Tech Sector: Flouting the Spirit of GAAP Rules

Not long ago a group of corporate chieftains here in the United States—the CEOs of General Motors, Verizon, JP Morgan, BlackRock, Berkshire Hathaway, and others—published an open letter calling for several improvements to corporate governance.

One of their complaints was the increasing use of non-GAAP financial reporting metrics, when companies should stick to Generally Accepted Accounting Principles. They singled out one specific example: reporting inflated net income numbers with a non-GAAP metric that excludes equity compensation costs. As the CEOs put it:

It is important to note that all compensation, including equity compensation, is plainly a cost of doing business and should be reflected in any non-GAAP measurement of earnings in precisely the same manner it is reflected in GAAP earnings.

Bravo. One of the biggest irritations in corporate reporting today is many companies’ insistence on reporting a net income measure that excludes equity compensation costs, when GAAP (and common sense) plainly says that you can’t. More than any other squabble about using non-GAAP metrics, this example underlines the problem. Companies should not be able to present a more impressive net income number that contradicts the intention GAAP, just because they don’t like what GAAP tells them to do.

Still, how rampant is the reporting of non-GAAP that excludes equity compensation costs? Funny you should ask.

You might remember the special report Radical Compliance wrote with Calcbench, looking at non-GAAP net income numbers for more than 800 companies—where equity compensation costs were one of the largest adjustments made. Equity compensation adjustments for that group totaled $32.8 billion in 2015, roughly 20 percent of the $164.1 billion in total adjustments.

The leading culprits in this practice are, of course, technology firms. In our study, the IT sector had $20.9 billion in equity compensation adjustments, or 63.7 percent of that $32.8 billion that all companies made. No other sector came close either in dollars adjusted, or number of adjustments made.

To get a more current sense of this bad habit, I looked at second quarter earnings reports for some of the big tech players. We have this:

That is, the only tech company that respects GAAP’s rules for expensing stock options and other equity compensation is Apple—one of the few companies that avoids reporting non-GAAP numbers entirely. All the other notable tech firms above do try to polish the earnings report by adjusting for equity compensation and talking up a non-GAAP metric that is, of course, higher than GAAP.

Point of clarity: Amazon and Netflix don’t use the phrase “non-GAAP net income” directly; they prefer “cash from operating activities.” The spirit of what they want to do—make their operations look better than what GAAP allows—is the same.

I’m not sure which companies deserve the biggest eye-roll here: Facebook and Google, for the sheer size of their adjustments; or Yahoo and Twitter, whose adjustments are smaller in absolute terms but help those companies perform the financial reporting alchemy that turns a GAAP loss into a non-GAAP profit.

As I have stressed before, all of this is legal. Companies currently are allowed to report non-GAAP numbers to investors, so long as they also reconcile that non-GAAP number back to the closest similar GAAP metric (in this case, net income). What’s more, in many instances, some adjustments to GAAP are reasonable—companies do launch one-time restructuring programs, or face unusual expenses because of a merger.

This business of pretending that equity compensation isn’t real, however—that is not one of those circumstances. Like it or not, regulators decided 10 years ago that equity compensation is a cost of doing business, and you can’t exclude that any more than you can exclude your electric bill or your supply costs to make yourself look better to investors. GAAP is what it is. Companies that disagree with the rule for expensing equity pay (like Facebook, which has said as much in its filings) should take their complaints to the Financial Accounting Standards Board and the Securities and Exchange Commission.

What’s worse is that our cavalcade of CEOs mentioned at the top of this post are right: this is a simple governance matter. If the audit committee tells the CEO and CFO to knock it off, they will knock it off. Tech companies could end this exasperating part of financial reporting tomorrow if they wanted.

Apple has already done so, and good for them. Let’s hope its brethren in Silicon Valley and elsewhere follow suit.