They’re the specially tailored numbers that typically flatter company income and downplay expenses.
Numbers like operating profits and free cash flow. U.S. financial regulators three years ago put these non-standardized measures in their crosshairs, zooming in on some of the most egregious uses of what critics call “earnings before bad stuff.”
Now, measures used to portray a company’s performance—but which don’t conform to generally accepted accounting principles (GAAP)— are getting attention from U.S. and international accounting rulemakers.
But don’t expect the same approach on both sides of the Atlantic.
The U.S. Financial Accounting Standards Board is exploring whether to make companies reveal more details in their income statements, potentially cutting down on their opportunities to present tailored, unsanctioned accounting metrics.
FASB appears to be leaving the heavy lifting, however, to the Securities and Exchange Commission, which in 2016 announced a crackdown on overuse of non-GAAP measures by reminding companies that they couldn’t promote non-GAAP information over audited results
In London, the International Accounting Standards Board is going several steps further.
In addition to calling for more income statement line items, IASB wants companies to present new subtotals based on two of the most common non-GAAP measures: operating profit and earnings before interest and taxes (EBIT). IASB doesn’t plan to use these labels, but its proposals coming out later this year are expected to be similar to the commonly used measures.
IASB also wants to include a line item in the income statement for the profits that subsidiary companies funnel into a business. In addition, the rulemaker plans to float requiring disclosures about unusual or infrequent items—a common reason for companies to report tailored financial metrics in the first place.
“Companies have a tendency to focus on unusual expenditures rather than identifying windfall profits,” IASB Chairman Hans Hoogervorst said in a podcast presentation in March. “While it may never be perfectly possible to identify unusual items, we have developed some definitions and some guidance that will strengthen discipline in this area.”
More Consistency, Transparency
The international standard-setter doesn’t want companies to stop using non-GAAP numbers, but it wants to force more consistency and transparency around them. Companies often present these figures without clarifying what information is included or excluded, which means investors and regulators cannot easily compare results—even for companies within the same industry, IASB says.
“Subtotals like Operating Profit and EBITDA are very commonly used, but in practice companies define these subtotals in very different ways,” Hoogervorst said in a March 6 speech in Mexico City.
If the board requires some of the non-GAAP measures to be disclosed in company footnotes, it won’t prescribe a methodology for coming up with the figures. It would, however, require companies to explain how they calculated the numbers.
“It’s clearly a step in the right direction and we support it,” said Liz Murrall, director of stewardship and reporting at the Investment Association.
Karthik Ramanna, professor of business and public policy at Oxford University’s Blavatnik School of Government, also has reservations.
“The IASB is responding to the proliferation of non-GAAP metrics by trying to put some statutory definitions around them,” Ramanna wrote in an email. “On one hand, this could curb abuse. But, to a degree, this is a problem of the IASB’s own making. So, the bigger issue is whether this moment of reckoning will prompt the IASB to recommit to prudent and verifiable accounting rules.”
The U.S. Picture
FASB is in a much earlier stage tackling the issue.
The board is looking for ways to make companies break down information in their income statements. The hope is that if businesses provide more details about things like costs of goods sold or sales, general, and administrative expenses, it will reduce the need for them to produce tailored, unauthorized financial measures.
The U.S. accounting rulemaker also continues to look at specific areas of its own rules, such as its hedge accounting guidance, to see if they need tweaking. Companies use the specialized financial approach when they feel longstanding accounting rules don’t adequately convey their results.
But for the most part, questions about non-GAAP metrics will largely remain in the hands of regulators.
Which is where they belong, said Patrick Hopkins, accounting professor at Indiana University. FASB doesn’t have authority over information conveyed outside of the audited financial statement. Even if the standard-setter were to come up with requirements for the 20 most commonly used non-GAAP measures, companies would just come up with another 20, he said.
“The best things we’ve seen is the SEC saying, ‘If you’re going to have to have a GAAP-like number and going to massage it, you need to reconcile it back to a GAAP metric,’” Hopkins said. “That’s been the best solution.”
Matt Jacques, chief accountant in the SEC’s division of enforcement, told attendees at an SEC Speaks event in Washington April 9 that he’s always struck by the lack of sophistication in tracking non-GAAP metrics.
“You’ve got these companies that are invested heavily in their financial reporting system,” he said, “but when you get to the non-GAAP measure, it’s Bob in a corner on a spreadsheet, recalculating from period to period.”
Sandy Peters, head of the financial reporting policy group at the CFA Institute, said she believes the SEC is best positioned to handle problems with the numbers.
“As long as they allow these non-GAAP measures, there’s going to be abuses,” Peters said. “And that’s what the key is—we’ve got to constantly keep the pressure on, no matter how good you make the guidelines.”
—With assistance from Amanda Iacone.