Market Overview

Analysis: Officials Warn Non-GAAP Financial Measures May Lack Credibility

Share:
Analysis: Officials Warn Non-GAAP Financial Measures May Lack Credibility
Related MAT
How The Toys 'R' Us Bankruptcy Impacted July's Jobs Data
Barbie World Isn't So Fantastic: A Look At The Challenges Facing Mattel
Related SPY
A Peek Into The Markets: US Stock Futures Edge Lower Ahead Of Economic Data
What Is The Buffett Indicator?
Nomura Holdings Inc Buys SPDR S&P 5……, Sempra Energy, AT&T Inc, Sells United ... (GuruFocus)

Virtually all of the S&P 500 companies have posted earnings this season, and the figures have certainly skewed positive.

As of June 1, 78 percent of S&P firms reported earnings above consensus estimates, and 76 percent have reported greater sales than expected.

A strong earnings season may have provided the stock market with a much-needed shot in the arm, after the major indices fell into correction territory amid macroeconomic concerns in late March. Since then, the S&P has rebounded to pare those losses despite lingering macro uncertainty.

The catch: some are questioning the integrity of the numbers being reported. This is because 88 percent of S&P companies have reported “adjusted” results.

What It Means

Companies are allowed to report their own accounting figures that differ from GAAP, the set of standards required by the Financial Accounting Standards Board, as long as the GAAP numbers are reported too.

These non-GAAP measures, also known as operating or pro forma earnings, are purportedly meant to smooth out earnings volatility resulting from transitory conditions and events, but have long been suspected of being more useful to corporate managers in need of a crutch than to shareholders seeking to understand the company’s performance.

“The use of non-GAAP numbers is more prevalent now than before,” Dr. Howard Bunsis, a professor of accounting at Eastern Michigan University, told Benzinga in an email. “The majority of earnings announcements seem to have these non-GAAP statements and references, telling investors that it is the non-GAAP numbers that matter.”

Why It’s Important

History records a widening spread between S&P operating and reported earnings in the late stages of an economy’s expansion phase, with incremental increases driven by drops in reported earnings.

In the present expansion stage, the increase in spread originates from a rise in operating earnings, rather than a significant decline in reported earnings.

“The problem, and it is a big one, is that operating earnings are not a set line in the income statement [before] certain costs,” Bernstein analysts said in a note. “Operating earnings are a non-GAAP earnings number reflecting the opinion of what corporate management would like earnings to be.”

The analysts quoted Russell Golden, chairman of the Financial Accounting Standards Board, with concerns that some non-GAAP measures lack credibility and inaccurately depict company circumstances. Companies can omit “unusual” items based on relative definitions of “unusual.”

Essentially, non-GAAP measurements allow companies to put “a rosy spin” on performance. Clearly, some adjustments are useful and appeal to the principle of conservatism, like writedowns of goodwill and other assets during economic downturns. And to be fair, these types of adjustments are seldom reversed, unless there’s an acquisition — even during economic booms.

But many of these adjustments fail the smell test. Mattel, Inc (NASDAQ: MAT) on April 26 reported first-quarter results, making adjustments to exclude the impact of bankruptcy procedures undertaken by Toys ‘R' Us.

For a toy company, how likely are the consequences stemming from the liquidation of North America’s largest toy retailer to be confined to one quarter?

A widening spread in operating and reported earnings means that more companies are reporting non-GAAP numbers and, by Bernstein’s assessment, pumping opinion over fact.

“The reporting of non-GAAP earnings by companies and the alacrity within which investors use them is worrying,” the analysts said. 

TD Ameritrade Chief Market Strategist JJ Kinahan said GAAP is often the number cited more in media headlines, but both GAAP and non-GAAP can be useful depending on the kind of analysis that's being undertaken. 

"If you’re going to do deep analysis, you have to look at both. If you’re doing a quick headline analysis, you should probably look at GAAP."

What’s Next

If corporate earnings statements are truly losing their mooring to the truth, what, or who, will help investors navigate the earnings seasons to come? Who’s ultimately responsible to stem this tide of grandiloquence?

Some question why the Securities and Exchange Commission hasn’t been more aggressive. Despite a host of regulations designed to prohibit misleading financial reporting, the SEC isn’t known for pursuing enforcement actions against transgressors.

Still, there’s an argument to be made that it is investors themselves who are willfully ignoring the largely spin-free GAAP numbers that are always available.

“My view is that we should look at everything,” said Eastern Michigan University's Bunsis. “Of course GAAP numbers are the most complete view of how a firm performed.” Non-GAAP numbers are best not left totally ignored, he said. 

Dennis Dick, co-host of Benzinga’s PreMarket Prep, is less holistic.

“I wouldn’t even look at a non-GAAP number. I don’t get it.” Investors should be talking GAAP, and only GAAP, all the time, Dick said — and he seems to disagree with Kinahan on which set of numbers the media often promulgates.

“It sounds like a media problem ...they should be highlighting always the GAAP number and not the non-GAAP."

Studies Show Value Of GAAP Figures

Dick's pointed criticism is perhaps not entirely undeserved. Look back to that Mattel earnings report: with the stock moving higher, the headline story of Mattel’s Q1 became the unexpected surge in Barbie and Hot Wheels sales.

The $27-million sales reversal — and what portion of that was comprised of Barbie and Hot Wheels product is unclear — related to Toys ‘R’ Us was excluded, not just from Mattel’s operating earnings, but from most media coverage.

Financial media may not be in a position to lead the charge. The value of a media report on a company’s earnings is in its description of why the stock is reacting, and stocks move on earnings primarily for one reason: how they compare to analyst estimates. And analysts aren’t basing their estimates on GAAP numbers when non-GAAP figures are available.

Non-GAAP numbers are thought to give a better picture of a company’s cash flows and continuing earnings, two items often used in the valuation models analysts use to arrive at their stock recommendations. GAAP is seen as being too conservative and too reflective of past performance to be useful.

In 2014, the FASB cited a study that found non-GAAP metrics were inferior to GAAP in terms of correlation to stock returns.

A Springer Science study from 2012 found that earnings that included stock compensation — a favorite target for exclusion — have significantly greater ability to predict future earnings.

Others have noted the rise in firms tying executive compensation to operating earnings rather than GAAP, and that aggressive non-GAAP users are linked to greater incidence of financial restatements. Both higher exec pay and earnings restatement have been associated with poor future stock returns.

The Dance Between Analysts, Companies, Media And Regulators

So why the devotion to non-GAAP? Sell-side analysts would argue that while adjusted earnings often inflate results, GAAP often understates, leaving the most useful measures somewhere in between the two.

But are management’s numbers leading analysts to their forecasts, or are managers massaging their numbers to meet analyst projections? It's most likely both are occurring at the same time.

It is perhaps in analysts’ interest that investors remain persuaded that nebulous non-GAAP figures are what matter, as this perpetuates a shroud of complexity around matters of finance that could help sell their research.

It remains to be seen if financial engineering becomes so egregious that analysts forsake it for GAAP.

Or perhaps, as scrutiny intensifies, corporations will self-correct and scale back their use of earnings adjustments.

Maybe the SEC will take a firmer stance against the inclusion of figures in quarterly reports that obfuscate a company’s performance.

The question is whether any of the above will take place before financial media and the investors who make up its audience decide that neither non-GAAP earnings nor the analyst estimates derived from them are actually useful in the context of evaluating equities.

Facts are often less exciting than opinion, but could provide superior returns. And there’s nothing more exciting than that.

Lizzy Balboa contributed to this report. 

See Also: CIO: The 'Confidence' In The Bull Market Is Over

Posted-In: Analyst Color Earnings News Education Opinion SEC Trading Ideas General Best of Benzinga

 

Related Articles (DIA + MAT)

View Comments and Join the Discussion!

Benzinga's Bulls & Bears Of The Week: AbbVie, Lululemon, Netflix, Snap And More

Barron's Picks And Pans: Lincoln National, Salesforce, Dollar Tree And More