The use of non-GAAP financial measures is widespread and sometimes misleading. It can result in higher reported current earnings, forecasts of improved future results, and larger executive compensation.
The constant pressure to report favorable earnings performance motivates many companies to report income numbers that exclude unusual events that almost always seem to be costly and depress earnings. For many years, the use of financial performance measures other than Generally Accepted
In 1973, the SEC issued Accounting Series Release (ASR) No. 142, “Conditions for Use of Non-GAAP Financial Measures,” warning of possible investor confusion from the use of financial measures outside of GAAP. This release states: “If accounting net income computed in conformity with [GAAP] is not an accurate reflection of economic performance for a company or an industry, it is not an appropriate solution to have each company independently decide what the best measure of its performance should be and present that figure to its shareholders as Truth.”
One of the objectives of the
Adjusting Earnings
Aside from excluding unusual events for reporting to the public, another prominent use of non-GAAP earnings performance has been to determine executive compensation. Since the passage of the Revenue Reconciliation Act of 1993, executive salaries amounting to more than $1 million aren’t
For example, Exelon Corporation used non-GAAP earnings to pump up executive bonuses significantly. Its 2012 audited earnings per share (EPS), based on GAAP, were $1.42. To arrive at the publicly reported, adjusted non-GAAP operating EPS of $2.85, management made 10 separate adjustments that amounted to a net increase of $1.43 per share, a little more than 100%. Adjustments that increased non-GAAP EPS included plant retirements and divestitures ($0.29), merger and integration costs ($0.31), State of Maryland commitments related to merger ($0.28), amortization of commodity contract intangibles ($0.93), and Federal Energy Regulatory Commission (FERC) settlement ($0.21). These adjustments increased EPS by $2.02.
The adjustments that decreased Exelon’s non-GAAP EPS included mark-to-market impact of economic hedging activities ($0.38), unrealized gains related to nuclear decommissioning trust funds ($0.07), and reassessment of state deferred income taxes ($0.14). The total decrease amounted to $0.59. But the EPS used for bonus purposes was $2.91. In other words, Exelon added $0.06 arbitrarily.
Perhaps the most outrageous use of a misleading non-GAAP earnings measure to improve profits was when Groupon, Inc. reported earnings in its initial public offering (IPO) in 2011. It invented a unique measure called “adjusted consolidated segment operating income (CSOI).” The biggest difference from GAAP earnings was online
A sample of online earnings press releases from 2013 shows the variety of ways that large and recognizable public companies are describing the costs and expenses they have excluded from their GAAP earnings to arrive at improved non-GAAP performance (see Table 1). Some highlights include Callaway Golf Company, which not only excluded charges related to cost-reduction initiatives as well as gains and sales related to sales of certain brands or products transitioned to a third-party model, but it also presented sales on a constant currency basis and calculated taxes at an assumed rate.
Electronic Arts excluded acquisition-related expenses, amortization of debt discount, certain nonrecurring litigation expenses, change in deferred net revenue (e.g., packaged goods, digital content), loss (gain) on strategic investments, restructuring charges, stock-based compensation, and income tax adjustments. And Gannett Company excluded special items consisting of workforce restructuring charges, transformation costs, pension settlement charges, a noncash impairment charge, a currency-related loss recognized in other nonoperating items, and certain credits to its income tax provision.
Gannett says it believes that such expenses and credits aren’t indicative of normal ongoing
A Broken System
Several conclusions seem obvious about the relevance and usability of the current financial reporting system. Even considering the imprecise nature of current accounting standards, it’s too easy for companies to turn poor GAAP earnings into great non-GAAP earnings by simply designing their own performance measures that can readily be adjusted to unethically report successful accomplishment of the goals created using those same measures. Consequently, non-GAAP earnings reporting should be strictly limited and permitted only in extraordinary circumstances—that is, in cases where current GAAP doesn’t clearly reflect economic reality. Companies should have to demonstrate a real necessity and communicate meaningful, unique reasons why they believe using a non-GAAP measure is mandatory to avoid misleading investors and others, not just to portray better short-term profits, earn bigger bonuses, and cash in on stock options.
The widespread use of non-GAAP performance measures seems to provide conclusive evidence that the current financial reporting system is broken. Neither the SEC’s December 2013 “Report on Review of Disclosure Requirements in Regulation S-K” nor the February 25, 2014, Financial Accounting Standards Board (FASB) news release, “Post Implementation Review Concludes Fair Value Accounting Standard Meets Its Objectives,” addresses the need for basic reporting reform.
The Public Company Accounting Oversight Board (PCAOB) should reconsider Release No. 2012-004, which states, “The
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Curtis C. Verschoor, CMA,
©2014 by the Institute of Management Accountants (IMA®), www.imanet.org; reprinted with permission.
Reprinted with permission from Strategic Finance.