Recent business news highlighted increasing concerns over the proliferation of various non-GAAP statistics in public companies’ Securities and Exchange Commission filings. Complaints have been raised about not only the number of reports that now include these stats but also their increasingly ludicrous, misleading and otherwise useless nature. Rightly so, critics are also questioning the ethics of managers who provide these disclosures.

One key event was the May 17 issuance of a Compliance and Disclosure Interpretation by the Securities and Exchange Commission’s Corporation Finance Division. It warns registrants against various general and specific non-GAAP reporting ploys, such as: adding back unusual GAAP losses and charges while not deducting unusual gains; emphasizing non-GAAP measures over GAAP measures; and reporting per-share amounts for EBITDA and free cash flow. (For clarity, this interpretation is a staff release, not a new rule approved by the commission; the CorpFin staff published it to give managers a heads-up on the sorts of things they will take exception to in reviews.)

The very next day, David Zion of Credit Suisse released his analysis of the interpretation in a report called “SEC Squeezing Non-GAAP.” And then a week later, Ciara Linnane of the online outlet MarketWatch also called attention to manipulated non-GAAP disclosures in a provocative article titled, “Here’s how investors are duped each earnings season.”

We were especially intrigued by Dani Burger’s May 18 article, “Paying a Price in the Stock Market for Pro Forma Earnings Tricks,” in Bloomberg Markets. In particular, it cites evidence from a Sanford C. Bernstein & Co. research report that indicates that companies tend to experience lower stock prices than the broader market when their managers tack inferior non-GAAP measures onto their GAAP statements.

In short, a growing number of corporate managers are jumping onto a wobbly wheeled bandwagon that’s careening over the credibility cliff.

Frankly, none of this finagling astonishes us. Because managers never concoct non-GAAP measures that put themselves in a poor light, former SEC Chief Accountant Lynn Turner once characterized these obvious image-polishing fabrications as EBS (“Everything but Bad Stuff”).

 

ON THE OTHER HAND

What may be surprising to some, though, is that we strongly believe non-GAAP information has huge potential for leading a positive financial reporting revolution.

How can we believe this contrary assertion is valid? The answer is that GAAP reporting simply isn’t good enough to usefully describe the truth, the whole truth, and nothing but the truth in financial reports.

First, their political nature makes GAAP reporting standards woefully incomplete, misleading and otherwise non-useful. In fact, we often call them PEAP, for “Politically Expedient Accounting Principles.”

Second, the extreme age of many standards makes all GAAP reports inadequate. In our eyes, the poster example is cost-based systematic depreciation, which has been applied in the United States since Andrew Jackson was president. Thus, we’ve also referred to GAAP as POOP because it consists of “Pitifully Old and Obsolete Principles.”

Inferior accounting principles first emerged and remain in use because the standard-setting process is both too slow to act and too unimaginative when it does. In particular, we think the Financial Accounting Standards Board often focuses on minor tweaks (like simplifying the equity method and deferred tax classifications) while leaving some big issues only partially improved (like lease and pension accounting) and completely ignoring other fundamental reforms (like requiring more market values to be reported and devising balance sheet categories that would be more informative than the existing antiquated current/noncurrent dichotomy).

Because of so many deep flaws in GAAP and a ponderous system that generally hasn’t produced significant progress, we encourage wise and ethical managers to bypass this bureaucratic process and create serious improvements by using responsible non-GAAP reporting to reveal the truth more usefully.

Of course, that kind of reporting differs greatly from the EBS-type disclosures that conniving managers are putting out.

 

QUALITY FINANCIAL REPORTING

In more than a few previous columns, we have described “Quality Financial Reporting,” a completely revolutionary paradigm for guiding practice that will improve literally everything when it’s fully implemented.

Specifically, this paradigm asserts that managers’ efforts to proactively meet financial statement users’ information needs will produce multiple benefits for all parties. This idea stands in stark contrast to the present paradigm, in which managers wait passively for FASB to tell them what to do, and then fruitlessly manipulate their reports to make themselves look better than they really are.

Some readers may recognize these four economic axioms that provide the theoretical basis for QFR:

  • Incomplete or otherwise untrustworthy information creates uncertainty.
  • Uncertainty leads to risk for investors.
  • Investors respond to risk by demanding higher rates of return.
  • Higher rates of return for investors equate to higher capital costs for managers and depress the market values of their companies’ securities.

Therefore, legitimately improved financial information will inevitably produce much better results.
The obvious way that managers can overcome GAAP’s deficiencies is to voluntarily enhance the quality of the information in their companies’ financial reports. Further, the most expeditious means of achieving that enhancement is disclosing actually useful, innovative non-GAAP information that reduces uncertainty, risk and capital costs.

In contrast, the present rush toward manipulative and otherwise tainted non-GAAP disclosures doesn’t begin to fill that bill. Indeed, the Bernstein research study shows they actually make things worse, not better.

 

ENHANCED TRANSPARENCY

Reports can be made more transparent by filling them with useful information that is truthful, comprehensive, accessible, timely and otherwise trustworthy. Here are several suggested non-GAAP enhancements:

Managers should openly and clearly reveal market values of all significant assets and liabilities, and changes in them. This practice would produce more useful measures of periodic income and sound economic descriptions of the resource base committed to earning that income. Of course, some will ask whether market values are feasibly attainable. All we can say is that they’d surely better be, because if managers don’t already have them, they’re making highly uninformed strategic and tactical decisions. We’ll also add that estimated market values can be useful without being precise; indeed, accuracy to the nearest million, $10 million or even $100 million would be more helpful than spuriously precise but uninformative GAAP book values.

Managers should more clearly describe the cash effects of significant transactions and events. While we don’t doubt accrual accounting’s usefulness, we don’t believe it’s the only useful way to inform investors. For example, management could provide enough explicit data to allow users to construct their own preferred measures of free cash flow, one of the most frequently disclosed (and abused) non-GAAP items.

Managers should not be held back by ages-old political compromises that dominate GAAP. As we mentioned, it would be useful to provide more insight into liquidity and solvency than is presently provided by the simple and very ancient current and noncurrent categories. Further, we’ve pled with managers for years to comply with preferred GAAP by reporting operating cash flows with the seldom-used direct presentation that would have been made mandatory in 1987 if one FASB member had not switched his vote at the last minute.

Managers should make supplemental information available with much greater frequency than the once-a-quarter rate that dates back to the early 1930s. These more timely reports would not need to be complete statements but could be summaries of key data, including revenue, cost of goods sold, labor costs, asset acquisitions and disposals, debt issuances and payments, and the like. We know that managers consult their dashboards to access this information daily, even continuously. Making it available to everyone in the capital markets would diminish their uncertainty and their perceived risk. The favorable outcomes for the reporting companies would be lower capital costs and higher market values for their securities. While potential liability exposure can be limited with disclaimers citing the tentative nature of these measures, the most effective defense against litigation would be making best efforts to report the truth.

Our bottom line is that great things will flow from a full commitment to complete transparency about both good and bad news, with no game-playing, image-polishing or other ill-conceived manipulative motives.

After all, the Bernstein report (and others) show that the markets are generally able to detect when they’re being toyed with, if not right away, then soon thereafter. Thus, upfront and honest managers can win their confidence and reap significant benefits.

 

ESCAPING THE DARK SIDE

Beyond doubt, most, maybe even nearly all, existing non-GAAP disclosures represent the dark side of that practice. We think they grow out of desperate managers’ misbegotten hopes that they can divert the markets’ attention from bad news. They’re irrationally willing to risk ruining their reputations and hurting their investors by pursuing the impossible goal of inflating their shares’ prices above their real intrinsic value.

Oh, how much better it will be when they either come to their senses or are replaced by others who have already had that epiphany! The sure outcome will be markets that are more completely informed and efficient.

We believe this revolution will eventually come to pass, and everyone will look back and shake their heads at how long so many people thought that it was a good idea to report the bare minimum required by GAAP and then pointlessly add corrupt non-GAAP measures to air-brush away unwanted wrinkles and blemishes.

 

IN CLOSING

The four axioms are unarguable, and so is their implication: Rewards will flow in floods to those who commit to telling the whole truth through channels that communicate it to everyone with clarity and timeliness.

We’ll close by noting the irony that such high-quality truthful information unfortunately falls into the non-GAAP category, at least for now.

 

Paul B. W. Miller is an emeritus professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions or Accounting Today. Reach them at paulandpaul@qfr.biz.

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