Reining in “Non-GAAP Financial Measures”

By Tom Selling

At the recent AICPA-sponsored mega-conference on SEC and PCAOB developments (see KPMG’s summary, here), the SEC staff, and even its chair, devoted a significant amount of bandwidth to non-GAAP measures of financial performance.  Some see this as part of the ongoing damage control efforts necessitated by unintended consequences of rules issued in 2003, which set forth very rigorous (it was thought) conditions for when a non-GAAP measure of performance could be made kosher.  But, issuers have treated the rules more like a safe harbor than a set of constraints.  So long as one conforms to the letter of the Commission’s requirements, the thinking goes, the SEC staff is powerless to object.

Actually, I’m of two minds on non-GAAP numbers, and how the SEC should regulate them.  On the charitable side, GAAP is so full of warts, that it is not surprising when GAAP is downplayed in favor of more useful variants.  One doesn’t need to delve too deeply to appreciate this.

Let’s take one of the most rudimentary accounting topics: depreciation of long-lived assets.  If given a choice when valuing a company, most analysts would prefer to know EBITDA — easily the most ubiquitous non-GAAP measure — than reported net income.  This is mainly because simplistic rules and management discretion combine to make depreciation an arbitrary and capricious predictor of the amount of cash it will take to replace used-up capacity.  With regards to the former, GAAP doesn’t adjust the historic cost basis of depreciation for inflation — much less does it attempt to measure the current costs of the specific assets that are used to produce goods and services.  And with regards to gaming the numbers, estimation of useful lives, choice of depreciation methods and the timing of impairment recognition are the low-hanging fruit of earnings management.

Consequently, EBITDA has evolved as a GAAP workaround; and I for one am glad to know when issuers provide it, rather than each analyst having to separately make their own educated guesses.  Free cash flow is usually the key variable in valuation models, and many analysts start the process of estimating free cash flow with reported EBITDA.  As a first approximation of the value of a firm’s equity, they might use an appropriate EBITDA multiplier and subtract the value of the debt. A slightly more sophisticated analysis would separately estimate future capital expenditures and apply a multiplier to the resulting estimate of free cash flows; even more sophisticated models forecast multiple years and weight each year by the cost of capital.

But, on the cynical side, I recognize that any non-GAAP number is more prone to be abused by management than a GAAP number.  Non-GAAP numbers don’t require that debits equal credits. They are outside the scope of the auditor’s report.  They are subject to the whims of management with regard to the manner of calculation. And, they can be turned on and off like a water faucet.