Apr 3rd 2011
Revealing the gaps in non-GAAP reporting
Stephen Taylor, Professor of Accounting and Associate Dean of Research at UTS Business School, is dedicated to understanding what information is important to capital markets and the incentives firms have for providing information where it’s not just a statutory requirement.
He says it’s all about getting a more complete picture of how markets use information.
The use of non-Generally Accepted Accounting Principles (non-GAAP) reporting by Australian firms is growing at a pace unmatched anywhere else in the world.
It’s a term used to describe the way companies supplement the information they provide in their statutory accounts with their own definition of profit, separate from the statutory definition of profit that every Australian company is required to report.
Many companies claim non-GAAP reporting is more representative of their results and argue that it’s good to provide more information to capital markets, but on the other hand, non-GAAP reporting leaves open the door for a misinterpretation of profit figures, especially if negative items are selectively removed to make a firm’s result look better.
One of the major concerns about this practice is whether managers are arguing that they should eliminate items that are non-recurring, or once-offs.
When you dig more deeply into many of these one-off items, you find they are related to actions such as closing a subsidiary that is no longer profitable. When we say that that’s a one-off item and shouldn’t be thought of in terms of the firms operating or recurring profit, we need to ask who’s really responsible for the fact that the subsidiary needs to be closed? Should the costs associated with that, the fact that it’s no longer profitable have been recognised in prior periods?
What can happen in these sorts of situations is negative performance that would ultimately reflect back on management and the board of directors is packaged up as a one-off item, and investors are told “look don’t worry about that because it’s not part of our recurring operations.”
Lynn Turner, a former chief accountant for the Securities and Exchange Commission, once described the practice of non gap reporting as “EBBS: earnings before bad stuff.”
Another problem with the practice of non-GAAP reporting is that in many cases it makes comparisons of results between similar firms almost a complete mystery.
The question is does anybody actually know for sure what non-GAAP profit figures really represent?
Not only is there the possibility that managers will opportunistically modify their definition of profit from one period to the next, so as to present their firm in the best possible light, but also it makes is potentially much harder for investors to make legitimate comparisons, not just over time for a given firm, but to be able to compare to compare results between firms.
In other major capital markets, such as the US, there are very strict requirements around how a firm can report a definition of profit other than the statutory definition. In Australia non-GAAP reporting is virtually unregulated.
The UTS Business School is in the process of using “text search” technology to build a database of Australian company reporting. From this research, we hope to be able to understand why firms use non-GAAP reporting and to examine the differences between firms that do and do not adopt the practice of reporting supplementary non-GAAP profit figures.
We’re also keen to better understand the consequences of non-GAAP reporting.
Do investors react more favourably to non-GAAP reported earnings than they do to statutory profit figures?
What happens if firms start choosing their won definitions of profit?
This research piece will have important implications, not just for regulators, but also for the investment community broadly and particularly accounting standard setters. If accounting setters are there for a reason, it’s essentially to provide rules that enable the production of a set of results that can be interpreted over time and between companies.
With a better understanding of why firms use non-GAAP reporting and the consequences of it, we will be much better informed about whether or not there’s any legitimate case for regulatory intervention in this practice.