There’s been a lot of media scrutiny over the use of non-GAAP accounting in the tech industry when it comes to reporting metrics that investors care about. The inflation of EBITDA and other practices are so common that the cumulative difference between GAAP and non-GAAP numbers has run into the tens of billions of dollars.
Non-GAAP accounting isn’t new, however, and the difficulty in tracking its use across industries is that every individual industry has different procedures for reporting their data. Where it’s inflated EBITDA in one industry, it can be adjusted cash flow in another. Today we’ll look at the practice in financial services, namely real estate investment trusts (REITs) and how non-GAAP accounting is flagging the attention of the SEC.
FFO, or “funds from operations,” is a common metric to report a certain type of REIT earnings. The National Association of REITs (NAREIT) defines FFO as net income (computed in accordance with GAAP), excluding gains (or losses) from the sale of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. When a REIT uses normalized or adjusted numbers in its calculation, they call this “Adjusted FFO.” It's a non-standard computation that can include a subtraction of recurring capital expenditures, periodic capital expenditures, or other KPIs.
This means that investors aren’t necessarily getting a true representation of the health of a REIT by just looking at a standard earnings report. They need to understand the context of this reporting by including non-GAAP adjustments and SEC comment letters. Take for example, REIT Company X. Here is their FFO vs. AFO:
A textual search of the MD&A reveals the discrepancies between AFFO and normalized FFO (the line above):
It’s clear that AFO is actively being used to smooth reported funds from operations, and that these numbers shouldn’t be taken at face value.
In short, the use of non-GAAP accounting is widespread, and just as it’s used to change the complexion of the tech industry (which, according to the New York Times article above, is to the tune of over $40 billion), it can also be used across other industries to paint a different picture of success and failure. It’s important for investors to evaluate these companies using a cross-section of several data sources before making important decisions. And with so much usable data available at your fingertips, there’s no excuse to find yourself stuck between a GAAP and a hard place.
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