Question

“Financial accounting metrics at companies ranging from Uber Technologies to Beyond Meat to We Co. have gotten creative, going far beyond the guidelines that fall under generally accepted accounting principles,” the Wall Street Journal reports. The article continues: “The number of companies reporting non-GAAP numbers has proliferated. In 1996, only 59% of filers used non-GAAP figures according to Audit Analytics. By 2017, that had grown to 97%.”

Required

a) What arguments do companies make in favor of disclosing non-GAAP (pro forma) numbers?

b) What should investors be concerned about with respect to non-GAAP disclosures by companies?

c) What steps has the SEC taken to minimize the potential abuse non-GAAP disclosures?

Answer 1

Question -1. What arguments do companies make in favor of disclosing non-GAAP (pro forma) numbers?   Answer -    There has been considerable debate about companies that use non-GAAP metrics for executive compensation and whether these firms are manipulating metrics to boost C-suite pay. For investors who follow environmental, social and governance (ESG) investing philosophy, a significant component of the governance factor is executive compensation and the metrics used to justify that pay. These investors and analysts need to be aware of non-GAAP metrics surrounding the debate, as excessive use of non-GAAP metrics and the aggressive adjustments done to reach compensation targets can suggest these firms are self-dealing and is a sign of poor governance.

The debate over non-GAAP executive pay metrics centers around two schools of thought. One argument suggests companies can use whatever metrics they want, including non-GAAP, but those metrics need to be transparently disclosed. The second school argues that certain non-GAAP metrics and adjustments are misleading and should be banned.

Question - What should investors be concerned about with respect to non-GAAP disclosures by companies?

Answer -  Non-GAAP earnings are an alternative accounting method used to measure the earnings of a company. Many companies report non-GAAP earnings in addition to their earnings based on Generally Accepted Accounting Principles (GAAP). These pro forma figures, which exclude "one-time" transactions, can sometimes provide a more accurate measure of a company’s financial performance from direct business operations.

However, investors need to be wary of a company's potential for misleading reporting which excludes items that have a negative effect on GAAP earnings, quarter after quarter.company's quality of earnings is important, so investors need to consider the validity of non-GAAP exclusions on a case-by-case basis to avoid being misled.

Question - 3. What steps has the SEC taken to minimize the potential abuse non-GAAP disclosures?

Answer -

Rules implemented by the U.S. Securities and Exchange Commission in 2003 impose additional disclosure and filing requirements on firms publicly disclosing non-GAAP earnings. We find the regulations produced (1) modest declines in the frequency of special- and other-item exclusions, (2) a decline in exclusion magnitude, (3) a modest decline in the probability disclosed earnings meet or beat forecasts, and (4) a decline in the association between returns and forecast errors. Our results suggest that, while the regulations reduced firms' use of non-GAAP disclosures to improve performance perceptions, they also reduced firms' willingness to use non-GAAP earnings to convey permanent earnings.