Investor group weighs trade-offs in non-GAAP measures

The CFA Institute has published a two-part report examining the controversy over non-GAAP financial measures from an investor perspective.

The group, which offers the Chartered Financial Analyst credential, proposes ways of strengthening the overall performance and reporting framework so non-GAAP financial measures remain available to accountants and investors, but only as supplements to regular GAAP.

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The Securities and Exchange Commission issued guidance last May on non-GAAP financial measures after it saw an increasing number of public companies providing more prominence to the non-GAAP numbers than to the GAAP results in their earnings releases. The SEC followed up with comment letters to specific companies, and the drive has led many companies to reduce the prominence of non-GAAP metrics in their earning releases. However, many investors still find the measures useful, even if they need to take the numbers with a grain of salt. The guidance by the SEC last May was not the first time the commission wrestled with the use and abuse of non-GAAP metrics.

“These measures have been a core part of reporting,” said 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 various signals being given around enhanced scrutiny around the reporting of these particular measures, in part because they have become more pervasive.”

The research firm Audit Analytics found last year that 449 of S&P 500 companies (that is, 88 percent) used at least one non-GAAP metric between July and September of 2015. A newer analysis by Audit Analytics this month found that 96 percent of the S&P 500 included non-GAAP measures in their earnings releases during the fourth quarter of 2016.

“When you look at the percentage of S&P 500 companies reporting these measures, there’s been an upward trend,” said Papa. “In some cases, there’s also been a concern about the differential between the non-GAAP represented number, like profits, vis a vis the actual GAAP number that’s reported.”

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.

“We had various investors and members reaching out to us, expressing concerns in some cases about the trend around reporting these numbers, and the type of adjustments that companies are making, particularly around stock option expenses and restructuring costs. On restructuring costs, they tend to be concerned when companies are in a situation where these are recurring expenses, but nevertheless they treat them as though they are one-off expenses.”

For its report, the CFA Institute surveyed financial analysts to get a better sense of what they think about non-GAAP measures more broadly and what securities regulators and standard-setting bodies need to do to encourage greater discipline around non-GAAP reporting.

“We found these measures are broadly used by investors, but in many cases they make further adjustments to a company’s reported non-GAAP measure to come to their own view of what an appropriate adjusted measure should be,” said Papa. “Nevertheless there are concerns around the prominence that’s given to them and the quality of reconciliations that are in place, so they support regulatory intervention of the type that the SEC has been providing in recent times and in the past. But there’s also support for more action to be taken by the accounting standard-setters around the existing GAAP framework, and other players as well. Auditors need to provide greater assurance, and audit committees need to play a stronger role.”

While members of the CFA Institute are accustomed to doing financial analysis to get a better sense of what the non-GAAP measures mean, that’s not necessarily true of the average investor.

“Many of our members would be sophisticated actors, and we found that 58 percent of the respondents indicated that they are making further adjustments,” said Papa. “That being said, there’s a risk that there may be some investors who would be constrained in making these adjustments. When you’re talking, for example, about retail investors, it could be resource intensive to have to always take the number that the company gives you and then have to do further analytical adjustments. The concerns that the securities regulators have, particularly when there’s prominence being accorded to these measures, and the risk that they may be a segment of the market that would have to rely heavily on these measures and are prone to being misled, I think that’s a valid concern. However, we observed that at least a subset of investors are in a position where they can still make their own adjustments. What the SEC is trying to do is a broader initiative to try and improve the overall performance reporting. It’s still timely because the capital markets at some level risk being misled if companies are reporting these particular measures in a misleading fashion.”