Investors: Mind The Gap In GAAP by Charlie Dreifus and Steven McBoyle, The Royce Funds
The increased use of non-GAAP practices is a worrisome trend that occludes transparency and can have a meaningful effect on stock prices. Portfolio Managers Charlie Dreifus and Steven McBoyle explain why.
We care deeply about accounting issues. Within the financial statements that a company presents for public scrutiny lies not only critical information about the state of assets, cash flows, et al., but also, we believe, about the values a business holds itself to.
In our view, scrutinizing accounting practices can reveal much about a company’s ethics. A business that pushes the boundary of accepted accounting practices is one that we always avoid.
Recently, we have observed a disturbing trend creeping more and more frequently into income statements—the growing gap between GAAP versus non-GAAP practices.
This disturbing trend, a practice we call, “earnings before bad stuff” (“EBBS”) entails consigning items off the income statement by declaring them “non-recurring” in order to burnish earnings.
What is GAAP?
(GAAP stands for “Generally Accepted Accounting Principles,” which are a common set of accounting principles, standards, and procedures that companies use to compile their financial statements. GAAP are a combination of standards set by policy boards and commonly accepted ways of recording and reporting accounting information.)
One’s rate of return is a function of the price one pays, so establishing valuation is critical for any value investor—and getting the most accurate valuation requires looking at earnings. The key question, however, is what number to use?
This is when accounting principles and practices come into play. Overstating earnings by using EBBS leads to overstating the value of the company. We follow a more prudent path and require “earnings that reflect economic reality.”
For investors less attuned to these accounting practices, we are concerned that the increased use of non-GAAP earnings is a worrisome trend.
Our concerns center on four specific elements:
- The problem is growing
- Industry standards are falling as a result
- These aggressive, non-GAAP practices evidence a failure of transparency from the managers to the owners of these companies
- The phenomenon has troubling implications for the integrity of executive incentive compensation.
A Growing Problem: More Companies Are Using Non-GAAP Practices
- A study in late 2015 by Audit Analytics shows that 88% of S&P 500 companies disclose non-GAAP figures, with 82% showing higher non-GAAP. Sadly, what we see on too many adjusted earnings figures are inaccurate numbers for both earnings and cash flows.1
- Non-GAAP references in proxy statements for S&P 500 companies are now 58% versus 27% five years ago.2
Falling Standards: Non-GAAP in Danger of Becoming the Norm
- Sell-side analysts have by and large embraced the use of non-GAAP figures in their estimates and earnings models, particularly in tech. We often have to reverse-engineer models from non-GAAP to GAAP, which seems crazy to us.
- Following the lead of sell-side analysts, many data providers compute consensus earnings forecasts based on adjusted earnings.
A Failure of Transparency to Investors
- It’s very likely that recurring items can be excluded in non-GAAP figures. What is to prevent a company from throwing in the kitchen sink? There’s a marked lack of clarity and specifics embedded in broad subjects and too much latitude to express ill-defined items such as “restructuring or profit improvement initiatives.” And if analysts aren’t wise to the game and fail to detect it, the company “beats” estimates. In fact, it seems that companies which use non-GAAP are by definition generally more prone to “beat” estimates employing these dubious practices.
- Company guidance is almost always presented in non-GAAP terms, thus giving the company wiggle room—too much in our estimation—to meet or exceed earnings expectations. We even had one company tell us, “GAAP guidance is not available” because “a reconciliation is not available without unreasonable effort.” This raises an obvious and disturbing question: Doesn’t a company need to start with GAAP in order to get to non-GAAP?
- The careless elimination of “non-cash” items becomes an excuse to burnish earnings. We wonder if they would do the same for depreciation? Eliminating non-cash items is appropriate for cash flows; it is not appropriate for earnings.
Troubling Consequences for the Integrity of Executive Incentive Compensation
- When used to determine executive incentive compensation, non-GAAP can set the bar far too low, which sheds light on management’s thinking. This also allows them to game results to meet performance targets—that is, for example, to acquire, if there’s no need account for, amortization of intangibles.
What do we think should be done about this? We have three recommendations:
- The S.E.C. and the Public Company Accounting Oversight Board need to carefully review and set out distinct definitions as to what can be included in adjustments. Currently there is far too much flexibility. The result of this would no doubt be lower earnings, and perhaps a lower stock market. Such a result would hopefully not deter the need for greater clarity. We’re hopeful that the recent SEC review of Regulation G will result in more rigorous adherence to traditional GAAP.
- We would not allow stock compensation, serial write offs, serial restructuring, dollar strength, intangible amortization, and similar things. We would allow true one-off events such as fires, earthquakes, and significant litigation charges or credits.
- The audit committees of company boards need to disallow rigging of the incentive pay mechanism—the compensation committee should receive sound guidance from the audit committee. They must insist on a full, fair, balanced, and understandable operating number. Obviously, the audit committee should also rein in the reporting of inappropriate operating income figures that management presents.
Why It Matters—The Effect on Valuations and Performance
Are we making too much of what to some may simply be nuances in the arcane field of accounting? We don’t think so. These practices are having meaningful effects on stock prices.
Without non-GAAP, the market and, of course, individual stocks would be even more expensive. There is no question in our minds that the recent proliferation of non-GAAP numbers has biased the performance of many growth stocks at the expense of value stocks—’dream stocks’ in the former category are always less expensive when making use of non-GAAP figures.
Finally, a study by Evercore ISI showed that a basket of stocks which combined cheap valuations with little or no differences between operating and GAAP earnings has outperformed the S&P 500 over the past 10 years.3
The Link Between Non-GAAP and Corporate Governance
We pay close attention to the presence (or absence) of a culture of accountability in each company we examine. Corporate governance is also equally critical to us.
Gaming GAAP—whether to goose the stock price, boost executive compensation, or some combination of the two—is in our view antithetical to a corporate culture committed to transparency and responsibility. In our experience, companies that consistently practice transparent and conservative accounting typically run their businesses in a similarly open and ethical fashion.
We have found that with these companies, it’s not just about accounting—it’s about accountability.
And those are the kinds of businesses we look for every day.
About the Authors
Steven McBoyle, who has 24 years of investment experience, serves as assistant portfolio manager for Special Equity and Special Equity Multi-Cap. Steven is a portfolio manager on Royce Premier Fund and Royce Heritage Fund.
1 Trends in Non-GAAP Disclosures. http://auditanalytics.com/blog/trends-in-non-gaap-disclosures.
3 Mind the GAAP Spread. Evercore ISI, Quantitative & Small Cap, 3/21/16.