The standard GAAP accounting measures are less and less useful to investors, according to a new book with the provocative title, “The End of Accounting.”
The book, by New York University accounting and finance professor Baruch Lev and SUNY Buffalo accounting professor Feng Gu, is entertainingly written and makes some powerful arguments, backed by extensive statistical analysis of thousands of companies and their financial statements.
“The evidence shows that reported earnings no longer move markets,” Lev said in an interview. “They used to, but we show for example that when companies miss analyst consensus forecasts, lots of people think this is calamitous. But prices go down an average of 1.5 percent, which today is a normal everyday thing. It’s basically nothing. If you beat the forecast, you gain half a percent in share prices. Lots of managers somehow massage that into beating the forecast. Earnings don’t really matter anymore.”
The authors see an increasing disconnect between share prices and key financial variables, such as sales, cost of sales, SG&A expenses, earnings, assets and liabilities. Based on the authors’ sample of thousands of public companies in the United States, they estimate that out of all the information actually used by investors, financial reports provide only about 5 or 6 percent of that information.
The financial analysts who closely follow corporate performance are showing increasing uncertainty about their future performance over time, based on the variability of analyst forecasts.
“We show that on average for all companies this spread of financial analysts is increasing, which has to be driven in part at least by the deteriorating value of the quality of the information that they are using,” said Lev.
The current trend toward increasing use of non-GAAP metrics makes a lot of sense then, even though the Securities and Exchange Commission is warning companies against the abuse of such nonstandard measures.
“The non-GAAP earnings that companies disclose, increasingly so, are in my mind really a symptom of the inability of managers to tell the story of their company with GAAP financial reports,” said Lev.
He pointed to Amazon as an example. “Amazon missed its consensus earnings forecast in six out of the last 12 quarters,” he said. “So is Amazon a failing company? Of course not. Amazon is an incredible success and is on the verge of conquering the world. But you cannot tell the story with a balance sheet and an income statement that is imposed on you. In the case of Amazon, it’s simple because everyone knows that this is an incredible success story. No one looks at the financial report. But there are thousands of small companies, let’s say biotech companies, which report huge losses, but are these losses a reflection of failing operations, or are these losses the result of expensing R&D and expensing information technology and expensing all their investment in intangibles? Are these failing companies or are these successful, growing companies? You cannot tell this story with GAAP numbers.”
He believes part of the problem lies with the Financial Accounting Standards Board. “Much of what the FASB did in the last 20 or 30 years is driven by what they call the ‘balance sheet model,’ in which they try to value assets and liabilities at market values,” said Lev. “And what you get from this are all kinds of one-time transitory changes in values that are then reflected in the income statement. So the income statement reflects write-offs of assets, impairments of assets, write-offs of goodwill, changes in fair values of assets and liabilities. These are all one-time changes, basically noise in earnings, and companies struggle how to convey to their investors normal type of earnings, permanent type of earnings, retained earnings. In my mind the non-GAAP earnings are just a symptom of the serious underlying problem of consistency of GAAP.”
However, non-GAAP measures can be misleading, he acknowledged. “All these non-GAAP disclosures are not very useful to investors because they’re not uniform,” said Lev. “Different companies report different things. Different companies subtract from GAAP earnings different items. Even the same companies are not consistent all the time. One year they subtract this, another year they don’t. So this is not useful information.”
Beth Paul, a partner in PricewaterhouseCoopers’ National Professional Service Group, sees a role for both GAAP and non-GAAP measures. “I think that non-GAAP measures can provide insight into a company’s business, and I think that investors sometimes ask companies for them and that’s why companies include them as well,” she said. “Sometimes companies include them because that’s how they manage their business, or it’s how they compensate their employees or it’s relevant to their debt covenants or other purposes. And sometimes they include them because they get questions from their analysts or investors about something like EBIDTA, and they provide it because there’s market demand.”
The SEC issued updated Compliance Disclosure and Interpretations in May on the use of non-GAAP reporting to address some of the recent misuses of non-GAAP metrics and inconsistency in how the measures are calculated. In a recent blog post, Paul noted that comparability of non-GAAP measures varies from one industry to another, while the judgment needed when calculating non-GAAP measures can make them susceptible to bias or misinterpretation without the proper context and transparency. PwC has posted a brief on the SEC interpretive guidance.
Paul believes the new SEC guidance will result in companies re-examining their non-GAAP measures to make sure they are complying. “It focused on a couple of key areas,” she told Accounting Today. “One was the prominence of the non-GAAP measure. It re-emphasized that when using a non-GAAP measure the GAAP measure should have equal or greater prominence and provided some indicators to consider when you’re thinking about whether you have the prominence right, things like are you leading with the GAAP vs. the non-GAAP, or do you have the GAAP in a different font. I think that companies will look at their current disclosure and say, ‘OK, based on this framework or interpretive guidance that the SEC put out, do we line up with that?’ That might be a change in the way they present the information. It might mean increased disclosure around that or increased transparency around some of the information as a result. That could be the impact of the new interpretations.”
Paul has not read Lev and Gu’s new book, but she believes GAAP still provides relevant and useful information.
The book includes sample reports that can be used within particular industries, such as media and entertainment, property and casualty insurance, pharmaceuticals and biotech, and oil and gas companies, to make such disclosures more comparable, uniform and consistent. “It’s basically an organizing principle,” said Lev. “We are not requiring a huge amount of new information, but it’s something that investors will be able to use consistently and compare over time.”
Despite the limitations of traditional accounting measures, he is skeptical about corporate sustainability reports and integrated reports as an alternative to GAAP reporting.
“Some people want to force companies to report their impact on the environment and adverse impact on societies all over the world,” said Lev. “These are highly political issues. We don’t ascribe to any of those. The main reason is that managers will never go along with this. It’s just madness. It just opens the company to continuous harassment by NGOs, lawsuits and so on. We don’t recommend any of those. There are more mainstream things like integrated reporting, but what is missing in integrated reporting is some kind of a uniform report.”
He points, for example, to General Electric’s 2015 integrated report. “What you get is a document of 68 pages, which is ridiculous,” said Lev. “You have a financial report of almost 200 pages. On top of it, you have 68 pages of an integrated report. Who reads these things? I read it because I was asked to comment on it, and I admit that there are some important elements of information, but they are hopelessly buried in 68 pages, including 17 pages of pictures, all smiling people, in all kinds of things that are completely useless. It’s not uniform.”