EBITDA has its good-faith skeptics and proponents. Skeptics of measures like EBITDA point to reliability issues. Depreciation is spread across multiple categories, from cost of goods sold to selling, general, and administrative to discontinued operations. Who knows which depreciation is being added back, whether the adjustments are consistent from year to year, or if the calculation is comparable to peers? And how could a measure of performance be reasonably complete without taking into account the costs to replace used-up capacity? Proponents, however, argue that GAAP depreciation and amortization may add more noise than information to reported net income. In addition, there are legitimate concerns about the bias in accounting earnings introduced by management playing earnings games. Beyond that, the simplistic allocation rules used to match depreciation and amortization bear little relation to the future cash flows for capital expenditures.
But before condemning non-GAAP metrics as misleading, CPAs should consider why they are increasingly being used.
But skeptics and proponents should also note that well-intentioned SEC rulemaking shares responsibility for the recent proliferation in non-GAAP metrics. At a December 2015 AICPA-sponsored conference on SEC and PCAOB developments, the SEC staff, and even its chair, devoted a significant amount of time to these metrics. This appears to be part of the ongoing efforts necessitated by the unintended consequences of rules issued in 2003, which set forth supposedly very rigorous conditions for when non-GAAP performance measures could be reported. Issuers, however, have treated the rules more like a safe harbor than a set of constraints. So long as one conforms to the letter of the SEC’s requirements, the thinking goes, the SEC staff has rendered itself powerless to object.
Motives for Using Non-GAAP Metrics
What could motivate a company’s management to de-emphasize, or even to replace, net income in favor of non-GAAP metrics? Three possibilities arise, two external and one internal. Internally, a company communicates non-GAAP metrics to investors in order to share the metrics it manages. In this case, the goal is to allow those outside the company to see the company through the eyes of management. This sounds helpful, as users naturally want to understand and gauge a company in a manner similar to management. But CPAs should question why a company finds a non-GAAP measure to be more appropriate for aligning management and shareholder interests than a GAAP measure.
This naturally leads to a second possibility. Too many of GAAP’s “customers” believe that its accounting does not adequately capture the underlying economics of a business. Many, such as Hayes above, might argue that GAAP is so full of warts that it is not surprising when it is downplayed in favor of other measurements.
A third, and admittedly cynical, possibility is that non-GAAP numbers are more susceptible to manipulation by management than GAAP numbers. Non-GAAP measures do not require that debits equal credits, are outside the scope of the auditor’s report, are subject to the whims of management with regard to the manner of calculation, and can be turned on and off whenever desired. It is simply easier to cherry-pick numbers and create all sorts of adjustments to suit management’s purposes.
Damage Control Mode
The use of non-GAAP performance metrics may or may not cause a focus on value-increasing business operation factors. As with GAAP itself, the choice of what is measured, as well as its transparency and consistency, is crucial. But there can be no question that the rising use of non-GAAP financial metrics will affect the accounting profession in ways that should cause concern. The risk to the profession is that they devalue the financial statements upon which the audit is based. Auditors are not called upon to raise issues about appropriateness, calculation, and reporting of non-GAAP metrics, and they are likely prone to distancing themselves from non-GAAP metrics to avoid potentially negative impacts on client relations or future repercussions due to users’ reliance on potentially misleading numbers. When CPAs’ incentives are to run away from financial information, there is a problem.
As a profession, CPAs should be concerned about the “why” and the “how” behind the increasing use of non-GAAP metrics. But what options does the profession have, given obvious shortcomings in GAAP that are not going away anytime soon? The following two suggestions would move the conversation beyond the platitude of saying that GAAP should be improved.
Require consistent reporting.
If non-GAAP metrics are included in the five-year financial summary table required by Item 301 of Regulation S-K, issuers should be required to describe any factors (e.g., accounting changes, business combinations, dispositions of business operations) that materially affect the comparability of the data. Furthermore, the SEC should require that if a non-GAAP measure is first presented in a given year, it must be presented for the previous four years and then for at least five consecutive future years. This requirement, as well as requiring explanations for any starts or stops in reporting, is necessary to provide consistency and would help curb abuse. Reporting could still be started or discontinued at will for any non-GAAP metric, but issuers should be required to provide information on the motive behind the metric to discourage situational reporting. If the metric really does better capture information for decision making, its use should not change often.
Accounting is facing a crisis—its primary “product” is increasingly being deemed insufficient by issuers and users.
Subject the metrics to a review of controls.
Issuers should be required to specifically affirm, similar to CEO/CFO financial statement certifications, that non-GAAP metrics are explicitly addressed in their disclosure controls and procedures. This would ensure that their calculation is specified in adequate detail, is calculated consistently, and is not misleading. The audit committee would then disclose whether its auditors provided a report on compliance with the non-GAAP rules [Item 10(e) of Regulation S-K when non-GAAP metrics are presented in financial statements], and if not, why not. Consistency of calculation, transparency, and proper controls related to non-GAAP metrics are critical for their use.
The Future of GAAP
Accounting is facing a crisis—its primary “product” is increasingly being deemed insufficient by issuers and users. The use of non-GAAP metrics raises significant issues about the quality of GAAP. A consideration of the informativeness of non-GAAP metrics disclosed by issuers in good faith, and the obstacles that prevent GAAP from being more informative, is necessary. More than 500 years of history would argue that accounting conveys very useful information. If GAAP is to remain the gold standard of financial reporting, CPAs must understand the use of these alternative metrics by issuers and users.
Requiring consistent reporting and a review of the controls around non-GAAP metrics is a step in the right direction. Only when financial statements are seen as valuable and auditors have an incentive to take a role in the review of non-GAAP metrics will the profession begin moving in a positive direction. Shining a light on these non-GAAP metrics will either cause them to fade into the shadows or reveal how they can be integrated into the standard financial reporting model. CPAs must care about them.