More on non-GAAP measures, or: just shoot me now

The CFA Institute has issued two related papers on non-GAAP measures, Investor Uses, Expectations and Concerns on Non-GAAP Financial Measures (NGFMs) and Bridging the Gap- Ensuring Effective Non-GAAP and Performance Reporting.

Here in part is how the first paper sums up its findings:

  • “Our survey results establish that company-reported NGFMs are useful for investors who apply them for varied reasons, including as a valuation input and as an indicator of accounting quality. We also find indications of sophisticated application of NGFMs by many investors, who make further adjustments including reversing questionable management adjustments so as to get the best view of economic reality. Nevertheless, because NGFMs provide one of the starting points for company analysis, there are multi-fold concerns around these measures.
  • There is an especially strong concern about exclusion of stock option expenses during NGFM calculation. It is also clear that many investors judge the appropriateness of different line item adjustments or exclusions on a case-by-case basis. They are generally uncomfortable with exclusions of recurring business expenses and comfortable with exclusions of truly one-off items (e.g., discontinued operations and one-off asset sales).
  • Our survey results also confirm that investors have concerns around the communication, consistency, comparability across periods and similar companies, and transparency of NGFMs. There are particular concerns related to the reconciliation of NGFMs to the most directly comparable GAAP/IFRS line items as well as on the inadequacy of disclosures around the adjustments made in calculating NGFMs…”

The second paper finds “a general sense that the ‘bite’ from securities regulators (e.g., enforcement actions) needs to match their ‘bark’ (i.e., overall intent to curb misleading NGFM reporting).” Among other things: “most investors expect and support the idea of standard setters providing guidance around NGFMs presented within financial statements. Another of our key findings is that there is strong support for some level of assurance on NGFMs.”

The two papers, taken together, represent a huge amount of intelligent consideration, and provide a lot of useful information and perspective. Still, I’ve been thinking for a long time now that no amount of additional contribution to the literature on this topic will do anything to change the playing field, and the CFA Institute’s two reports can’t possibly do much to change that impression. It seems to me that non-GAAP measures might have become the financial reporting equivalent of the self-absorbed “identity politics” that is said to have taken the Democrats off-track, distracting them from more pressing (but less easily articulated) sources of risk and mayhem. Take this passage from the first report:

  • “A particular worry is the risk of some investors mispricing companies’ securities by applying multiples-based valuation methods (e.g., value determined as a multiple, such as the price-to-earnings ratio [P/E]). Mispricing can occur if an investor fails to discriminate between a GAAP/IFRS-based earnings per share EPS and an adjusted EPS measure in the P/E denominator. Investor caution with NGFMs is also necessary for interpreting return on equity ROE or return on invested capital that is based on adjusted earnings in the numerator but a GAAP/IFRS-based denominator (i.e., equity), because such return calculations would give a misleading and overstated picture of headline profitability.”

Well, that’s fine, but an investor who makes a major resource allocation decision based solely on applying some multiple to a single number is doing little more than gambling anyway. If he or she then compounds the superficiality of the approach by carelessly applying the calculation to the wrong number (and, presumably, by not meaningfully engaging with anything else in the financial statements or MD&A), then how well are things ever going to turn out? Trying to help such people (if they exist as more than theoretical illustrations) is inherently futile. To varying degrees, the articulation of the problem seldom gets past this same problem of trying to save investors from themselves, many of whom don’t want to be saved anyway. It ends up tying the report’s author, Vincent Papa, in this hopeless knot during an interview with Accounting Today:

  • “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…”

Which seems like an accounting variation on the old complaint cited by Woody Allen: “The food here is terrible. And such small portions.” I agree with the point about enforcement action – if this is truly such an ongoing problem, then let’s find an example who really embodies what we dislike, and throw the book at them. Otherwise, if we’re not collectively willing to draw some brighter lines in this area (and plainly we’re not, if we can’t even decide on whether we want the portions to be larger or smaller), then I don’t think this continued whining reflects particularly well on anyone…

The opinions expressed are solely those of the author.

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