Protecting Investors

Neil Gross

Neil Gross is the executive director of the Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada). During his 30 years as a lawyer, he specialized in investment malpractice litigation and securities law.

Every company can calculate non-GAAP metrics however they want, so there’s real risk of investors and markets being misled

By Neil Gross |

Legendary film star Mae West once remarked, a little knowingly, that "too much of a good thing can be wonderful." But in the financial world, where access to information is generally considered a very good thing, is more information necessarily better?

Indeed, is it wonderful when companies supplement their regulatory filings with performance measurements not required under, and not defined by, generally accepted accounting principles (non-GAAP metrics)? Does this additional information help investors gain a deeper and more nuanced understanding of the company's true financial position? Or do non-GAAP metrics actually obscure rather than clarify?

Non-GAAP reporting is certainly on the rise. According to Bloomberg LP, 63% of companies in the S&P 500 composite index supplement their filings with non-GAAP performance numbers. That's up from just 20% in 2008. The increase has been even more pronounced among companies in the S&P/TSX 60 index, as a recent analysis states that only one of those 60 issuers still presents nothing but GAAP metrics in its regulatory filings.

That same analysis reveals how phenomenally buoyant non-GAAP adjustments tend to be when it comes to reporting income, earnings and profitability. In up to 90% of cases, adjustments conjured by management served to increase the relevant reported metric, resulting in the adjusted figure being materially higher than the GAAP-reported figure.

In effect, the majority of corporate management teams are telling the market that standard accounting rules and concepts understate their company's performance because they don't really "get" how the business works.

This might be true on occasion. No doubt, accountants don't understand some businesses. But do accounting rules misconceive corporate earnings and expenses 90% of the time? Not likely.

It's also unlikely that dollars get mightier over time, but that's what's being suggested in the non-GAAP universe. For example, in 2009, the net income reported by S&P 500 composite index companies on a non-GAAP basis was 36% higher than the net income they reported on a GAAP basis. By 2015, the same differential had somehow become 42%. Does that make any sense? Ordinarily, you would think, the dollar amounts might vary but the measurement differential should remain more or less constant.

Yet, that just highlights the key characteristic of non-GAAP metrics: they're not constant. They have no fixed definition and aren't bound by convention. Companies literally can make these metrics up as they go along and then change them whenever, however, and however much they like.

Canadian securities regulators place few constraints on this. For the most part, all they ask (and "ask" is the operative word, as their wishes are expressed only in non-binding guidelines) is that companies present GAAP numbers alongside their non-GAAP calculations, with equal or greater prominence, and that they provide a reconciliation between the two.

There's good reason for concern that this regulatory light-touch approach is failing. New research indicates some 35% of companies on the TSX 60 index may be non-compliant with the guidelines. In addition, recent reports from the Canadian Securities Administrators reveal that issuer disclosure has been deficient, on average, more than 70% of the time — including 20% of cases in which restatement and refiling have been ordered and a further 9% in which enforcement action had to be taken. Presumably, these numbers incorporate those cases where non-GAAP presentations were the problem.

Beyond the statistics, though, regulators should be concerned about whether there's a principled basis for the laissez-faire approach they've taken on the use of remodelled performance numbers. More information is good for investors only if it's good information. But the problem with non-GAAP metrics is that every company can calculate them however they want, so there's real risk of investors being misled if they try to compare companies on what seem to be, but actually aren't, similar yardsticks.

Also, nonsense numbers do have an impact downstream, polluting the well of information from which corporate valuations and market prices ultimately get drawn.

Commentators have noted that this is not a new problem. It was rampant two decades ago when dot-coms burst upon the scene, claiming their business models placed them outside the GAAP paradigm and supposedly justified sky-high valuations — even though most of the dot-coms had never yet earned a nickel of revenue.

It all ended badly back then. Must it happen again?
 

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