Re:Balance -- Jim Peterson

Non-GAAP Metrics – What Does “Generally Accepted” Really Mean?

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“Non-GAAP reporting has largely superseded GAAP reporting as the focus upon which management wishes analysts to pay attention.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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Book Announcement: "Count Down -- The Past, Present and Uncertain Future of the Big Four Accounting Firms"

For those who may have wondered -- my reduced schedule here in recent months had a reason: completion and readying for publication of my book, "Count Down -- The Past, Present and Uncertain Future of the Big Four Accounting Firms".

I am pleased and proud that the book is next in the Emerald Publishing Group's series, "Studies in the Development of Accounting Thought," edited by Gary Previts, E. Mandell de Windt Professor of Accountancy at Case Western Reserve University, member of the Accounting Hall of Fame and past president of the American Accounting Association.

Its scope -- bringing together themes long explored here and going back to my column in the International Herald Tribune -- is summarized in this from Emerald:

The post-Enron disintegration of Arthur Andersen in 2002 reduced to the surviving Big Four the number of international accounting firms that audit nearly all of the world’s largest public companies -- Deloitte, EY, KPMG and PwC.

 Despite their strengths -- market dominance, double-digit annual growth in non-audit services and continued revenue expansion to a global total above $ 120 billion in 2014 – the viability of the Big Four and their business model faces serious threats:

• Widespread dissatisfaction with the standard form and language of their core product -- the traditional “pass-fail” auditor’s report.

• The persistent “expectations gap” between their perceived performance quality and the stated desires of information users.

• Difficult relations with regulators and oversight agencies.

• And especially, the questionable ability of the Big Four and their partners to survive a “black swan” financial shock – a litigation judgment or law enforcement sanction on the scale that destroyed Arthur Andersen.

"Count Down" looks at the complex challenges facing the Big Four, questions the feasibility and achievability of the various proffered “solutions,” and proposes an evolved model for Big Audit that would be both sustainable for the large firms and fit to serve the capital markets of the 21^st century.

“ This book lifts the lid on the story behind the financial statements of the world’s major companies. If you want to understand the system that is allegedly validating the reported data - and why the system is a clone of the Maginot Line - expensive, obsolete and irrelevant - read on. Weak as the present system is, there is a solution. It will take a major change in regulatory attitude and a fresh approach, unfettered by history. The section on the imaginative use of Big Data is worth study by itself. “

     -- Duane R. Kullberg, Arthur Andersen & Co., S.C. Chief Executive Officer, 1980-1989

“Illusions of safety in size doomed allosaurus, empires, and auto makers. In his Count Down, Jim Peterson examines the fragility of the ineffectual audit regime, and the imminent threats to its survival. Peterson combines the insider’s knowledge with an outsider’s critical but sympathetic perspective and suggestions in this fascinating and insightful volume—a must-read for accountants and students of accounting.”

     -- Shyam Sunder, James L. Frank Professor of Accounting, Economics, and Finance, Yale School of Management

Scheduled release date is October 15. For information, and to order:

     From Emerald Books

     From Amazon

Please share with your friends and colleagues. For questions and other inquiries -- and for Emerald's pre-publication discount -- please write me: [email protected]

The American Accountancy Regulators’ Report Card: Not a Pretty Sight

 

"Kee-rist. Seven years of college, down the drain."

Two “F’s” -- two “D’s” -- and one big, glaring “Incomplete.”

That is the grade report this winter for the American accountancy regulators and standard-setters. If they were already on double secret probation, like Bluto and his fraternity brothers in Animal House, they’d be in the Dean’s office and on track for expulsion.

Start with the failures. First was the low-visibility footnote during the February 5 love-fest by which the SEC rubber-stamped the PCAOB’s new budget. As part of his remarks, the latter’s chairman James Doty said, as of a mere missing line item, “We don’t have an active project or work going on within the board to move forward on a term limit for auditors.”

There’s an ignominious end to an unworthy project. Not that it hasn’t long been obvious that Doty lacked board support, legislative backing or a sound intellectual or empirical basis for his marathon flogging of mandatory auditor rotation -- an idea was neither new nor defensible even when re-launched by the PCAOB three years ago. Somewhere on the report card of the agency’s meager accomplishments, there should be accountability for the waste of time, energy and resources expended in the tedious meetings, road trips and public panels on this misbegotten effort.

A second similar stealth exercise involved the ever-elusive relationship between generally accepted accounting standards in the US and the globally-preferred International Financial Reporting Standards. There, the chimerical “adopto-vergence” -- or whatever mot du jour is now in vogue – received a double hit. The SEC’s February 3 issuance of its latest Five Year Strategic Plan confirmed its long-standing attitude of death-by-inattention – with the anodyne statement (page 8) that “the agency will work to promote higher quality financial reporting worldwide,” while undertaking only to “consider, among other things, whether a single set of high-quality global accounting standards is achievable,” but conspicuously remaining totally silent and without a word of mention of IFRS.

While on January 29, the Financial Accounting Standards Foundation, governing parent of the American standard-setter, actually announced the grant of $ 3 million to support the work of the International Accounting Standards Board in its development of IFRS. While this subvention was touted as supportive of four on-going IFRS projects, skeptics of the long-term dithering on standards convergence would understandably view such an exercise in cross-border funding as if the coach of the American hockey team at the Olympics had qualified his loyalty by supplying equipment and training to the Russians.

As for the two activities that do not enhance a resume, even if they barely pass muster: First, the PCAOB on January 30 punted its extended deadline for comments on the proposal to identify audit engagement partners – an idea of such long gestation and so little substance that its potential usefulness is inverse to the time of its exposure.

And second on the “D” list, the PCAOB remains mired without progress on its small-change proposal to amend the standard auditor’s report, to include among other things the requirement for disclosure of “critical audit matters.” Never mind the overwhelmingly negative reactions in over four hundred comment letters on the concept release and proposed rule. Issuers, users and the profession alike have submitted the dual messages that any expanded disclosure should come from management and audit committees, and that the PCAOB’s proposal would only generate more unhelpful boilerplate and a minimum of user-friendly information.   

Last and still open is the question what to make of PCAOB chairman Doty’s bravura assertion before the SEC, in his remarks but not in his published speech, that, “Based on recent discussions, I am also optimistic that we will be able, during 2014, to sign a long-sought agreement to inspect the audit work of PCAOB-registered firms based in China.”

There may be those so beguiled by Doty’s melodious Texas accent and handsome career gravitas as to believe that this remarkable hostage to fortune amounts to credible likelihood of PCAOB inspection of audit firms in China. They are entitled to their views -- and the maneuvering after the SEC Administrative Law Judge’s enforcement order of January 22 against the Chinese firms of the Big Four for failure to produce subpoenaed documents is at least not inconsistent.

But over a decade into the PCAOB’s shut-out from China, Chairman Doty’s actual record of diplomatic accomplishment – contrasted with the bravado of his speech in the friendliest possible home-court setting – deservedly recalls Winston Churchill’s description of Clement Attlee, as “a sheep in sheep’s clothing.”

This is especially true as Doty heads into his fourth year as agency chairman – a tenure not exceeded by any of his predecessors – making it a good prediction that he will be either gone or going by the time of next year’s SEC budget party, leaving his successor to hold the poisoned chalice of a still-pending Chinese impasse.

And that’s especially the case, when recalling that the Chinese approach to negotiations – reflected in Zhou Enlai’s long-view perspective as to the impact of the French Revolution[1] – “too early to say” – is measured not in the tenure of American functionaries but over eras of celestial duration.

 

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[1] For the purpose, resolution is not needed of the commentators’ question whether Zhou was referring to the storming of the Bastille in 1798, or to the Paris student demonstrations in 1968.