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Oct 19, 2018 2018-10 Accountancy Faculty

Gies professor not surprised by proliferation of non-GAAP metrics

More top companies are using non-GAAP metrics to explain their financial performance, and a new report from Audit Analytics suggests the trend of using numbers outside the Generally Accepted Accounting Principles is continuing to grow.

“That’s pretty much in line with what I’ve seen in my research,” said Nerissa Brown, associate professor of accountancy at the University of Illinois’ Gies College of Business. “The proliferation of non-GAAP metrics stands out in work I’ve done on non-GAAP reporting for publicly-held firms, as well as initial public offerings.”

“But the use of non-GAAP metrics by top S&P 500 companies is undoubtedly high” added Brown. Audit Analytics examined approximately 300 companies that were publicly held in both 1996 and 2016. The report found that among S&P 500 companies, 59% reported non-GAAP metrics in 1996. That number grew to 76% in 2006 and 97% in 2017. Not only are more companies using non-GAAP figures, but also the amount of non-GAAP figures used per filing tripled from 2.35 in 1996 to 7.45 in 2016.

 Under GAAP, companies report earnings based on accounting principles that are “generally accepted” like reporting expenses during the same period as related revenues. However in some instances, there may be irregular expenses often during mergers or acquisitions. Companies feel like they can better describe their financial situation if they remove those one-time expenses, causing it to be a non-GAAP measurement.

“Firms want to re-cast their earnings metrics into a positive light,” said Brown. “Some firms want to inform investors about core earnings they think are more recurring from year to year. They want to strip out those earnings items that happen sporadically. Some firms, though, may be driven by more opportunistic motives.”

Brown says a manager’s compensation could be tied to a non-GAAP earnings target or to meeting or beating the street consensus earnings estimate. Firms may use non-GAAP figures to help achieve those incentives.

“The danger is when investors fixate on that higher non-GAAP number without really understanding what’s been taken out and what’s been left in. Some firms cherry pick the items they strip out,” she said.

New research by Brown, Gies Accountancy Head W. Brooke Elliott, and Gies PhD alumna Stephanie Grant highlights the tendencies for investor fixation. They find that nonprofessional investors over-rely on non-GAAP earnings that appear in image “tweets” on social media—a practice that is on the rise. Despite that danger, Brown stops short of advocating for more regulation. She says the quality of non-GAAP metrics is “much better” than it was 15 years ago. The SEC passed Regulation G in 2003, which requires “registrants that publicly disclose material information that includes non-GAAP financial measures to provide a reconciliation to the most directly comparable GAAP financial measures.”

Brown says Regulation G doesn’t constrain firms from providing non-GAAP numbers; but if they are going to do so, they should provide investors with a reconciliation, essentially a road map, so they know what was taken out. Firms should explain why the non-GAAP measure is useful and how it’s being used internally. Firms also cannot highlight a non-GAAP number more prominently than a GAAP number. “Non-GAAP metrics can be seen as a way for companies to tell their story, like a free response,” said Brown. “You don’t want to constrain their communication with investors, because sometimes managers do have a good story to tell based on unusual events that happened that year.”