The non-GAAP financial measures pile-on continues. Certainly, the SEC has recently been making the public-speaking rounds and issuing CDIs warning companies of its concern about abuses of non-GAAP metrics, such as substituting individually tailored revenue recognition and measurement methods for those of GAAP or using a non-GAAP measure inconsistently between periods without adequate explanation. (See, e.g., this PubCo post and this PubCo post.) Now, this article in the WSJ suggests that there may be even more to it than just potentially misleading numbers: according to a study by consultant Audit Analytics, conducted for the WSJ, companies that lean heavily on non-GAAP measures to significantly pump up their earnings “are more likely to encounter some kinds of accounting problems than those that stick to standard measures….”
The study, which looked at companies in the S&P 1500 for the period 2011 to 2015, compared the incidence of formal restatements, revision restatements and material weaknesses relative to non-GAAP measures, both the incidence of use and the extent of “improvement” in earnings reflected in the customized metrics. Among companies that reported only GAAP measures, only 3.8% had formal earnings restatements and only 7.5% had material weaknesses in internal control. Among companies using non-GAAP metrics that showed adjusted earnings at least twice as high as their GAAP earnings (referred to as “heavy users”), the rate of formal restatement was 6.5% and of material weakness was 11%. Notably, the comparable rates for companies that used non-GAAP metrics but were not “heavy users” were only marginally higher than the GAAP-only companies: 4.5% had formal earnings restatements and 8.5% had material weaknesses in internal control.
The article acknowledges that these results do not “necessarily mean such companies are less scrupulous in their bookkeeping. But it does suggest that heavy use of metrics outside of generally accepted accounting principles—sometimes referred to derisively as ‘earnings before bad stuff’—could be a warning sign.” Although no specific causal relationship was alleged, according to a representative of Audit Analytics, “an overprominent user of non-GAAP metrics would justify more attention and is a red flag” because it may suggest that “a company’s accounting is ‘more aggressive.’”
Of course, it is well recognized that some uses of non-GAAP measures are appropriate and even helpful in understanding a company’s business. An example given in the article was “showing a company’s results in constant currency.” And, according to one Berkeley accounting professor cited in the article, the use of non-GAAP metrics should not automatically be read to signal aggressive practices: “For instance, companies using non-GAAP income measures to exclude employee stock compensation may be the kind of younger outfits that encounter troubles with accounting systems because they are expanding rapidly….But non-GAAP use could also signify a company is concerned with managing market expectations and ‘may be more likely to push the line on GAAP earnings….’”