One concern backed up by academic research is that investors who put too much faith in non-GAAP figures could eventually get burned. Companies that omit relatively large expenses from their home-cooked profits tend to have lower future stock returns than companies that have the smallest exclusions, according to scholars at the University of Michigan.
“We have this crazy game of backing out costs because companies want to pretend like they aren’t going to matter,” said Jack Ciesielski, the Observer’s publisher. “But in the end, they’re still eating up shareholder capital.”
Critics argue the non-standard accounting deserves more regulatory scrutiny because it can be used to inflate earnings. A 2014 paper by researchers at the University of Washington and the University of Georgia found that companies are more likely to report non-GAAP numbers that strip out losses rather than gains.
Many investors agree that non-GAAP profit that excludes, say, one-time restructuring costs, is perfectly fine -- and even more useful at times. The problem is, supposedly one-time costs can show up again -- and that’s a worry for investors, said the University of Washington’s Sarah McVay, one of the authors of the 2014 paper.
Technology companies, in particular, have long argued that traditional metrics aren’t the best way to measure their growing businesses. Facebook Inc. and Twitter Inc., for instance, routinely strip out hundreds of millions of dollars of annual stock compensation expense to calculate their non-GAAP profit. For Twitter last year, that adjustment meant the difference between profit and loss -- its non-GAAP income was $276 million, while GAAP results showed it lost $521 million.
In his latest shareholder letter, Warren Buffett disparaged the omission of pay as “the most egregious” example of non-GAAP accounting. “The very name says it all: ‘compensation,”’ he wrote in his annual letter posted online Saturday. “If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?”
Spokesmen for Facebook and Twitter declined to comment beyond what their companies have disclosed in regulatory filings.
Companies that exclude stock compensation from non-GAAP results say they do so because valuing unvested shares and options can be subjective and the formulas used to estimate awards aren’t consistent across different firms.
McVay said that’s no excuse. “That would apply to virtually everything because there are estimates left, right and center throughout accounting ,” she said. “I think they just don’t want it to hurt their bottom line.”
Speaking in California in January, the SEC’s Higgins spotlighted the decision to reject the non-GAAP metric that ConocoPhillips invented. “We thought that was a bridge too far,” Higgins said, describing the SEC’s view without naming the company.