The debate over the use of non-GAAP performance measures continues. Even as the prevalence of these items grows in the financial reports of public companies (and those that want to be), cautionary tales of the uses and abuses of such metrics garner headlines. A recent New York Times piece entitled “Fantasy Math Is Helping Companies Spin Losses Into Profits” pretty much sums up one side of the issue with its headline alone.
The NYT piece focuses on companies that provided measures of “adjusted earnings” which had been adjusted to remove items like stock-based compensation expense, restructuring costs, asset write-downs, and other items that the subject company considers unusual or non-recurring. Citing a study performed by The Analyst’s Accounting Observer, 30 companies on the S&P 500 that generated accounting losses in 2015 were found to have reported profits “on an adjusted basis” after corrections for these non-recurring items.
Is there anything wrong with this picture? Well, in my opinion, not necessarily.
Accounting rules are just that – accounting rules. Many companies actually operate their businesses using internal metrics that might focus more on cash flow or recurring revenues or run-rate performance. This is not to diminish the need for disclosure of GAAP-compliant financial statements. But if something is truly non-recurring, perhaps like a non-cash goodwill impairment charge or a hefty legal settlement, those things at least deserve consideration for exclusion when thinking about ongoing earning power. One has to be careful, however. As Chris Mercer often says, “business life is full of one non-recurring event after another.”
The inclusion of metrics like adjusted EBITDA (arguably the most popular non-GAAP measure) can be helpful to analysts and investors, but only when accompanied by the discrete adjustments used by management to arrive at such a figure. As recently noted by venture capitalist Fred Wilson, “[this] is not spinning. [It] is transparency and it is good.”
Even the FASB has commented that having two sets of information can be a powerful analytical tool in understanding the underlying business. To address this issue, the FASB’s Financial Performance Reporting Project aims to evaluate ways to improve the relevance of information presented in the performance statement. In April, the SEC also voted to solicit public comments on modernizing certain business and financial disclosure requirements in Regulation S-K.
Mercer Capital has previously written on this topic in context of initial public offerings and stock-based compensation expense, and we will continue to monitor the development of these initiatives. If you have questions about how we treat non-GAAP metrics from a valuation perspective, please contact a Mercer Capital professional.
Related Links
- Equity-Based Compensation: Are Non-GAAP Earnings Misleading?
- Non-GAAP Measures are Gaining Popularity in IPOs
- Our Economy Has Changed. Should Our Accounting Standards?
Mercer Capital’s Financial Reporting Blog
Mercer Capital monitors the latest financial reporting news relevant to CFOs and financial managers. The Financial Reporting Blog is updated weekly. Follow us on Twitter at @MercerFairValue.
