In 2016, Bank of America reported that 90 percent of companies are reporting “adjusted” earnings — that’s up from 70 percent in 2010. Non-GAAP accounting measures have gained traction in adjusted earnings reports because they allow companies to smooth fluctuations caused by non-recurring items, such as write-downs. It’s become a widely accepted opinion among business owners that non-GAAP measures allow them to more accurately reflect the state of their business.But as experts in finance and investing have noted, this more unconventional approach also threatens the credibility of important financial data since it’s typically not audited and therefore adjustments are at the discretion of management.
The most highly regarded American investor and self-made billionaire, Warren Buffett himself, has been a longtime critic of non-standard accounting metrics — although he was recently called out by the SEC for using such practices himself. Buffett has said that financial analysts are guilty of “parroting the phony, compensation-ignoring ‘earnings’ figures fed to them by management.” He’s been particularly vocal in his criticism of stock-based compensation, which may be a non-cash expense, but which he’s said should nonetheless be considered an expense.
While Buffett may be the most prevalent example of a business owner/investor capitalizing on non-GAAP accounting measures, other experts are well aware of the trend.
Noted academic Aswath Damodaran wrote a lengthy review on the value and pricing of stock-based compensation as it relates to social media giant Twitter, in 2014. In it, he outlined the specific adjustments made by the company to get from its reported losses to profits, and from reported EBITDA to adjusted EBITDA. Twitter’s adjustments allowed the company to shift a substantial fourth-quarter loss — exceeding half a billion dollars — into a net profit of $9.774 million, and positive EBITDA of $44,745.
In response to comments of Damodaran’s review, he noted, “As for companies (that) report non-GAAP numbers, it is because investors and analysts actually use them. The fault lies not with the companies but with the rest of us for even paying attention to these numbers.”
Mary Jo White, Chair of the SEC, has also noted the prevalence of such measures in analyst reports and press coverage. In 2015 she announced to the National Conference of the American Institute of CPAs, that the SEC would begin reining in the most aggressive uses of non-GAAP accounting.
Non-GAAP accounting clearly isn’t going away, and it’s been proven that it can be both useful and harmful. Determining the real story starts with the management discussion and analysis.
The MD&A that accompanies financial filings will often include the backstory, rationale or context for a number. Of course, it can be difficult and time-consuming to comb through the MD&A looking for something specific. But it can provide the insight you need to determine if the facing financials are truly credible and accurate.
At idaciti, transparency in financial data is one of our core values. That’s why we’ve built a textual search function into our financial data software platform that allows users to find granular information within MD&A in seconds.
Let’s take a look at the MD&A of technology companies A and B. In technology, EBITDA is a KPI used to translate the value of a company to investors. Therefore, it’s in their best interest to present the most favorable measure possible. It also means that a textual search of the term “adjusted EBITDA” may yield some insights.
It is interesting that in its reconciliation from GAAP Net Loss to Adjusted EBITDA (showing profits), both companies had very significant add-backs of stock-based compensation. It’s questionable whether such add-backs (which basically turn a net loss into a ‘profit’) are warranted — and both Buffet and Damodaran have raised a similar concern.
Are these stock-based compensation expenses ‘non-recurring,' which can then lend credibility to the add-back? Probably not. Stock-based compensation is a mainstay of the technology industry, which uses it as a way of attracting deeper talent in lieu of salary, or as a way of incentivizing employees with dreams of ownership. It could be fair to assume that this is a more permanent expense, than transitory.
Unfortunately, many investors and analysts often pay far too much attention to this non-GAAP accounting measure. This is precisely what companies want you to focus on, because it allows them to 'manage' the numbers and create a positive illusion. Therefore, it is important to analyze and study the 'adjustments' made to reconcile GAAP income to non-GAAP income ('adjusted EBITDA) in the MD&A. You can also perform this analysis with idaciti:
Of course, to look back at several years of MD&A to see if this non-GAAP reporting is credible would normally take hours, days or weeks. With idaciti’s textual analytics, we managed to draw out these insights in minutes.
It’s easier than ever to scrub MD&A for terms like “adjust EBITDA” or “non-GAAP EPS” and find a number of incidences of each within the filings. And that means it’s easier to find the truth you’re looking for.
To learn how we're improving on financial tools and the functionality of databases like the ones used for EDGAR filings, read our "Letters to the SEC" series, starting here.
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