Peeling away financial reporting issues one layer at a time

Reining in “Non-GAAP Financial Measures”

At the recent AICPA-sponsored mega-conference on SEC and PCAOB developments (see KPMG’s summary, here), the SEC staff, and even its chair, devoted a significant amount of bandwidth to non-GAAP measures of financial performance.  Some see this as part of the ongoing damage control efforts necessitated by unintended consequences of rules issued in 2003, which set forth very rigorous (it was thought) conditions for when a non-GAAP measure of performance could be made kosher.  But, issuers have treated the rules more like a safe harbor than a set of constraints.  So long as one conforms to the letter of the Commission’s requirements, the thinking goes, the SEC staff is powerless to object.

Actually, I’m of two minds on non-GAAP numbers, and how the SEC should regulate them.  On the charitable side, GAAP is so full of warts, that it is not surprising when GAAP is downplayed in favor of more useful variants.  One doesn’t need to delve too deeply to appreciate this.

Let’s take one of the most rudimentary accounting topics: depreciation of long-lived assets.  If given a choice when valuing a company, most analysts would prefer to know EBITDA — easily the most ubiquitous non-GAAP measure — than reported net income.  This is mainly because simplistic rules and management discretion combine to make depreciation an arbitrary and capricious predictor of the amount of cash it will take to replace used-up capacity.  With regards to the former, GAAP doesn’t adjust the historic cost basis of depreciation for inflation — much less does it attempt to measure the current costs of the specific assets that are used to produce goods and services.  And with regards to gaming the numbers, estimation of useful lives, choice of depreciation methods and the timing of impairment recognition are the low-hanging fruit of earnings management.

Consequently, EBITDA has evolved as a GAAP workaround; and I for one am glad to know when issuers provide it, rather than each analyst having to separately make their own educated guesses.  Free cash flow is usually the key variable in valuation models, and many analysts start the process of estimating free cash flow with reported EBITDA.  As a first approximation of the value of a firm’s equity, they might use an appropriate EBITDA multiplier and subtract the value of the debt. A slightly more sophisticated analysis would separately estimate future capital expenditures and apply a multiplier to the resulting estimate of free cash flows; even more sophisticated models forecast multiple years and weight each year by the cost of capital.

But, on the cynical side, I recognize that any non-GAAP number is more prone to be abused by management than a GAAP number.  Non-GAAP numbers don’t require that debits equal credits. They are outside the scope of the auditor’s report.  They are subject to the whims of management with regard to the manner of calculation. And, they can be turned on and off like a water faucet.

One particularly noxious example that the SEC Division of Corporation Finance staff took note of at the conference was surely inspired by the drop in energy prices — and was the impetus for this post. Certain issuers in the oil and gas industry, being eager to mute the negative spin from cratering revenues and profits, recently devised an “adjustment” to GAAP revenues by substituting  “normalized” oil and gas prices for actual prices.  At first blush, a measure of “normalized” revenues would seem to be misleading, but to be as fair as I am able, these issuers may have been inspired to draw parallels to the worst rule ever created by the SEC.

Oil Price Volatility is So Inconvenient

Prior to 2010, oil and gas companies were required to disclose their quantities of “proven” reserves (in physical quantities as well as dollars) based on energy prices at the balance sheet date.  This would seem reasonable and uncontroversial, yet the SEC saw fit to change the base price from  a single-day closing price to a 12-month average price:

“Some [commenters] believed that reliance on a single-day spot price is subject to significant volatility and results in frequent adjustment of reserves. These commenters expressed the view that variations in single-day prices provide temporary alterations in reserve quantities that are not meaningful [I hate that word] or may lead investors to incorrect conclusions, do not represent the general price trend, and do not provide a meaningful [I still hate it] basis for determination of reserve or enterprise value.”

I have already picked apart this blatant kowtow to Big Oil in a contemporaneous post. I mention it here to put into context the attempt by oil and gas companies to engineer a new species of a non-GAAP performance measure, and the political pressure that today’s SEC staff surely had to face when considering whether or not to give Big Oil a pass.

I’m happy to report that the SEC staff didn’t fold.  Here is how KPMG reported it:

“The DCF staff has objected to the use of a non-GAAP financial measure adjusting sales to eliminate drastic declines in commodity prices. Underlying volatility in commodity prices in the industry makes it challenging to identify what constitutes a “normal price” and, thus, the amount of the adjustment. The DCF staff noted that the measure typically was included only when commodity prices moved in a direction that had a negative effect on reported results. [Italics supplied.]

But, the staff’s reasoning, at least to the extent reported by KPMG, is not fully satisfying.   While it was noted that reporting measures based on normalized commodity prices could be discontinued at will, the same can be said for all non-GAAP measures, good and bad.

Albeit undiplomatically, here is how I would have explained the objection to normalizing oil and gas revenues:

We recognize that GAAP stinks.  It stinks especially in the oil and gas industry where current period sales of oil and gas, produced from reserves that may have been discovered decades earlier, bears little relationship to current economic performance.  (Incidentally, that’s one of the most important reasons we require extensive supplemental disclosures by companies operating in this industry.)  But, with “normalized earnings,” we smell a rat.  It does not provide useful information to investors.  It stinks even worse than GAAP.  Period.

And If I Had Written the Non-GAAP Rules (with the benefit of hindsight)

Finally, although I realize that the staff cannot object to non-GAAP measures that meet the technical requirements set forth in SEC regulations, this is an opportune time to show how to tighten up the rules, which while well-intentioned, have made it too easy for issuers to play games with non-GAAP financial measures.  The AICPA’s conference is just one indication that the public would be better served if SEC resources could be devoted to other matters.    I would add the following requirements to the existing rules:

  • To disclose that non-GAAP measures are explicitly addressed in the issuer’s documentation of its disclosure controls and procedures, to assure that their calculation is specified in adequate detail, is calculated consistently and is not misleading.
  • To disclose whether the independent auditor provided the audit committee with a report on compliance with the non-GAAP rules (Item 10(e) of Regulation S-K); and if not, why not.
  • To display every non-GAAP measure in the five-year financial summary table required by Item 301 of Regulation S-K.  In this way, the issuer will also be required to describe any factors (such as accounting changes, business combinations or dispositions of business operations) that materially affect the comparability of the data.
  • If a non-GAAP measure is first presented in a given year, it must be presented for the previous 4 years and at least 5 consecutive future years.

Problem solved.

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