Non-GAAP financial metrics are back in the news today thanks to a fresh report from Audit Analytics, which finds that almost all large companies now report at least one such metric in their financial statements, and that the number of non-GAAP metrics the average filer reports has tripled in the last 20 years.
Audit Analytics looked at non-GAAP metrics reported by S&P 500 companies in 1996, 2006, and 2016. In that first year, only about 60 percent of companies used any non-GAAP metrics at all, and the average company offered 2.35 non-GAAP metrics per filing. Take a look at Figure 1, below, to see how that has changed over time.
By 2017, only 3 percent of the S&P 500 did not report any non-GAAP metrics. The most common non-GAAP metrics related to income: 82 percent of all companies offered some kind of adjusted income number — whether the company called it operating income or some other adjustment ginned up to make income look better than what traditional GAAP would allow.
Other common non-GAAP metrics pertained to earnings per share, EBITDA, cash flow, and funds from operations (a common, and GAAP-approved, metric in the real estate world). See Figure 2, below.
The rise of non-GAAP reporting has long been a complaint among the financial reporting purists of the world. Those complaints reached a crescendo in 2016 when the SEC published updated guidance on when companies can use non-GAAP, and how to reconcile those numbers back to standard GAAP so investors can follow the logic of a company’s non-GAAP thinking.
This Audit Analytics report shows that non-GAAP is still very much alive. It also captures some examples of non-GAAP that strain credulity.
Remember the Purpose of Non-GAAP
Consider the abstract question that non-GAAP raises. Should companies deviate from GAAP to provide investors a more complete picture of operations? Or should companies deviate from operations to give investors a more standard picture of financial performance? Which choice serves investors better?
Current SEC rules split the difference, by allowing companies to report non-GAAP metrics only if they also explain why those metrics are useful, and reconcile those non-GAAP measures back to the closest one allowed in GAAP.
OK, but then — why would some companies report multiple non-GAAP metrics of the same thing?
Audit Analytics flagged several instances where companies reported multiple non-GAAP measures of EPS: Medtronic, General Electric, Procter & Gamble, Boeing, and a few others. All of them reported two different calculations for adjusted EPS, plus the GAAP-approved EPS we’ve all seen at the bottom of the income statement for years.
Audit Analytics also found several companies reporting multiple non-GAAP metrics for cash flow. CenturyLink, for example, reported net cash provided by operating activities (a GAAP-approved metric) of $2.6 billion in 2017. It also reported “free cash flow” of $1.68 billion, “cash provided by operating activities before after-tax discretionary pension contribution” of $2.94 billion, and “free cash flow before after-tax discretionary pension contribution” of $2 billion.
That’s three different adjustments to net cash from operations, which is a critical metric for liquidity. Signet Jewelers, Amazon, Northrop Grumman, and Tenet Healthcare also provided three non-GAAP metrics for cash flow.
This is where I start to squint at corporate financial disclosures. One non-GAAP metric tells investors, “GAAP tells you this number, but we believe this other number better represents our true position.” Multiple non-GAAP metrics tell investors, “We can look at the disclosure this way, and it’s one number; or this other way, and it’s another number; or this third way, and it’s this other number.” Ad nauseam.
That seems more likely to confuse investors — especially “Mr. and Mrs. 401(k),” the retail investors that supposedly matter so much to SEC chairman Jay Clayton — more than inform them. At the least, companies disclosure controls that are airtight accurate, to reconcile all these numbers back to something comparable across multiple companies.
Or, as Audit Analytics diplomatically observed about General Electric: “In GE’s case, an overly complex non-GAAP presentation mirrors an overly complex business structure, which could, arguably, be correlated to poor stock performance in the past year.”
GE’s board seemed to make the correlation, since it just fired CEO John Flannery after 14 ham-fisted months at the top. Success should be a simple story, told with simple facts.
What Gets Adjusted
The most common adjustments are shown in Figure 2, below. None are breaking news unto themselves; companies have been using them for years. But…
First, adjustments related to taxes rose sharply in 2017, due to the arrival of tax reform at the end of 2017. Almost as many companies reported non-GAAP metrics that were lower than the GAAP counterparts, since they had been piling up tax deferred assets for years that were suddenly worth less thanks to the lower corporate tax rate, and that write-down flows through the income statement.
Second, we still see a stubborn number of companies adjusting for equity-based compensation, and that number can add up to lots of adjustment — especially for high-growth technology companies that might not turn much profit, and give out stock options like candy.
Non-GAAP is supposed to adjust numbers for one-time items: mergers, restructurings, goodwill impairment, tax law reform. Last time I checked, stock options were a fairly regular occurrence at most tech companies. So adjustments for equity pay deserve the evil eye, in addition to the squinting.