As investors know, Generally Accepted Accounting Principles, or GAAP, are the standards and procedures that companies follow when compiling their financial results. However, in addition to providing investors with financial results based on GAAP, public companies increasingly provide non-GAAP accounting as well. By one account, 334 of the 500 companies in the S&P 500 Index provided non-GAAP metrics in 2014, up from 232 in 2009. Concerns have arisen over this increasing use of non-GAAP metrics, which companies could use to present their results in a favorable but potentially misleading light.
In his recent annual letter to Berkshire Hathaway Inc. investors, Chairman Warren Buffett discussed how the use of non-GAAP metrics can be misleading. According to Buffett, “the most egregious example” of the common practice of companies providing non-GAAP metrics and telling investors “to ignore certain expense items that are all too real” is stock-based compensation. Presenting investors with non-GAAP figures excluding stock-based compensation is particularly prevalent among technology companies. In Buffett’s view, compensation is a real and recurring expense that management should include in the calculation of earnings. Twitter, Inc., the well-known micro-blogging service, provided GAAP and non-GAAP metrics in 2015, and the difference between the two was particularly stark. Twitter reported a $521 million loss under GAAP, as opposed to a $277 million non-GAAP profit. As Buffett warned, the non-GAAP measure excludes $682 million of stock-based compensation. Tesla Motors, Inc. similarly reported significantly different GAAP and non-GAAP numbers in 2015, with a GAAP net loss of $889 million on $4 billion in revenue as compared to a non-GAAP net loss of $295 million on $5.3 billion in revenue.
Buffett also faults Wall Street analysts for “parroting the phony, compensation-ignoring ‘earnings’ figures fed to them by management” and “propagating misleading numbers that can deceive investors.” Financial writer Richard Beales agrees that “too often analysts indulge in this financial fantasy” of using non-GAAP numbers that exclude stock-based compensation.
Mary Jo White, Chair of the United States Securities and Exchange Commission (SEC), raised concerns that the use of non-GAAP metrics can mislead investors in her keynote address at the 2015 National Conference of the American Institute of Certified Public Accountants. She noted the prevalence of such measures in analyst reports and press coverage. While companies may provide non-GAAP metrics as long as they also report GAAP results and do not give non-GAAP measures greater prominence, the SEC has recently signaled that it will rein in some of the most aggressive uses of non-GAAP accounting.
In its 2014 annual report, ConocoPhillips Co. provided GAAP and non-GAAP results, including non-GAAP metrics based on much higher 2013 prices for oil and related commodities, including natural gas. The use of these older prices, while not in accordance with GAAP, made the company’s financials appear much rosier in light of the steep fall in the price of oil, increasing earnings by $755 million. While the company claimed that this disclosure showed its results controlled for oil price swings, the SEC pushed ConocoPhillips to stop using such potentially misleading non-GAAP metrics. A skeptic might wonder how likely the company would have been to report its results using a similar non-GAAP metric if oil prices had dramatically increased.
While non-GAAP accounting may serve a purpose when used properly to inform investors about company results excluding one-time non-recurring expenses, investors should follow the lead of the SEC and Buffett and cautiously scrutinize non-GAAP disclosures. When used improperly, such disclosures could obscure a company’s true health and mislead investors.