(Editor's Note: This article reflects the views and opinions of Editor Marc Pentacoff and does not reflect the views of Seeking Alpha or its editorial team).
GAAP stands for generally accepted accounting principles created by the Financial Accounting Standards Board and SEC rulemaking. Non-GAAP refers to accounting practices not defined by those organizations. Under Regulation G, companies can present non-GAAP if there is a reconciliation to GAAP and provided that it is not misleading or more emphasized.
Approximately 90% of the S&P 500 (NYSEARCA:SPY) are reporting non-GAAP, up from 72% in 2009. The divergence between non-GAAP and GAAP earnings has hit a hefty 28.9% in Q1 2016. Is non-GAAP a more useful tool than GAAP? Should journalists and the financial profession be focusing on non-GAAP or GAAP when reporting earnings?
GAAP always needs to be adjusted to create a forward-looking perspective, but as of late, too many managements are reporting a rosy history by using non-GAAP measures.
While the empirical literature is mixed with regard to whether GAAP or non-GAAP better explain equity returns, it is consistent on two issues: (1) non-GAAP figures are almost always higher than GAAP; and (2) that a significant portion of corporate managers use flexibility in non-GAAP to opportunistically meet analyst expectations.
Accounting Vs. Finance
Accounting and finance have different ends in mind. Accountants set out to properly and fairly record the changes in balance sheets over time - the income and cash flow statements are basically a reconciliation of balance sheets through time.
Accountants are backward-looking, but the financial analyst wants a forward-looking take. For this reason, they will remove items which they don't believe are helpful from a forward-looking perspective. They often advocate the removal of some non-cash charge on the basis of it being non-cash today, even if it was a real cash expense in the past.
But beyond the question of which adjustments are fair, the biggest issue with non-GAAP is that analysts and the media are treating it as authoritative. The second issue is that some managements are taking advantage of the first issue.
To illustrate this, we will use a contemporary example: Valeant Pharmaceuticals (NYSE:VRX). We will only deal with the period before Q4 2015 to illustrate the problem of non-GAAP and the culture surrounding it.
Valeant's Non-GAAP Cash EPS
On October 19, 2015, Valeant reported Q3 2015 results:
GAAP EPS $0.14; Cash EPS $2.74
The company also offered us this guidance for Q4:
Cash EPS increased to $4.00-4.20 from $3.98-4.18
How did the newspapers report this? Here is the Wall Street Journal's take:
"Valeant's latest earnings report contained everything investors usually want to hear. It reported third-quarter revenue of $2.8 billion and adjusted earnings per share of $2.74. Both topped analysts' estimates. And the company once again raised its full-year guidance for the top and bottom lines."
Notice that the journalist calls it "adjusted earnings per share" and reports it as if it were official, referring to it as the company's "bottom line."
Two points: (1) this figure isn't an "earnings" figure from an accounting or financial point of view; and (2) a journalist at a reputable paper reported non-GAAP without blinking. Meanwhile, Valeant only listed $2.14 per share in GAAP cash from operations for the period.
To quote venerable Chair White, "You can never use a non-GAAP measure in a misleading way."
In the same interview where the above quote is from, there is this exchange:
Mary Jo White: "One of the things that we get reports on that causes us some concern is whether some analysts are distinguishing as they should be between the GAAP and the non-GAAP measures."
Mr. Berman: "They aren't. They're focusing on non-GAAP measures."
Pithy and accurate. There is no question that non-GAAP has become authoritative to a segment of the financial profession. This is the primary problem - and we are all the problem. Seeking Alpha similarly reported Valeant's Q3 earnings as:
Valeant Pharmaceuticals: Q3 EPS of $2.74
Revenue of $2.79B (+35.4% Y/Y)
EPS of $2.74? No sir, that is non-GAAP cash EPS. That isn't even an earnings figure since it neglects to take into the capital spend necessary to maintain earning power, i.e., amortization or depreciation or their real cash counterparts, capital expenditures.
Let's take a look at Valeant's reconciliation for this period:
Notice that the biggest difference between net income and non-GAAP "cash EPS" is "amortization and impairment of finite-lived intangible assets." Since these assets are, by definition, finite-lived, their earning power will diminish over time. This is what those amortization charges are trying to represent.
A major divergence between GAAP and non-GAAP, as above, indicates that the flow of value according to inflexible accounting rules is very different from the flow of value according to management.
If Valeant were a manufacturer, no one would accept that ignoring depreciation or capital expenditures is faithful to reality since the depreciation charge is an estimate of the obsolescence and wearing out of PP&E. Reinvestment in PP&E is a requirement for most businesses - this implies Valeant wasn't counting all of its costs in cash EPS when it excluded amortization. Calling it "EPS" could be "potentially misleading." What was needed here was a critical look at the company's GAAP to non-GAAP reconciliation and a questioning of the biggest factor in the difference:
- It is really non-recurring?
- It is really non-cash in the long run?
The management of Valeant was trying to get the media to ignore the fact that the asset side of the balance sheet was shrinking without reinvestment - just like most do through depreciation and depletion.
The S&P 500
According to FactSet, there is a growing divergence between GAAP and non-GAAP:
With the difference hitting 28.9%, we need to ask ourselves what this means. The managements of the S&P 500 companies are essentially advocating that we ignore expenses from recent periods, which would lower earnings by nearly 30%, claiming that a large portion of those expenses are non-recurring or non-cash. And they are - the big 28.9% mean difference is due largely to excluded goodwill and asset impairments related to the fall in crude oil prices. These are non-cash and are not helpful for a forward-looking perspective, expect for their reflection on management.
At the same time, when corporations periodically report earnings under the 1934 Securities Exchange Act, they are supposed to be reporting "how they did," not "what is my earning power now." What happened recently is that the asset side of the balance sheet of S&P 500 got whacked in a revaluation - but it won't happen again, they say.
Critics generally advocate for non-GAAP by attacking GAAP. But they are attacking a straw man by suggesting that accounting serves a different function than it does. Some have also claimed GAAP is as malleable as non-GAAP, which would be a basic misunderstanding of accounting practice.
What the critics seem to forget is that accounting is there to serve as a comparable and accurate record of history. The accountant's job is to capture all balance sheet changes, including those which are purely historical and have no cash component.
A bigger cultural issue with GAAP's critics is that they are ignoring that many corporate managements are using non-GAAP to make themselves look good. For instance, research suggests that corporate managers are able to beat estimates with unexpected exclusions. It also seems the that companies which report non-GAAP figures beat estimates more frequently than companies which do not. One paper reads:
"Our study shows that managers can opportunistically define alternative earnings measure to exceed analyst forecasts."
And ahead in the same paper:
"This paper provided evidence for a previously undocumented tool that managers use to meet or beat forecasts: managing the actual definition of earnings."
I noted that the financial analyst always has to adjust GAAP figures because they are just a form of record keeping and are backward-looking in nature. What we are doing when we ignore GAAP and look only to non-GAAP is to say that the past isn't important. Most adjustments are due to historical actions, which are still "flowing through" to the income statement today. But clearly, the future can only be projected from a faithful representation of the past.
Discussion of Common Adjustments
A large number of companies remove stock-based compensation from their non-GAAP. This is a real expense. GAAP already tends to understate stock option-based compensation expense due to Black-Scholes systematically underpricing longer-dated options. Therefore, these adjustments to GAAP are typically inappropriate.
One of the most acceptable adjustments is goodwill impairments, partially because they tend to be enormous relative to earnings and are a writing off an intangible asset. The primary thing to consider when you see a goodwill impairment adjusted out is to remember that this loss is real and it reflects a negative judgment on a past investment decision. It is true that GAAP has a downward bias with goodwill - you cannot write it up - however, impairments are glossed over and forgiven too easily by analysts. They are real losses - the cash and value simply went out the door in the past.
Amortization of Customer Relationships
In the acquisition process, a value is frequently given to a new intangible asset called "customer relationships." This is assigned a life span, and the accountants amortize it going forward, reducing future net income. This specific merger accounting figure can frequently be adjusted out. In the acquisition process, other assets are similarly written up or created, which have only a semblance of economic reality. These are reasonable adjustments. That said, purchased intangible assets with a finite life, which might be written up in an acquisition, should be amortized and not adjusted out if their earning power will need to be replaced.
These costs can be a good adjustment, at least insofar as you are trying to see through the mess of an acquisition or a corporate reorganization. However, it frequently happens that restructuring costs recur every year. If that is the case, do not remove them, as they are no longer a one-off expense but a cost of doing business.
Depreciation and Amortization
Depreciation and amortization are "reserve" type charges, which represent the approximate wearing out, obsolescence, or estimated end date of a productive asset. These charges spread out the cost of the investment to future periods when the asset will also be used. These charges are supposed to represent an estimate of future reinvestment in the business, if all else was equal between the periods (it won't be).
The accounting techniques for depreciation are crude and frequently don't reflect the underlying reality - sometimes they overstate the case, and other times they understate it. A back-of-the-envelope way to get some perspective on this question, and adjust GAAP as necessary, is to estimate needed reinvestment in a business from historical capital expenditures and acquisitions as found in its cash flow statement. It is never appropriate to assume depreciation and amortization is not a real cost - one is always inspecting the extent to which those charges are too small or too large.
Before we conclude, take note of the chart below which lists the impact of various non-GAAP adjustments, as a percent of the total adjustment, for the period of July through September 2015 (source):
Non-GAAP serves a critical role for management communication, but it cannot replace the tough record-keeping qualities of GAAP. Managements have been well incentivized to use non-GAAP since the media has been taking them as gospel. And like many phenomena in the stock market, some exploited this pattern to fantastic effect. The empirical literature suggests that a significant portion of management teams are opportunistic with their non-GAAP, using it to hit analysts' expectations.
Accounting is the language of business, and its rules are incredibly easy to criticize but notoriously difficult to improve. The difficulty of improving U.S. accounting rules is, in my view, a sign of their general quality. The media and the financial profession are too quick to dismiss the testimony of the financial statements.
Disclosure: I am/we are long SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.