Monday, July 22, 2013

Financial Reporting and the use of non-GAAP measures

After reading the CFO Journal on WSJ on the topic of "non-GAAP" measures, I would like to share my views financial reporting and the use of these non-GAAP measures.

Everyone is probably familiar with the accounting scandals in the early 2000s. SEC passed the Sarbanes-Oxyley Act to enhance financial disclosures for public companies. Nonetheless, 11 years after, there are still many companies taking advantage of loopholes in SEC's regulation G, which allows companies to report non-GAAP measures when they report results.

What are non-GAAP measures? These are operating and financial metrics that do not comply with Generally Accepted Accounting Principles (GAAP), hence the name "non-GAAP". Companies argue these non-GAAP are more representative of the financial position of the company for investors than traditional GAAP measures. Examples of non-GAAP measures include EBIT, EBITDA, adjusted EBITDA, Free Cash Flow, Funds From Operations (FFO). Although measures such as EBIT and EBITDA can be strictly calculated from GAAP financials, companies often make discretionary adjustments. Free Cash Flow may sound easy in principle but there are many companies that exclude working capital investments in their definition of Free Cash Flow, absurd in my view! 

As an investor, I think non-GAAP measures were created with good intentions but management took advantage of the lax regulation regarding non-GAAP measures and often  paint a much more rosier picture of the company. I gave some brief example below but I am certain that there are many company out there giving misleading non-GAAP measures.

Manipulating non-GAAP Financial Measures:

Be very careful when assessing the financial healthy of a company based on non-GAAP measures like adjusted EBITDA or adjusted earnings. Although the company claims that these measures exclude "one-time" (often called "nonrecurring" or "unusual") items, be wary of the claim. Under SEC regulation G, companies must reconcile non-GAAP financial measures with a comparable GAAP financial measure. Investor must conduct their due diligence to make sure that companies are not mis-classifying one-time items. Often, companies try to stuff regular expenses in unusual items so that their adjusted numbers look much more cleaner. Maintenance expenses, bad debt expenses and advertising expenses are NORMAL costs of operating a business. Excluding them in the adjusted earnings calculation inflate the profitability of the company and goes against common sense of doing business.

Another non-GAAP measure is revenue growth metric like same-store-sales. This is a commonly used metric in the retail sector. This metric is dependent on the definition of how many stores were active during a period. Many companies exclude results from stores that just opened and are less than 1 year old. Nonetheless, investor must pay attention to the how company defines active stores. A clever trick used by management to mask poor sales performance is to re-fine active stores. Krispy Kreme tried this trick in 2004 to mask the poor performance of its new stores.

Another actual example is Groupon when it filed for its IPO two years ago. It included a measure called "adjusted consolidated segment operating income" or adjusted CSOI. Adverting and acquisition expenses are not fully expensed in CSOI; instead they are treated like capital assets and only a portion of them gets expensed into CSOI. Treating marketing and acquisition expenses as capital assets is absurd in my opinion. Groupon or any company that uses CSOI as a non-GAAP measures assumes that the expenses will have future benefits but that's only IF those expenses bring in future customers or revenue. On the other hand, purchasing a machinery that can produce X amount of products is much more likely produce future benefits than advertising expenses. Therefore, it is obvious that the machinery should be capitalized [put on the balance sheet] while marketing costs should be expensed. [put on the income statement]

In the end, GAAP measures still matter: 

Most investors are focusing less on GAAP numbers and more on these pro-forma numbers. Nonetheless, GAAP measures still matter and investors should still pay attention to the reported GAAP income. As an investor myself, I understand that GAAP numbers are volatile and may be inappropriate to use in ratios such as P/E. Nonetheless, I average the earnings (as suggested by Ben Graham) and still utilize GAAP earnings for ratios such as P/E. Given that GAAP numbers are audited (companies still pay millions in annual audit fees after all), I can feel safer using GAAP numbers than use non-GAAP measures like "adjusted earnings".

Non-GAAP measures are helpful, but be wary when using them. Always double check what the measures actually mean and that the definition stays consistent over time.

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