(Bloomberg) It’s generally accepted that a lot of accounting isn’t, well, generally accepted.
But with more and more companies promoting bookkeeping that deviates from U.S. standards known as GAAP, for Generally Accepted Accounting Principles, the Securities and Exchange Commission is warning about getting too creative.
The concern is too much non-GAAP accounting could make it harder for investors to size up companies—a risk that was driven home during the Nasdaq boom of the late 1990s and more recently at Groupon Inc., which before going public used profit measures that stripped out some of its biggest costs. Groupon has mostly lost money and market value ever since.
Using non-standard accounting is perfectly legal, provided companies also report the official GAAP numbers. These days, young companies aren’t the only ones offering up two sets of books.
ConocoPhillips, which dates back to 1875, was admonished by the SEC last year for promoting accounting metrics that the agency said cushioned the oil driller’s books against the plunge in oil prices.
ConocoPhillips based some of its calculations on prices from 2013, before crude cratered. The trick added $755 million to ConocoPhillips’ home-cooked measure of profit.
“That brings new meaning to the old phrase, ‘pick a number, any number,”’ said Lynn Turner, a former chief accountant at the SEC. “It’s exceedingly aggressive, and everyone would know that it’s aggressive.”
A ConocoPhillips spokesman said the company was trying to help investors compare results from one year to the next by focusing on factors the company can control, like taxes, royalties and output. To that end, it stripped out energy price trends, the company told the SEC in a letter in June.
But the SEC said the approach looked too opportunistic and ordered ConocoPhillips to stand down, Keith Higgins, the SEC’s director of corporate finance, said at a conference in January.
While creative accounting has been around forever, non-traditional measures—“metrics,” in industry parlance—have been on the rise lately. Companies routinely highlight the non-GAAP results in press releases that announce earnings, and Wall Street analysts often fixate on the adjusted figures. The number of companies in the Standard & Poor’s 500 Index reporting non-GAAP results rose to 334 in 2014 from 232 in 2009, according to research from The Analyst’s Accounting Observer.
That’s why the SEC is worried some companies might be pushing the envelope, with Chair Mary Jo White warning in December that non-GAAP figures can be misleading.
One concern backed up by academic research is that investors who put too much faith in non-GAAP figures could eventually get burned. Companies that omit relatively large expenses from their home-cooked profits tend to have lower future stock returns than companies that have the smallest exclusions, according to scholars at the University of Michigan.
“We have this crazy game of backing out costs because companies want to pretend like they aren’t going to matter,” said Jack Ciesielski, the Observer’s publisher. “But in the end, they’re still eating up shareholder capital.”
Critics argue the non-standard accounting deserves more regulatory scrutiny because it can be used to inflate earnings. A 2014 paper by researchers at the University of Washington and the University of Georgia found that companies are more likely to report non-GAAP numbers that strip out losses rather than gains.
Many investors agree that non-GAAP profit that excludes, say, one-time restructuring costs, is perfectly fine—and even more useful at times. The problem is, supposedly one-time costs can show up again—and that’s a worry for investors, said the University of Washington’s Sarah McVay, one of the authors of the 2014 paper.
Technology companies, in particular, have long argued that traditional metrics aren’t the best way to measure their growing businesses. Facebook Inc. and Twitter Inc., for instance, routinely strip out hundreds of millions of dollars of annual stock compensation expense to calculate their non-GAAP profit.
For Twitter last year, that adjustment meant the difference between profit and loss—its non-GAAP income was $276 million, while GAAP results showed it lost $521 million.
In his latest shareholder letter, Warren Buffett disparaged the omission of pay as “the most egregious” example of non-GAAP accounting. “The very name says it all: ‘compensation,”’ he wrote in his annual letter posted online Saturday. “If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?”
Spokesmen for Facebook and Twitter declined to comment beyond what their companies have disclosed in regulatory filings.
Companies that exclude stock compensation from non-GAAP results say they do so because valuing unvested shares and options can be subjective and the formulas used to estimate awards aren’t consistent across different firms.
McVay said that’s no excuse. “That would apply to virtually everything because there are estimates left, right and center throughout accounting,” she said. “I think they just don’t want it to hurt their bottom line.”
Speaking in California in January, the SEC’s Higgins spotlighted the decision to reject the non-GAAP metric that ConocoPhillips invented. “We thought that was a bridge too far,” Higgins said, describing the SEC’s view without naming the company.
ConocoPhillips’ 2014 annual report said the metric showed how much more cash the company wrings out of every barrel of oil, while filtering out something it can’t control—swings in oil prices.
“It’s not necessarily trying to mislead,” Brian Youngberg, an energy analyst at Edward Jones & Co. in St. Louis, said of the approach. ConocoPhillips’ tactic “shows if you can take price out of the equation, they actually are working toward improving their profitability per barrel for the things they control.”
Shivaram Rajgopal, an accounting professor at Columbia Business School, disagreed, saying the SEC was right to push the company to drop the measure.
“It’s preposterous in a commodity business to argue I am going to revalue my profits off last year’s oil price,” Rajgopal said. “They are going to live and die by the price.”