Baruch Lev and Feng Gu have a problem with accounting. Both are professors of accounting and finance at NYU/Stern and SUNY Buffalo, respectively, who believe that GAAP financial statements have significant liabilities that limit original intent of GAAP—to represent the past and present status of a company in order to help investors predict the health of the company. The implications for FP&A are important.
GAAP vs. non-GAAP
Lev and Gu published “The End of Accounting” in 2016, in which they state the challenge: “The problem with reported earnings, and financial statements in general, is that they no longer reflect the realities of businesses. Instead, they follow an arcane set of accounting rules and regulations.” The authors take issue with earnings that mix one-time vagaries with long-term performance; illiquid assets that are marked to market; and subjective accounting assumptions that can swing earnings, such as rates of depreciation, future pension liabilities, or debt assumptions.
One example of the impact of assumptions: Last fall, Exxon was surrounded with questions about whether the value of its stated oil and gas reserves should be adjusted as market prices cratered, from over $110 per barrel to less than $30. Four of its main rivals booked more than $50 billion in write-down and impairments, while Exxon booked none at that time (the company did at a later date). Exxon claimed this was because of conservative accounting assumptions at the initiation of the project, and the belief that markets are volatile and that they can ramp up production at a time of their choosing, made large write-downs unnecessary.
The alternative, as suggested by the authors and effectively in place already on investor calls, are non-GAAP recalibrations of earnings and other operational metrics, including customer churn, annual recurring revenue and spending per customer. The company non-GAAP proponents cite the most is Amazon. Every year, CEO Jeff Bezos reprints his 1997 letter to shareholders in which he wrote, “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.” Amazon believes cash flow is maximized by obsessing over customers, and they track some 400 different customer metrics and pioneered many alternative metrics in the ecommerce sector.
Critics claim that the movement away from GAAP would lead to less rigorous analysis and confusing disclosures where any type of reporting is accepted. Sarcastically, these critics propose the EBE metric—“earnings before expenses.” Now, Lev and Gu have published a recent article that adds empirical data to support their book by arguing that investors may actually prefer non-GAAP reporting. They reach three important conclusions:
- Non-GAAP information is useful to investors, determined by the fact that changes in non-GAAP earnings were statistically correlated with price changes, whereas changes in GAAP earnings was not.
- Non-GAAP earnings are consistent across periods and, in fact, more consistent than GAAP earnings due to the elimination of transitory effects.
- GAAP earnings do not appear intended to mislead investors, as only a small percentage of cases found wide “surprise” disparities between GAAP and non-GAAP earnings.
This should make intuitive sense for FP&A. We often are the keepers of performance management, which is based on taking company objectives and breaking them down to actionable metrics for different business units. In addition, FP&A is “bilingual” in translating financial GAAP to the business units. The drivers in our driver-based models will link operations to GL lines to facilitate that linkage.
FP&A best practices
Lev and Gu’s work points to a set of best practices for FP&A to consider, to make these numbers actionable in a similar manner so that accounting is broadly understood.
First is to make a distinction between non-GAAP performance and financial measures. The SEC has strict rules regarding the presentation to financial measures (NGFMs) released to outside investors, and has actually tightened the reporting standards about what and how they can be presented (for reference, check the Harvard Law School Forum on Corporate Governance and Financial Regulation). Do not run afoul of these guidelines, and be sure to coordinate with your investor relations, legal and accounting teams in how the numbers are calculated and presented.
Second, non-GAAP metrics should have rigorous standards and answer the basic “W” questions: Who is the business owner of the metrics responsible for its improvement, and who is the neutral third party who is going to calculate it accurately? What is the definition of metric as written in business prose? Where is the acknowledged “true” data? When will it be calculated—frequency and periodicity of the metric? Why is this metric important to improving the business? How will the number be calculated (standard definition)?
Third, there is an opportunity to align your business if the numbers used to speak to investors relate to those used in internal management reporting and down to line operators. To the extent possible, non-GAAP reporting should be designed to roll-up from business units to an aggregate company level, and to be comparable across different units in the same way that a dollar of cash flow is intended. If the numbers are important enough to be reported to investors, they should be important enough to guide internal teams.
For years, Amazon delivered scant margins and earnings, and now is being touted as the most likely company to break the trillion-dollar market capitalization barrier. They have a culture that is rigorously focused on metrics, and they have rewarded their investors handsomely, and grown tremendously. To capture the full value of a company, FP&A needs to keep an eye on all the metrics.
Bryan Lapidus, FP&A, is a contributing consultant and author to the Association for Financial Professionals. Reach him at BLapidus@AllegianceAG.com.