The world of financial reporting is obsessing of late on the fixation of public companies, analysts and investors with financial reporting metrics other than those compliant with Generally Accepted Accounting Principles (GAAP).
As Den Howlett put it in his blog of June 1:
“Non-GAAP reporting has largely superseded GAAP reporting as the focus upon which management wishes analysts to pay attention.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.”
On July 31, Francine McKenna listed companies urging non-GAAP metrics on their followers – Brixmor, Herbalife, Apple, the New York Times, FedEx, GE and Microsoft – and a roster of regulatory functionaries wringing their collective hands – SEC Chairman Mary Jo White, Commissioner Kara Stein and chief accountant James Schnurr, and PCAOB chairman Jim Doty.
One concern was phrased in August remarks by Cindy Fornelli of the profession’s Center For Audit Quality:
“There is no authoritative framework that defines the calculation of each non-GAAP financial measure. This allows for flexibility, in that it enables non-GAAP financial measures to be tailored from one company to the next. However, the more tailored the calculation, the less comparable the measure may be across an industry….”
And yet, Francine McKenna’s blog of November 9 also put the futile issue of attempting to limit choice:
“The proliferation of non-GAAP metrics and the thousands of versions of each has made [users’] life a nightmare. It’s like standing behind the person in the Starbucks line who orders their coffee with seven different variations.”
Which of course will not do – consumers will be served. So the hard question was as put in a May speech by Hans Hoogervorst, chairman of the International Accounting Standards Board,
“whether IFRS Standards provide sufficient criteria by which performance can be judged by users of financial statements.”
As for actual abuses, the regulators will deal as best they can -- the record so far being spotty. While the SEC’s Division of Corporation Finance issued guidance in May, in practice, its review of non-GAAP filings has evidently given a pass to GE, although as reported by Dow Jones,
“the agency contended that the company’s disclosures could be unclear or confusing to investors and that its metrics may have excluded some costs they shouldn’t have.”
It is both noteworthy and unsurprising that non-GAAP measures have the unsettling tendency to favor an issuer’s desired reporting goals (see Howlett, above, and see Kevin LaCroix’s D&O Diary for August 8) -- the inevitable gaming of financial reporting being a human trait as old as the systems themselves.
So it should be timely to examine this central proposition:
If decision-making by the broad population of information users is now so focused on non-GAAP measures, does that not essentially challenge the adequacy, sufficiency and legitimacy of GAAP itself?
In other words, even though ill-founded herd behavior based on “conventional wisdom” is based on proximity, convenience and inertia, it still compels re-examination of GAAP’s basic utility – it being a core observation that even a position both long-established and intellectually robust is not immune from rejection or displacement.
Examples range from the trivial to the profound of beliefs that are “generally accepted.” Nothing abstract compels the action of a driver approaching an octagonal red sign – the expected stop is “generally accepted.” No written code obliges the congregation to stand for the bride when her father walks her to the altar.
Yet beliefs evolve. It was long held that the earth was the center of the astronomical universe, a position “generally accepted” by the world’s best thinkers from the time of Ptolemy, even as the model’s complexity of deferents, epicycles, eccentrics and equants become unwieldy to the point of breakdown – eventually to be consigned to history’s dustbin with the contributions of Copernicus, Keppler and Galileo.
Social policies supported by coercive legal systems throughout history included the “general acceptance” of such inhumanities as child labor, chattel slavery and exclusion of minorities – all of them to be swept away in more enlightened eras.
As for the future of GAAP under its current challenges, theoreticians in the development of knowledge teach that the displacement of long-held paradigms happens only when two conditions are met:
- First, the necessity must come to be recognized even by those with interests in preserving the status quo.
- Second, an alternative paradigm must be available to which to migrate. (For those interested, see Thomas Kuhn, “The Structure of Scientific Revolutions” (University of Chicago Press 1962).
So if as suggested, the dialog as to non-GAAP metrics has indeed engaged the attention of a quorum of the key players, there are two next steps in the process:
- The actual if reluctant acceptance of the need to explore the supplanting of GAAP itself.
- And the convening of a far-reaching discussion of the structure by which non-GAAP measures can be identified, articulated and codified with sufficient clarity to be integrated into a reporting and assurance structure by which investor needs can be truly served.
No part of this challenge lies beyond the reach of those leaders among the community of interests that comprise the Big Audit model. What is wanting is the acknowledgement that the state of the debate has indeed come this far.
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