Mind the GAAP

Firms increasingly report a number called non-GAAP or pro-forma earnings along with earnings based on Generally Accepted Accounting Principles (GAAP). Non-GAAP is a customized version of earnings calculated after excluding earnings components that don’t require cash payments or are otherwise not important for understanding the future value of the firm. Firms first report GAAP earnings. Then they detail each item that was added or subtracted from GAAP earnings to arrive at non-GAAP earnings. The building blocks for a modern company are investments in research and development (R&D), branding, customer relationships, computerized data and software, and human capital. Yet these intangible investments are treated as expenses in calculation of profits, and not as assets. The more a company invests in improving its future profits by making knowledge investments, the higher its reported losses. The bottom-line number thus becomes an inaccurate indicator for future profitability. So, many firms present a non-GAAP number by adding back intangible expenses.

Is a company making profit or a loss? It’s undoubtedly an important question in the minds of managers, investors, bankers, and boards of directors (investors would like to buy shares of, and banks would prefer to lend money to, a profitable company). But surprisingly, this question is becoming increasingly difficult to answer. The bottom-line number in income statements, which shows a profit or a loss, is calculated after so many deductions and adjustments that it provides no assurance of a firm’s core profitability. Compounding this development is the fact that, along with earnings based on Generally Accepted Accounting Principles (GAAP), firms increasingly report a number called non-GAAP or pro-forma earnings.

GAAP is a fancy term for accounting rules and regulations. Non-GAAP, as the name suggests, is a profit number based on calculations that don’t follow accounting rules. Over 95% of S&P 500 companies report both GAAP and non-GAAP earnings, showing its wide prevalence. Here we’ll explain the benefits and downsides, as well as the reasons for increased reporting of non-GAAP numbers.

Non-GAAP earnings are a customized version of earnings calculated after excluding earnings components that don’t require cash payments or are otherwise not important for understanding the future value of the firm. Firms first report GAAP earnings. Then they detail each item that was added or subtracted from GAAP earnings to arrive at non-GAAP earnings.

Non-GAAP reporting can totally change the picture of a company’s profitability. For example, for the fiscal year 2019, Pinterest reported a loss of $1.36 billion. It converted that loss into a non-GAAP profit of $17 million by adjusting certain costs. Losses turning into profits is becoming quite common for firms of all sizes. Hand-collected data from 2010 to 2019 shows that almost a fifth of firms that report GAAP losses turn their GAAP loss into a positive non-GAAP number.

What are the reasons for increased use of non-GAAP numbers? In our previous HBR articles, we claimed that financial statements are becoming less and less useful for assessing a firm’s performance. The building blocks for a modern company are investments in research and development (R&D), branding, customer relationships, computerized data and software, and human capital. The economic purpose of these intangible investments is no different from that of an industrial company’s factories and buildings. Yet these intangible investments are treated as expenses in calculation of profits, and not as assets. The more a company invests in improving its future profits by making knowledge investments, the higher its reported losses. The bottom-line number thus becomes an inaccurate indicator for future profitability. So, many firms present a non-GAAP number by adding back intangible expenses. For example, Vonage presented a “pre-marketing operating income” and Groupon presented an “adjusted consolidated segment operating income” by excluding marketing costs, arguing that they were investments, not expenses.

In addition, there are three important deductions that could distort the picture of core profitability: Stock option expenses, write-off acquired intangibles, and restructuring charges. Firms increasingly pay compensation to their employees via equity and stock options instead of regular salaries and performance-based cash bonuses. In fact, stock-based compensation now contributes 70% of the total compensation to a CEO. GAAP requires that the costs of stock-based compensation be deducted in the calculation of profits. However, stock-based compensation does not impose cash payments. On the contrary, when employees exercise their stock options, firms could save as much as 10% of their tax payments. Hence, many firms report non-GAAP earnings by adding back stock-option expenses, thereby reporting a number they claim better represents cash profits. For example, Roku turned its loss of $15 million into a positive number by excluding $26 million in stock-based compensation.

Acquisition of other companies has become a favored method of growth for modern corporations. A large part of the price paid for acquisition is for intangibles. For example, Facebook paid $17 billion for WhatsApp, entirely for its intangibles. Companies must test each year whether the acquired intangible is still worth the original value. If not, the reduction in the value must be deducted in the calculation of GAAP profits, even though it has no effect on the company’s cash balance. Such write-offs are not inconsequential. GE recorded a $22 billion write-off in just one year. Any profit or loss number calculated after deducting such an amount is unusable for predicting future profits because companies don’t record such write-offs every year. Hence, companies often add back that deduction to report a new non-GAAP number (see Amazon, for example).

Another important area is restructuring costs and loss on sale of assets. As we argued in a previous article, the pace of corporate creative destruction has increased. Technological progress is accelerating, and products and businesses are becoming obsolete faster. As a result, firms close unremunerative business segments more frequently, sell those assets at a loss, and pay severance to workers. Those costs are rightly deducted from GAAP profits. Yet restructuring events don’t occur every year. Profits calculated after deducting the one-time items are not useful for forecasting the future. Therefore, firms often report pro-forma earnings that exclude such restructuring costs, like Logitech and Lowes did.

Firms typically report higher non-GAAP earnings than GAAP earnings. Is such reporting of non-GAAP numbers informative to investors, or is it used by companies to mislead them? Research remains divided on this issue. Some studies show that investors and analysts find pro-forma earnings to be informative in determining a firm’s core profitability, particularly for loss firms. Boards of directors use pro-forma earnings to determine performance-based bonuses for CEOs, which, despite causing higher payment, could be beneficial to shareholders. For example, a CEO could postpone the closing of a loss-making business because doing so would reduce his GAAP-based bonus, causing further harm to shareholders.

But other studies claim that firms provide pro-forma earnings only to opportunistically report higher profits. Some exclusions from pro-forma earnings are not just one-time items but also affect future performance. Firms could also exclude negative items to meet investors’ expectations of profits. Securities and Exchange Commission (SEC) frowns upon the reporting of pro-forma earnings. SEC chairman Mary Jo White once said: “Your investor relations folks, your CFO, they love the non-GAAP measures because they tell a better story,” but “we have a lot of concern in that space.”

Limitations in financial reporting will only increase with time, and changes in accounting rules to mitigate those limitations will not occur soon. We support the view that whenever appropriate, managers must report pro-forma earnings while detailing and explaining the reason for each exclusion. Additional information shouldn’t hurt anyone. Using that information, investors can form their own opinion about a company’s profitability by adding or subtracting items they feel are most appropriate. If an investor doesn’t believe in pro-forma earnings, he or she can disregard the non-GAAP earnings and consider only the GAAP earnings.

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