Unofficial Earnings Measures Problem
According to Sherman and Young (2016), albeit unofficial measures of revenue are relatively novel for many firms, all types of businesses have been using non-GAAP and non-IFRS measures of earnings for a considerable time. A particularly popular unofficial earnings measure among private equity investors is Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA). This is because EBITDA is thought to offer a quick proxy for the amount of cash flow that is available to service debt (Sherman and Young, 2016). Thus, alternative metrics that were once utilized by companies sparingly have become increasingly universal and more detached from actual or real figures. Nonetheless, as Sherman and Young (2017) reiterate in their report, it is not strange for alternative measures of earnings or revenue to result in problems. Given that companies formulate their own techniques of computation, there is no vivid and definite way of comparing the metrics from one company to another or in most occasions, from one financial year to another within the same company.
One of the key prerequisites of Sarbanes-Oxley is that companies on the United States exchanges should reconcile Generally Accepted Accounting Principles measures of earnings to non-GAAP measures (Sherman and Young, 2016). Companies that report under International Financial Reporting Standard (IFRS) also have a similar requirement. The Securities and Exchange Commission (SEC) also requires that company management be capable of espousing the reasoning behind their inclusion of alternative measures in their financial disclosures. For instance, a firm can justify the use or inclusion of a non-GAAP measure of earnings by stating that it is needed by one of its bond agreements. In as much as, such alterations and regulations are positive steps in curbing the problem of unofficial earnings measure, they are yet to solve the problem and significant discrepancies in reporting still persist. For instance, Twitter reported a GAAP loss per share of $0.96 in 2014, but also reported a non-GAAP profit of $0.34 per share in the same year. Amazon also reported GAAP earnings per share of $0.37 in 2015, as well as, non-GAAP earnings per share $4.14 as revealed in the report by Sherman and Young (2016). Based on Amazon’s financial reporting, the earnings measures imply that alternative measure produced a relatively modest price-to-earnings ratio of 106, instead of the mind-boggling 1,192. This finding suggests that unofficial measures may be a better representation of earnings which in reality is not true. This is because alternative measures tend to be normally idiosyncratic.Unofficial Earnings Measures Problem
Common unofficial earnings measures such as EBITDA can be non-comparable from one business to another or from one year to another in the same company due to discordances in what is incorporated or exempted from the calculation. Other common non-GAAP measures that companies use in their financial reporting are adjusted net income, adjusted EBITDA, EBIT, free cash flow, same-store sales, sales per square foot, adjusted revenue, EBITDAR, adjusted EPS, funds from operation and average revenue per customer (Voss, 2016). The proliferation of such unofficial or alternative metrics only poses further problems for investors. Moreover, they cause harm to the companies by overstating their growth prospects beyond what standard GAAP measures would normally espouse, obscuring their financial health and rewarding executives of the companies beyond what can be justified based on their financial positions. As such, analysts and investors should exercise immense caution in their interpretation of unofficial earnings measures and also closely evaluate the corporate explanations that management give for using the alternative metrics. Moreover, top executives, corporate strategies, board members and compliance officers need to make sure that the alternative measures that companies use serve the purpose of reducing bias and improving transparency in financial reports.
Historical Background-unofficial Earnings Measures Problem
Unofficial earnings measures have become increasingly common among large companies. As Jagannath and Koller (2013) report, McKinsey and Co. discovered that all of the twenty-five largest nonfinancial companies based in the United States reported a portion of their earnings using non-GAAP measures. In addition, a survey conducted by PWC (2016) also found that ninety-five of the Financial Times Stock Exchange 100 Index entities utilized different forms of unofficial or non-GAAP measure. The report by Sherman and Young (2017) revealed that in 2016, the chairman of the International Accounting Standards Board (IASB), Hans Hoogervorst asserted in an address to the European Accounting Association that more than eighty-eight percent of the companies that constitute the S&P 500 incorporated unofficial metrics or non-GAAP metrics in their earnings report. Hoogervorst further added that eighty-two percent of the earnings reported by the companies that used non-GAAP measures indicated higher profits than they would have reported using Generally Accepted Accounting Principles metrics. This evinces that the intention of the companies for using these non-GAAP measures was to present these results in a favorable light.
There is no doubt that companies are using unofficial earnings measures. However, there are certain contexts whereby alternative financial reporting is not used. A good example is in the United States whereby alternative financial reporting is not used in quarterly Form 10-Q filings and annual Form 10-K which are scrutinized by the SEC. This is because the SEC requires that companies using non-GAAP measures reconcile them with their closest or most similar GAAP equivalents. Nonetheless, despite these measures by the SEC, alternative financial reporting is becoming more the norm than the exception in numerous companies. This is evident in the earnings-call summaries and press releases that frequently portray non-GAAP measures that are increasingly detached from their GAAP-based equivalents as Sherman and Young (2017) report. In addition, financial reports by third parties that are prepared from the SEC filings such as articles in the business press and analyst’ reports can and often utilize unofficial earnings measures without referring to or reconciling them with GAAP measures. This point is reiterated by Seetharaman (2017), who states in his report that recent articles regarding Yahoo, Groupon and LinkedIn among other companies point out their non-GAAP profits or earnings, but fail to mention their GAAP losses. Thus, in various settings, non-GAAP measures or unofficial earnings measures have assumed their own trajectories when it comes to financial reporting.
The real issue of unofficial earnings measures/non-GAAP metrics-unofficial Earnings Measures Problem
The most justifiable and least problematic non-GAAP measures are those that provide vital information that official GAAP measures do not offer, for instance, sales figures. In real sense, the more problematic issues are custom measures that suggest an alternate way of computing things that official figures already compute. In various situations, these custom metrics avail an alternative representation of earnings by eliminating one or more expenses that are required by Generally Accepted Accounting Principles. Alternative financial reporting using unofficial measures can provide a useful point of view about a company’s ability to deliver recurrent or sustainable earnings. Notwithstanding, it is not always vivid whether the rationale of the company for utilizing non-GAAP metrics is to assist people discern the company better or merely to paint the company’s financials in a more favorable light (Sherman and Young, 2017). A good example of such confusion in interpretation is evident in PepsiCo Inc.’s 2015 annual report. Even though the report included a 33-page reconciliation of non-GAAP information and GAAP information, some of the explanations were not entirely clear or convincing.
According to Sherman and Young (2017), PepsiCo reported its 2015 net revenue as $63 billion which was 5.4% lower than the previous year’s revenue. Moreover, some of the profit measures also declined. The decrease in revenue can be attributed partly to the strength of the dollar in 2015; a phenomenon which prompted Pepsi’s management to claim that organic revenue growth which is a non-GAAP metric used by the company, the impacts of divestitures and acquisitions and the effects of foreign currencies rose and did not decline. This argument by management would have not only been plausible but also stronger if not for the company’s explanations in previous years that perceived and treaded impacts of divestitures and acquisitions, as well as, adjustments for foreign exchange fluctuations differently. For instance, based on Pepsi’s 2007 annual report, management pointed to the company’s 12% growth in sales as being based on GAAP measures and figures (PepsiCo, 2007). It is vital to note that the 12% increase in sales reported by PepsiCo in 2007 comprised of two percentage points of net revenue growth that are attributable to foreign exchange impacts emanating from a weak United States dollar, as well as, a 3% growth from acquisitions. The implication of this difference in financial reporting and metrics is that in 2007, PepsiCo’s non-GAAP organic revenues improved by only seven percent instead of twelve percent. In other words, PepsiCo financial reporting focused on GAAP measures and revenues in 2007 and unofficial or non-GAAP measures and revenues in 2015, indicating that the company chooses different measures to use and discordant figures to report as long as it sends a favorable message of its financial performance as Sherman and Young (2017) report.
In the same way, companies have continued to adjust their reported earnings to refrain from including mainstream expenses such as regulatory fines, fees paid to directors, severance payments, pension costs, rebranding expenses and executive bonuses as reported by Rapoport (2015). The improved boldness of companies has resulted in more elaborate justifications for the utilization of unofficial earnings measures as is seen in nonrecurring expenses, stock grants and unwelcome news.
Nonrecurring Expenses-unofficial Earnings Measures Problem
Often, companies seek to provide various explanations for their poor performances by indicating that certain expenses were “one-time events” that should not be included in the overall calculation. As such, some of the expenses that are normally listed as nonrecurring expenses include novel product development expenses, restructuring expenses and acquisition costs. However, in a situation whereby a company frequently acquires other companies, it does not make much financial sense that the costs that are related to these acquisitions are not included in the company’s financial reports. As Sherman and Young (2017) state, if a business acquires intangible assets that generate revenues, there are certain costs that are associated with the process of generating those revenues. Despite the fact that the rules governing how these costs should be amortized is not perfect, the technique of computing the earnings by including the revenues emanating from a company’s assets while shunning the costs that are associated with these assets is not logical.
Stock Grants-unofficial Earnings Measures Problem
According to the report by Sherman and Young (2017), LinkedIn reported net operating losses in the period between January 2013 and December 2015 of $180 million in the company’s official incomes statements. Nonetheless, management decided to shift the focus of the analyst community to discordant numbers. Thus, instead of reporting its losses based on Generally Accepted Accounting Principles, LinkedIn presented an adjusted EBITDA for the years 2014 and 2015 of $1.37 billion through the removal of amortization charges and depreciation, as well as, the cost of stock-based compensation.
As Sherman and Young (2017) report, LinkedIn is not the only company that is making an effort to divest the impacts of stock-based compensation from the information in its financial performance reports. For example, Twitter utilized issued shares to its workers valued at more than one hundred and twenty percent of the company’s operating income from the year 2014 to the year 2015. Through the exclusion of this expense from its earning computations, Twitter was able to change a negative earnings report into what is referred to as positive pro forma earnings. In as much as proponents of this approach agree that stock and option grants tend to have dilutive impacts on the other shareholders of the company, they contend that the inclusion of such stocks into earnings gives a more accurate picture of the financial performance of the company. Moreover, the proponents state that grants are not real money given that stock grants are normally noncash expenses.
There are at least two problems that Sherman and Young (2017) bring to light concerning the argument that grants are not real money given that stock grants are normally noncash expenses. First, despite the fact that stock-based compensation does not entail a direct cash payment, it involves an expenditure or disbursement of company shares. Thus, the distribution of shares to workers means that the shareholders will end up owning less of the company. Instead, these shares could have been sold at the market prices and the company gets the proceeds which will later trickle down to the prevailing shareholders of the company. Second, the earnings of the company are not supposed to be a reflection of the cash flow, instead, these earnings are meant to evince the financial performance of the company with the inclusion of accruals. As such, accrual accounting is undertaken for the purpose of evincing expenses in the period when the related revenues are generated and not the period when the cash flow takes place. This is because the cash flow statement already shows how cash flow occurs. It is imperative to note that when companies exclude noncash obligations, they fail to paint the true picture that earnings should be painting. According to Barth, Gow and Taylor (2012), recent studies espouse the notion that unofficial or non-GAAP earnings measures that fail to include stock-based compensation tend to have less predictive power for future earning compared to financial reporting metrics that include the expense.
Unwelcomed News-unofficial Earnings Measures Problem
Corporate managers tend to normally downplay bad news and report good news instead. This tendency has seen the surge in the use of non-GAAP financial metrics by companies. Sherman and Young (2017) provide the example of the energy sector whereby oil reserve assets are treated as assets based on global oil prices. The implication of this treatment is that when the prices of oil decrease, the underlying value of the reserves will also decrease. Oil companies are then required by regulatory bodies to decrease the carrying value of oil on the statement of financial position to the current market value of the reserves. In accounting language, this phenomenon is referred to as an impairment. This impairment demonstrates a real cost to the company that is indicated as an expense in the company’s income statements. However, as Fahey (2016) reports, certain energy companies have adjusted their non-GAAP earnings in the past few years with the objective of not reflecting the asset impairment charges that emanate from a decrease in oil prices which they hope will overshadow the bad news. Nonetheless, it does not make financial sense to refrain from including such asset impairment charges from earnings without also adjusting the earnings windfalls that emanate from oil price increases.
Based on the report by Rapoport (2015), the demeanor of minimizing bad news transcends the energy sector as seen in the showcasing of profits using non- GAAP metrics and losses under Generally Accepted Accounting Principles in 2014 by forty companies with initial public offerings as reported by the Wall Street Journal. Such practices not only cause confusion among analysts and investors but also make shareholders skeptical of what the companies are trying to evince.
Impacts of Unofficial Earnings Measures
Risks in setting executive compensation-unofficial Earnings Measures Problem
More and more executive remuneration packages are continuously being based on adjusted earnings. As a result, keeping in mind that even Generally Accepted Accounting Principle numbers are subject to earnings management, the payment of bonuses based on metrics chosen by executives can turn out to be extremely risky for compensation committees. As Sherman and Young (2017) state, this risk is better seen and appreciated when one looks at the case of the global energy company, BL PLC whereby the Bob Dudley, the CEO received compensation of $20 million in 2015 which was an increase in his compensation from the previous year of $16.4 million while the company had in fact reported its worst loss ever. Perplexed and frustrated shareholders displayed their disapproval of such measures by voting down the company’s report, especially on director pay. However, the resolution of the shareholders was nonbinding in the end.
Challenges in comparing financial performance-unofficial Earnings Measures Problem
Unofficial earnings measures can result in challenged that hinder effective comparison between the financial performances of companies. For instance, there is an ongoing debate regarding whether companies should incorporate the cost of stock grants in their earnings computations or whether the companies should exclude the cost. While the argument for excluding the stock grant cost is that it is a noncash expense, the counterargument points out that, stock options are accompanied by costs that should be contemplated as an expense under Generally Accepted Accounting Principles. For instance, Microsoft Corporation and other technology companies normally report non-GAAP earnings that are adjusted for the cost of stock-based compensation.
While the question of how to treat stock options of often academic, it became more real for Microsoft when it acquired LinkedIn in 2016. After the acquisition of LinkedIn by the Microsoft, the former’s earnings were no longer recast and reported to exempt the value of the stock options from the financial reports (Sherman and Young, 2017). This rendered it difficult for analysts and investors to compare the financial performance of LinkedIn pre and post its acquisition by Microsoft. Since the manner in which non-GAAP performance measures are computed can change from one year to another, it is vital to note that board members, executives and internal strategists should always be ready to utilize numerous sources to formulate a meaningful picture of the company’s financial performance and make comparisons where appropriate with competitors in the industry.
Stock Price Implications-unofficial Earnings Measures Problem
According to the report by Sherman and Young (2017), a clear example of what can transpire when a company abuses unofficial or non-GAAP earnings measures was evident when SEC raised concerns regarding the accounting practices of Valeant Pharmaceuticals International Inc. in 2016. This was after the SEC noted that in the last four years, Valeant Pharmaceuticals International Inc. had reported GAAP net losses of around $330 million while also asserting non-GAAP net incomes of approximately $9.8 billion in the same period of four years. As Grover (2016) states, the SEC particularly questioned Valeant’s decision or practice of excluding acquisition-related expenses in light of the company’s reliance on its frequent and large acquisitions of other companies and businesses. Despite the fact that Valeant Pharmaceuticals International Inc. argued that such acquisition expenses were not related to the core operating performance of the company, financial analysts, investors and the SEC were not convinced. The outcome of this discovery was a fall in the company’s stock price by approximately ninety percent in the months that led to the announcement of the discovery of Valeant’s use of unofficial or non-GAAP measures by the SEC. Ultimately, Valeant Pharmaceuticals International Inc. relented and decided to stop referring to core results (Sherman and Young, 2017).
Recommendations-unofficial Earnings Measures Problem
The Financial Accounting Standards Board (FASB) has been engaged in continuous research to improve the information that is displayed in company’s official income statements. An ideal consideration would be to formulate more precise definitions of operating activities, as well as, how to distinguish between infrequent and recurring items. If this provision is adopted, it would have a profound impact on the corporate practices that relate to non-GAAP metrics.
For instance, when a company states that a certain expense is “one-off” it should be made to report this expense nonetheless. This can be facilitated by the SEC and other regulators requiring that events that companies tend to refer to as “one-off” be contemplated as non-recurring only in situations whereby the time-frame for recurrence of such an event is every five years. In as much as the suggestion of five years is arbitrary, it is better than two years since it almost equivalent to the length of a typical business cycle. As such, the SEC and other regulating bodies worldwide could then shift their focus to the proper definition of a pertinent “event.” Examples of scenarios that require further definition and clarification are when a company is writing down the value of its foreign operations as a result of economic uncertainty and currency devaluation and considering it as a “one-off” event.
A key reason why numerous companies utilize unofficial earnings measures is so that they can be able to track financial performance at a degree of detail that supersedes the information available in the income statement. In order to curb this practice, the Financial Accounting and Standards Board and the International Accounting and Standards Board could decide to include novel subtotals on the income statement which will in turn formulate official versions of some of the more common non-GAAP metrics, for instance, the widely used EBITDA. Notwithstanding, such a provision will not address the more customized representations of EBITDA that are sometimes denoted as adjusted EBITDA, with the latter excluding certain items that the management reckons are not representative of the operating results of the company. In such situations, consistency and comparability would still persist as a problem which would require management to provide explanations regarding how the metrics were computed and how these measures compare with the metrics utilized by the company in the previous years.
The Financial Accounting and Standards Board and the International Accounting and Standards Board could also improve matters significantly through clarification of the manner in which disclosures relating to nonrecurring versus recurring activities are relayed. A good example is whereby the income statement can be modified to render a measure of recurring operating income as an official metric and the all the pertinent nonrecurring and financial items being listed below the subtopic recurring operating income. Such as provision by the regulating bodies would be extremely vital to curbing the perceived need by companies to generate and utilize unofficial or non-GAAP earnings measures. These recommendations will also go a long way in improving the credibility, reliability and integrity of companies’ non-GAAP disclosures in their financial performance reports.
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