The number of companies reporting non-GAAP measures is on the rise, as is the hyperventilating over their use

There is a growing backlash against the use of measures that don't meet Generally Accepted Accounting Principles (GAAP) when reporting earnings results, and its quickly becoming a frenzy.

Late last month, the New York Times proclaimed, "Fantasy Math Is Helping Companies Spin Losses into Profits." A headline on Yahoo in March warned, "Companies haven't fudged their numbers this much since the financial crisis." Even Warren Buffett got into the act—although in his famously level-headed way—suggesting in his annual letter to shareholders: "It has become common for managers to tell their owners to ignore certain expense items that are all too real."

Fantasy math? Fudged numbers? Ignoring reality? So what's going on here? What is happening is that more big companies are using non-GAAP measures when they report earnings, suggesting to investors that the by-the-book accounting actually obscures the real picture when it comes to how well their companies are doing. In fact, according to a recent study in the Analyst's Accounting Observer, 90 percent of companies in the Standard & Poor's 500-stock index reported non-GAAP results last year, up from 72 percent in 2009.

freakout imageThe problem has gotten so bad that the Securities and Exchange Commission has taken note. SEC leaders are suggesting that it may have to clamp down on the practice if companies don't curb their reliance on non-GAAP measures themselves. "It's something that we are really looking at—whether we need to rein that in a bit even by regulation," SEC Chairman Mary Jo White said in March at a conference in Washington. "We have a lot of concern in that space."

It's not just talk. Last year, the SEC took ConocoPhillips to task for using non-GAAP measures in some calculations that inflated the value of oil by using 2013 prices before the oil market collapsed. A Conoco spokesperson told Bloomberg it was trying to help investors compare results year to year. The SEC asked it to stop the practice.

The Old Numbers Game

The use of non-GAAP measures is, of course, nothing new. Companies have been pulling out or adding in numbers that make their results look better for eons. Sometimes it's justified and sometimes it's not. The high instance of non-GAAP usage, however, may indicate that companies are blurring the lines between trying to make an honest representation of reality and gilding the lily.

"There are occasions where investors do value non-GAAP disclosures," says Amy Borrus, deputy director of the Council of Institutional Investors. "Foreign exchange is a good example. For companies that have significant operations outside the United States, for example, foreign currency fluctuations can buffet financial reporting significantly. In such cases, it can be useful for investors to see a reconciliation based on a fixed exchange rate."

In some ways, non-GAAP reporting is like using pain-killers. It has an important use, but it's easy for companies to get addicted and start to abuse it. And now there might be an epidemic of overuse that is not uncommon when a bull market starts to get a little long in the horns. Indeed the last time the gap between true GAAP reporting and non-GAAP earnings was this large, it was 2009 and the stock market was in the throes of a massive correction.

"Generally, the rise in non-GAAP reporting is a red flag for investors," says Borrus."Too much of this can lead investors to make mistakes in evaluating company performance. Companies tend to cherry pick non-GAAP measures. They use non-GAAP metrics when they make earnings look better but not use them when doing so would make earnings look worse."

Borrus has a good point. It's hard to justify using non-GAAP measures if you only use them when they make results look better. If they clarify things for investors, than it shouldn't matter if they inflate or deflate the numbers. It's unlikely, though, that companies will hang on to their non-GAAP figures when they cut the wrong way. And that's where problems arise. If 90 percent of companies are using them, it's a good bet they could be masking some serious problems. The headlines may be hyperbole, but no doubt there is some fuzzy math going on.

Serving a Purpose

According to a report by Deloitte, "Non-GAAP measures can be meaningful and provide valuable information about what is important to management."

Deloitte offers 10 questions to ask when trying to decide to present non-GAAP numbers or not.

  1. Is the measure misleading or prohibited?

  2. Is the measure presented with the most directly comparable GAAP measure and with no greater prominence than the GAAP measure?

  3. Is the measure appropriately defined and described, and clearly labeled as non-GAAP?

  4. Does the reconciliation between the GAAP and non-GAAP measure clearly label and describe the nature of each adjustment, and is each adjustment appropriate?

  5. Is there transparent and company-specific disclosure of the substantive reason(s) why management believes that the measure is useful for investors and the purpose for which management uses the measure?

  6. Is the measure consistently prepared from period to period in accordance with a defined policy, and is it comparable to that of the company’s peers?

  7. Is the measure balanced (i.e., it adjusts not only for nonrecurring expenses but also for nonrecurring gains)?

  8. Does the measure appropriately focus on material adjustments and not include immaterial adjustments that would not seem to be a focus of management?

  9. Do the disclosure controls and procedures address non-GAAP measures?

  10. Is the audit committee involved in the oversight of the preparation and use of non-GAAP measures?

If you can answer those honestly and still think that non-GAAP measures will give investors a clearer picture of results without raising the hackles of the SEC, than ignore the bluster and proceed with caution.