Question

In: Accounting

Do nonGAAP metrics rationalize dividend policy?

Do nonGAAP metrics rationalize dividend policy?

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Expert Solution

This is a tip for reviewing REITS (Real Estate Investment Trusts). While REITS are required to require to report EPS since it is a GAAP metric, the industry standard metric is FFO (Funds from Operations) and AFFO (Adjusted Funds From Operations). To calculate FFO, add back depreciation and gains/losses on sales of real estate to net income (while AFFO may include other adjustments). Management is required to provide a reconciliation from EPS to FFO in their quarterly filings since FFO is a non-GAAP metric, so an investor can find a REITs FFO/AFFO figures in their Form 10-Q and 10-K. Whenever I assess a REIT’s payout ratio, this is the metric I will use in the denominator rather than EPS.

I believe the use of non-GAAP income measures has crossed the line of propriety and now does more harm than good. Accounting practitioners and regulators need to get U.S.-listed businesses to stop using non-GAAP earnings and earnings per share (EPS) figures in company earnings releases. Failure to do so may bring a race to the bottom as companies use ever-more-aggressive accounting presentations to curry favor with investors and analysts. The unchecked use of non-GAAP measures risks significant harm to U.S. financial reporting.

HISTORICAL BACKGROUND :-

The U.S. accounting environment is the most sophisticated in the world. Users of audited, GAAP-based financial statements take comfort that reported balances are generally comparable across companies. But the United States has struggled for a century to find agreed-upon ways to report financial performance. Getting to where we are today has been a bumpy road, and there is no easy way out of the current situation. If history is any guide, it will take considerable effort to rein in use of non-GAAP earnings.

Modern financial reporting emerged in the 19th Century as American railroad managers published financial information to persuade anxious British investors to support capital-intensive expansion in North America. Disclosure eased concerns of outsiders worried about getting their money back.

An early controversy was accounting for depreciation of equipment. Gradual wear and tear from rail activity degraded the earnings power of fixed assets. Most companies wrote off original costs when equipment was removed from service. Failure to provide for depreciation overstated periodic income and may have motivated railroad executives to favor dividend payments over capital reinvestment. Late investors who valued stocks on unsustainable dividend yields faced disappointment when the companies reduced dividends to fund needed capital expenditures.

In 1906, Congress passed the Hepburn Act to allow the Interstate Commerce Commission (ICC) to regulate railroad rates and impose uniform accounting practices. Rules promulgated by the ICC required railroads to include a provision for depreciation on their income statements. Railroad executives pushed back, arguing that uniform accounting rules were unnecessary. The ICC dithered and chose not to enforce its regulations vigorously. Thus, the first attempt to standardize financial accounting failed.

For technology operators, the deep seated issue is which constituency is favored in capital distributions. It could be management, employees, shareholders, even their domicile. When management’s largesse favors themselves and key employees, Wall Street analysts rationalize this obscenity by figuring valuation on non-GAAP rather than GAAP accounting conventions. Non-GAAP numbers X-out annualized options dilution.

Over the years, mega cap companies like IBM, General Electric, Microsoft, even Exxon Mobil have moved closer to shareholder based gratification. IBM is the best example where management, years ago, went public with their coherent policy which embraced an aggressive share buyback program as well as rising cash dividends based on earnings growth.


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