Companies have been criticised for using non-GAAP measures in their annual reports – effectively overstating their profits. Concerns are mounting as the practice grows
This article was first published in the May 2019 Africa edition of Accounting and Business magazine.
A bond prospectus is a sales document – literally. So there was some small commotion when office rental company WeWork included a non-GAAP measure called ‘community-adjusted EBITDA’ in its recent prospectus.
WeWork is a typical ‘unicorn’ startup: a company that has a valuation in the billions but has never turned a profit. Its business model relies on leasing offices, refurbishing them and renting them out to (largely) small and medium-sized companies. It is not a complex business, so what is behind the company’s ‘accounting for the community’ metric?
WeWork appears to consider its community-adjusted EBITDA as a piece of information essential to investors who wish to understand its business. But its approach has drawn criticism from some, who claim it is corporate nonsense-speak intended to obscure understanding of the business.
The metric has its defenders. But the point is that where one person sees an abstraction of something relatively straightforward, another sees a clarification of something that, if not unique, is still perfectly fair.
The bottom line is that WeWork believes that extant reporting standards are not sufficient for describing its business, so it has found another way to report what it thinks is important. The problem is that it also makes the company look good in the process, an outcome that will inevitably draw scrutiny from sceptics.
Everyone’s at it
WeWork is not alone in its use of non-GAAP metrics. A 2016 PwC study, An alternative picture of performance, found that 95% of UK FTSE 100 companies report using alternative performance measures (APMs).
Concerns are growing that the trend in using non-GAAP measures to describe a business is open to manipulation. There are concerns among investors and regulators that companies use APMs to inflate profits, obscure recurring items and shroud their business model in language that is not comparable across their sector.
There are also fears investors are being misled into treating non-GAAP with the same reverence as the audited numbers. The former chairman of the US Securities and Exchange Commission Mary Jo White worries whether analysts are distinguishing between them at all (see panel left).
Multiple studies show that there is a crucial difference between profit reported under GAAP and profit reported under non-GAAP. Research by Citi in 2016 showed there is as much as a 30% difference between the two. That is easily the difference between being very solvent and very bankrupt.
So why do investors rely on non-GAAP reporting at all? And why aren’t APMs audited? It’s important to recognise that financial reporting standards are both unwieldy and tremendously flexible. This creates what the chairman of the International Accounting Standards Board, Hans Hoogervorst, calls ‘an open invitation for non-GAAP to step in’ (see how the IASB is addressing the issue on page 48 of April’s AB). The standards are also backward-facing.
So it’s arguably natural that investors seek information that cannot be adequately measured by GAAP. But what they are presented with in the world of non-GAAP disclosures – sometimes rose-tinted figures – may not be what they seek, or find.
Investors broadly trust non-GAAP partly because regulations require companies to match their non-GAAP numbers to the closest GAAP equivalent. But somehow these regulations don’t seem to be stopping the trend, as Hoogervorst puts it, of non-GAAP numbers ‘getting increasingly detached from reality’.
But would expanding the audit to include APMs help? Recent events suggest that auditors are already struggling with their current brief. As super-investor Carl Ichan points out, unsettlingly, ‘even GAAP numbers are suspect’. Expanding the scope of the audit to cover myriad non-GAAP measures would put even more pressure on the audit.
And isn’t part of the point of non-GAAP measures that they sit outside strict frameworks? If they became subject to audit, companies and investors might think up new ways to talk about performance or to seek information and thereby advantage.
The difficulty is that only sophisticated investors have the skills to challenge non-GAAP numbers, and there are a great many investors who do not meet that definition. Warren Buffet, a long-time critic of non-GAAP (but whose investment company Berkshire Hathaway does make use of APMs), believes that accounting literacy is key: investors, he believes, should understand it like a ‘native language’ to unravel its more artistic uses.
Some combination of standards-setting, regulation and investor pressure on companies that are particularly creative with their use of non-GAAP seems to be required. As Deutsche Asset Management’s David Bianco puts it: ‘The best measure lies somewhere between GAAP and non-GAAP.’
Felicity Hawksley, journalist
"Research in 2016 showed there is as much as a 30% difference between profit reported under GAAP and profit reported under non-GAAP"