Is the end of non-GAAP measures in sight? Maybe. And that's a good thing.

Regular readers of my analyses of company quarterly reports will know that I am contemptuous of non-GAAP measures.  To me, those measures have always been misleading and downright abusive in some cases.

My reasons are straightforward to understand: if you incur a cost that you choose to exclude because it has a non cash element and it is recurring in nature then you are relying on factors that have nothing to do with the business in order to support that position. My primary target here is stock based compensation or SBC.

When SBC was first used - way back when - it was meant to cover situations that are unusual. The last 10-15 years has seen an increasing number of companies reporting and using SBC as a way of presenting a better operating picture than exists. When SBC is co-mingled with one off or genuinely unusual events then the non-GAAP picture becomes murky.

Non-GAAP reporting has largely superceded GAAP reporting as the focus upon which management wishes analysts to pay attention. Many of those same analysts have happily fallen in line if that means the stock price can be pumped upwards. While not illegal, the use of non-GAAP measures speaks loudly to the corrosive nature of what I see as meaningless measures used to both enrich a chosen few while putting impossible pressures on management to perform.

On the flip side, those fund mangers who obsess about GAAP have happily fallen into short selling, making the (reasonable) assumption that what goes up must come down and that non-GAAP distortions provide an excellent way to  profit on any whiff of bad news.

Taken together, I  believe that leads to an imperfect market, far removed from the ideals most people who claim 'the market decides' as an axiom for accepting share price activity and the volatility that goes with it.

That may come to an end according to a report by Francine McKenna, a long time colleague in the corporate governance arena.

As a buyer, this may seem to have little relevance but for me, it is all part of due diligence when selecting a vendor that may - or may not - be around in five years time.

Some problems associated with non-GAAP

In many cases involving technology companies, SBC has grown to the point where it can account for all of the profit reported using non-GAAP measures. Conversely, SBC accounts for most of the loss, when set against GAAP measures. That in itself should be cause for alarm and why, in most earnings reports, I specifically refer to GAAP measures.

Supporters of SBC argue that in times of hyper growth, it is important to concentrate on cash conservation. SBC provides a way to overcome that problem when companies spend on sales and marketing ahead of revenue and where that spend is mostly people related.

That argument has its roots in the idea that modern technology markets are very much 'winner takes all' and cash conservation coupled to an implied ever rising stock price, is a good way to ensure you get the best talent available to execute against the business plan, which, in turn, will lead to a place on the winner's podium and fabulous riches for all who play the game. Conversely, that means there will be a lot of losers.

There are numerous problems with this argument, not least of which is the assumption that the only thing that matters to people is the size of their compensation package. It helps amplify and distort the competition for talent to the point where only the richest can survive and thrive. There is a reason why Facebook, Apple and Google attract the best people well beyond the perceived 'cool' factor of working with these companies.

Another problem is that the myth of non-GAAP measures has gained considerable currency among otherwise uninformed and, quite frankly, intellectually challenged pundits who would prefer we ditch GAAP altogether. You can find most of them on SeekingAlpha. What these idiots fail to understand is why GAAP exists in the first place.

The idea behind GAAP (and IFRS in the international field) is to provide a level playing field of rules upon which regulators are agreed makes for a method of comparison between one company and another. That's the theory and most of the time it holds up well, if imperfectly. When you allow non-GAAP measures, which are not (and cannot) be subject to checks and balances via the audit regime, then you introduce uncertainty and difficulty in the measurement and comparison of results. That in turn should mean a greater concentration of effort to ensure that measures are transparent in their disclosure. Sadly, that's rarely the case.

As an aside, I have no problem with using cash based measures for internal, operational reporting. Why? No business with adequate cash to meet its obligations has ever failed. However, it is the combination of SBC as a significant lever, combined with a clear need to influence the stock price that leads to problems. I can think of at least a handful of technology vendors that have IPO'd in the last five years where stock price management has become pretty much the only thing on the minds of senior leadership. That sometimes leads to attempts at manipulation that from the outside look decidedly strange. A year ago, one CEO confided in me that he was deeply concerned with the way his company's stock price was moving because he could see no way to influence what he saw as an unsustainable rise in stock price. Reining back non-GAAP won't necessarily change that but it would help considerably.

What's happening?

From McKenna's story on this topic:

The SEC’s Division of Corporation Finance is forming an internal task force to closely review the use of “non-GAAP” numbers and whether companies respond to recently updated guidance on using these metrics.

So-called comment letters will go to companies that don’t comply with the new guidance in their second quarter earnings releases.

The SEC’s corporation finance division issues comment letters to companies to request additional supplemental information or request a revision in its filing with the agency.

We know that as a general principle, the last thing that any CEO or CFO wants is an inquiry letter from the SEC. Regulation post-Enron is tough enough but inquiries can lead to serious unpleasantness and a management distraction that almost always leads to heads rolling.

Right now, the guidance has a distinctly voluntary flavor but recent commentary from the SEC along with concerns about the way Valeant Pharmaceuticals has used non-GAAP measures has brought this topic to the fore. From McKenna:

The SEC’s Chief Accountant James Schnurr explained the problem for investors in a speech in March to accountants and lawyers who serve pharmaceutical and biotech companies. “I am particularly troubled,” said Schnurr, “by the extent and nature of the adjustments to arrive at alternative financial measures of profitability, as compared to net income, and alternative measures of cash generation, as compared to the measures of liquidity or cash generation.”

One of the key statements in the guidance refers to the potential for review of  'recurring costs' in non-GAAP measures of which SBC must surely be a prime candidate.

My take

I am no fan of regulation as a general principle but I am a fan of regulation that levels the playing field and provides some means of keeping egregious behavior in check. The way non-GAAP has developed requires an overhaul and the latest guidance is a positive step in that direction.

If the guidance on offer has regulatory teeth then this will be a good thing for everyone as I believe it will help ensure a much healthier business environment. That has to be good for customers.

Prior to seeing McKenna's story, I noted that Aneel Bhusri, Workday's CEO put some emphasis on profitability in his company's discussion of the forward position in its Q1 FY2017 results. Upon reflection and in light of the new guidance, I would not be surprised that talk of SEC enforcement and increased oversight weigh in that thinking. Elsewhere, I am aware that the CFO at at least one other very well known technology company is attempting to find ways out of its SBC hole as it strives to achieve sustainable profitability as measured by GAAP. On the other hand, it doesn't go un-noticed that SAP, long seen as conservative in its accounting practices, has made increasing use of SBC and non-GAAP (as opposed to constant currency) measures in its reporting. I know why but I don't believe it is helpful.

Abandoning non-GAAP measures at this stage would be very difficult in a market which has become enamored of those measures. However, the SEC could do everyone a big favor by making clear to investors and analysts that the original purpose behind allowing for non-GAAP measures has not gone away and that the crucial wording around 'recurring costs' as a target for review has meaning. Given the current climate where sentiment has shifted towards finding profit rather than the relentless pursuit of growth, this should be an easy sell for all but the most idiotic.