Better Ways to Look at Non-GAAP Accounting

Well, it’s happened. The financial reporting world has reached peak non-GAAP discussion.

The moment happened sometime last week. We had two research reports about use of non-GAAP accounting metrics published at the same time (one from Audit Analytics, the other from Calcbench and Radical Compliance), and a speech from Securities & Exchange Commission chairman Mary Jo White that mentioned it, and the Center for Audit Quality unveiling a guide audit committees can use to evaluate non-GAAP metrics.

Non-GAAP is everywhere. A task force within the SEC is studying it. The Public Company Accounting Oversight Board has its advisory group looking into it. Even non-accountants are talking about non-GAAP, from the Society of Corporate Compliance & Ethics and corporate law firms—groups that don’t usually seize upon the raw thrill of Generally Accepted Accounting Principles.

And that’s just within the last two weeks. Skim the speeches of SEC officials from earlier in the year, and you’ll see that non-GAAP has been one of the biggest corporate reporting concerns in 2016. The most useful discourse on non-GAAP probably came from Deputy Chief Accountant Wesley Bricker, who gave a speech in May that gave specific, detailed examples of the SEC’s concerns. Most of his points then ended up in the non-GAAP guidance the SEC published later that month.

Now we need to convert all that discussion of financial reporting rules into something useful for investors. Otherwise we really will have passed peak non-GAAP—the point at which all future discussion starts to generate more noise than insight, and finding that way forward will get ever more difficult.

So what can we do?

First, remember what investors are supposed to do with GAAP. A common refrain in all this non-GAAP talk is to say something along the lines of, “GAAP exists to ensure comparability of financial performance among companies.” At the simplest level that’s true—but it misses the larger point about why we want that comparability in the first place. We want to financial performance to be comparable among multiple companies so investors can reward successful companies and punish laggards.

That’s the goal we need to keep in mind as we think about how to handle all these GAAP and non-GAAP metrics. Once investors have access to the information they need to make intelligent financial decisions, regulators should declare victory and shut up.

View the debate through that lens, and a few points become clear. For example, the SEC’s nit-picky guidance about the presentation of GAAP and non-GAAP metrics (giving them equal billing in headlines, avoiding flowery adjectives, and the like) isn’t nit-picky at all. That guidance gets to the goal of not confusing investors. They can have fair, equal access to all data, and make up their own minds.

On the other hand, questions about the substance of non-GAAP metrics—that is, whether a non-GAAP metric provides useful information to investors—are much more complicated. If so many companies now report non-GAAP metrics of financial performance (88 percent of the S&P 500, according to Audit Analytics), then it’s fair to ask whether the problem is GAAP rather than all the companies coming up with their own narratives to tell investors.

Which brings us to our second step, have better dialogue among regulators, companies, and auditors about what to do. Right now, we have too many groups talking past each other about non-GAAP. My favorite example is Facebook, which reports a non-GAAP net income metric that excludes the cost of expensing equity pay. In 2015 that adjustment boosted its non-GAAP net income by 80 percent. And why does Facebook make this adjustment? Because it believes the GAAP accounting rules to report equity compensation expense are imprecise.

If that’s the case, then Facebook and other unhappy filers with high equity pay costs (tech and finance companies) can take it up with the Financial Accounting Standards Board again. But you can’t tell investors that they should ignore GAAP numbers because you think GAAP stinks.

Conversely, regulators (and others) can’t raise the specter that investors will be confused or overwhelmed by every non-GAAP metric they see. They try not to do that; just last week, Chairman White said, “we also allow, indeed require, companies to tell their own stories in their MD&A.”  The disclosure regime needs to help companies tell their story more accurately as much as it needs to help investors understand those stories.

Finally, a productive discussion about non-GAAP has to admit what investors really want. Yes, foremost they want reliable numbers—but they also want rising stock prices. Rising stock prices come from growth in revenue and earnings. So if those numbers are paramount, perhaps we should look more closely at all numbers companies cite as indicators of growth, GAAP and non-GAAP alike.

Does that mean some non-GAAP numbers should be audited? Maybe. (I can hear the CFOs gasping already.) Can we get audit firms to offer opinions on the substantive value of a non-GAAP metric, rather than just the metric’s accuracy? Possibly. (Now I hear the audit partners gasping, too.) Most likely, many other ideas are out there and worth considering.

Right now, however, all we have is lots of talk about the proliferation of non-GAAP. That doesn’t move the ball very much for investors.