More on non-GAAP earnings measures (how could it be otherwise…?)

The Globe and Mail recently devoted a surprising amount of space to non-GAAP earnings measures.

Here’s how it framed the issue:

  • “Imagine, if you will, something terrible: A fire begins in your home and rages, uncontrolled. No one is hurt, thankfully, because you’re away from the house at the time. But the structure is ruined and, financially, you’ve just taken a huge blow – because you failed to renew your home insurance policy.
  • You are devastated. But your accountant advises you not to worry. After all, the destruction of your house is merely a non-cash loss.
  • The example may seem extreme, but the accountant’s words are not unlike the message being offered to shareholders by many large public companies in Canada when they report sales and profits each quarter. In an attempt to burnish their image with investors and drive their stock prices higher, companies are offering up a host of gerrymandered measures to make their costs appear lower, to ignore real losses, and to make their profitability seem higher.
  • Restructuring costs, stock payments to executives, writeoffs from deals that went badly – all of these are being removed by corporate accountants who use “adjusted” measures of earnings. Company management justifies hiding some of these costs because, just like an uninsured house that burns down, they do not involve an immediate outflow of cash.
  • But the effect is often to deceive investors and to make many Toronto Stock Exchange-listed companies look healthier than they really are…”

The Globe’s coverage seems to have been inspired in large part by a new report from Veritas Investment Research Corp., indicating that “70 per cent of the members of the S&P/TSX 60 stock index of large public companies used some form of non-GAAP metric in their results as compiled by Bloomberg” and that “about 35 per cent of the members of the S&P/TSX 60 may not be following the guidelines of Canadian securities regulators about how they should present financial numbers.” The article quotes Veritas’ Anthony Scilipoti as follows: “This is the root of all evil, the current No. 1 problem in financial reporting…The regulators, investors, the auditors – this is a challenge for everyone involved. … It’s gotten out of control, and investors can’t assess what the truth is.”

Crucially though, Veritas isn’t calling for the root-of-all-evil practice to be banned. Scilipoti writes in an accompanying commentary: “..forms of non-GAAP measures have been around since the beginning of time and serve a purpose. Instead, we are calling for all stakeholders to pay greater attention to the issue. Securities regulators and auditors must enforce compliance with issued guidelines. Management teams must be more transparent. And investors need to stop believing blindly. Before accepting any financial metric – GAAP or non-GAAP – investors should at least consider three items: the business facts surrounding its presentation, the accounting conventions used in its calculation, and the preparer’s objectives.”

And that really is the point I think. The convoluted analogy with the insurance policy only works to a limited extent: the guy’s lost his house no matter what, and he has to find another place to live regardless, so the accountant’s just engaging in pointless spin. Investing in shares of a particular company doesn’t have much to do with that – no one compels you to do it, and the factors that go into making it a good or bad decision are complex and often volatile, depending on the characteristics of the entity itself and on the investing environment as a whole and on the individual risk-tolerance of the investor, all of which may constantly require reassessing. The article cites various instances in which entities steered investors into focusing more on an adjusted earnings measure than on the IFRS-compliant one, but the broader point is that even focusing on the IFRS-compliant measure doesn’t get you very far toward well-reasoned decision-making. Put another way, anyone who would be comprehensively misled by such measures can’t be a very reflective investor in the first place.

That assumes of course that the measures aren’t actually misleading, that an investor can understand how they’re derived, what their limitations are and so forth, in accordance with regulatory expectations and guidelines. In an accompanying interview, OSC Chief Accountant Cameron McInnis says these guidelines have worked well over the years, although the article holds out the thought that they might be upgraded into mandatory rules in the future. Among other things, this might make it easier to impose penalties for non-compliance. But in truth, I think versions of this issue will always be with us, because of the inherent tension between how some entities want to tell their story, and how some readers would prefer it to be told. Sometimes the tension plays out almost like a game that you can easily see through and largely roll your eyes at; sometimes it’s more problematic than that, but not so much that anyone with their wits about them should lose their house over it…

The opinions expressed are solely those of the author

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