Non-GAAP Earnings Metrics: Consumer Beware

by April 4, 2016

This is one of a series of articles, Covering Financials, focused on financial accounting disclosures and how you as a journalist can interpret and report on them. The first four articles (see related links) introduce the financial accounting concepts utilized in this and future articles. If you have a topic you are interested in, post your request in the comments or email me at steven.orpurt@asu.edu.

Your Interest as a Reporter in Non-GAAP Pro-Forma Earnings

Generally Accepted Accounting Principles (GAAP) require entities to report net income on the income statement. There is no new news there. But many companies also report pro-forma earnings. Pro-forma means “as if.” Pro-forma earnings are a non-GAAP measure of earnings implying that entities can calculate the earnings as they see fit, as long as it isn’t misleading and investors can reasonably view the information as informative. You can find many interesting financial reporting topics by comparing and contrasting pro-forma earnings with GAAP net income. The differences are often unusual items that managers don’t want to highlight.

What are Non-GAAP “Pro-Forma” Earnings Metrics?

GAAP net income on the income statement includes all revenues and gains less all expenses and losses. Unsurprisingly, many managers do not think that bottom-line GAAP net income emphasizes what they think is an appropriate view of an entity’s financial performance. For instance, GAAP net income may include a loss from a fire. Since managers do not foresee that type of loss recurring, and likely consider it outside their control, they may want to present a pro-forma earnings (non-GAAP) result “as if” the fire did not occur. Investors often view this type of pro-forma earnings disclosure as informative.

But since GAAP does not offer specific guidance on pro-forma earnings, entities create custom versions. And with no GAAP guidance, it is tempting (and easy for managers) to embellish their pro-forma earnings measures, perhaps misleading some investors. Making matters more interesting, many entities hold press conferences to announce their earnings and focus on their pro-forma earnings, not GAAP net income. And then the financial press reports the pro-forma earnings often without mentioning that it is not GAAP net income. An interesting question for an investigative reporter then is, “What items cause the difference between GAAP net income and pro-forma earnings?” History suggests each entity’s answer will likely be unique each year.

Recent SEC Remarks on Non-GAAP (pro-Forma) Earnings

The topic of non-GAAP (pro-forma) earnings will be more visible in the next several years because the U.S. Securities and Exchange Commission (SEC) has recently indicated plans to more closely monitor pro-forma earnings disclosures. Just this March, 2016, James Schnurr, chief accountant at the SEC, said that the SEC has concern over increased use and aggressive calculation of the non-GAAP measure. Of concern to the SEC and investors, non-GAAP earnings are almost always higher than GAAP net income. According to the SEC non-GAAP earnings were more than 20% higher for S&P 500 firms during 2014 with the percentage increasing for 2015 as entities continue reporting their 2015 financial statement results. While investors quickly acknowledge that pro-forma earnings inform, they quickly cite examples where pro-forma earnings are “earnings before all the bad stuff.” Let’s look at a good use of pro-forma earnings and a less-than-stellar use.

Amazon in the early 2000s popularized pro-forma earnings. Amazon published their pro-forma earnings results in response to investors’ continued questions about the performance of its online retail sales model and compensation of employees. GAAP required Amazon to report net income with its online sales model results combined with other activities (such as acquisitions), making it difficult for investors to assess. So Amazon, quite helpfully, produced a pro-forma earnings number. Amazon clearly showed the presented pro-forma earnings results were used to compensate employees, addressing an important investor question. And they reconciled pro-forma earnings to GAAP net income so investors could understand all the adjustments. Most investors found Amazon’s disclosure helpful.

In contrast, Groupon included a pro-forma earnings number entitled, “Adjusted Consolidated Segment Operating Income” (ACSOI) in its first filing with the SEC in 2011. Groupon management described ACSOI as GAAP net income excluding online marketing expenses, stock-based compensation expenses and acquisition related expenses. When investors questioned Groupon’s management about ACSOI, Groupon’s management stated that it excluded online marketing expenses. Their reason: they considered these expenses an upfront investment to acquire new subscribers that they expected to end when Groupon finished its rapid expansion. Investors were clearly unimpressed, believing that Groupon would have to continue incurring marketing expenses to retain subscribers. Groupon, naively, provided no data or analysis to support its ACSOI pro-forma earnings number. The SEC was also unimpressed, curtly stating in its response to Groupon’s initial public equity filings, “It appears that online marketing expense is a normal, recurring operating cash expenditure of the company. Your removal of this item from your results of operations creates a non-GAAP measure that is potentially misleading to readers. Please revise your non-GAAP measure accordingly.” Ouch. Read the full SEC letter to Groupon for added context.

What other expenses and losses do entities exclude from net income to produce their pro-forma earnings? Well, over the years just about anything. Restructuring expenses, stock-based compensation expenses, one-time losses from theft, fire, weather, etc., acquisition expenses to purchase other firms and more. The problem with excluding these expense and loss items is that they often tend to recur. One entity excluded weather damage from hail, but operates where hail is frequent. From a reporter’s viewpoint, the issue is whether or not pro-forma earnings inform investors. If not, managers may simply be trying to report good results. Clearly the SEC worries how entities are reporting non-GAAP earnings, which strongly indicates entities have overstepped regulatory boundaries. As entities report their 2015 pro-forma financial results you might find interesting topics by exploring the differences between pro-forma earnings and net income. That is, exploring the “bad stuff” that management would prefer not to acknowledge.