When do non-GAAP metrics become fraudulent publicity?

For years, companies reported their figures under GAAP or IFRS standards. But what happens when a company commingles the GAAP/IFRS-based financial information with other performance metrics in its reports and press releases? These extra measures have no standards, and no one audits them — perfect conditions for fraud.

Let's create a company. Sprocketblend Inc. normally prepares its financial statements in accordance with generally accepted accounting principles (GAAP). These comprise a common set of accounting principles, standards and procedures that companies use to prepare their financial statements. In its first-quarter press release, Sprocketblend uses many of the GAAP terms found in its financial statements to describe its operating results. However, it also included a non-GAAP measure called "Recurring Net Income (RNI)." RNI is calculated by adding certain types of expenses and other reconciling items back to GAAP-reported net income. RNI appears to indicate that Sprocketblend is performing remarkably well, unlike its mediocre GAAP net income figures. The company's audit doesn't cover RNI, so readers of the press release were left scratching their heads because they couldn't know if Sprocketblend was upfront about its numbers or might be playing a little hocus-pocus. Not good.

Let's go a little deeper with two actual recent cases that illustrate this rapidly emerging fraudulent financial-reporting threat.

In a May enforcement action, the U.S. Securities and Exchange Commission (SEC) concluded that Swisher Hygiene Inc. fraudulently prepared its 2011 financial statements by violating GAAP. The SEC said Swisher had entered into a deferred prosecution agreement and paid a $2 million penalty. Swisher's departures from GAAP included failures to properly account for a debt prepayment penalty, certain employment contracts, earnouts and a variety of other improper earnings management issues.

In an April enforcement action, the SEC imposed a $1 million penalty on Cabela's Incorporated for violations of the Securities Exchange Act requirements to maintain accurate accounting records and a sufficient system of internal controls. In Cabela's case, these violations led to the company's failure to eliminate certain intercompany promotions fees in preparing its consolidated financial statements — a violation of GAAP.

What's fascinating about the Swisher and Cabela cases isn't the specific accounting rules they violated but, rather, the underlying motives that drove the violations. While most financial reporting fraudsters are motivated by a desire to misstate a specific figure reported under GAAP or IFRS (the International Financial Reporting Standards) — such as revenue, net income or total assets — non-GAAP performance measures drove these cases.

In Swisher's case, the focus was on "Adjusted EBITDA," a metric that the company focused on in its press releases in discussing the company's performance. EBITDA, a non-GAAP term that many companies commonly report, is an acronym for "earnings before interest, taxes, depreciation and amortization" (i.e. each of these expenses is added back to net income or loss).

Adjusted EBITDA — as disclosed by Swisher — excluded certain additional items from net income, including foreign currency gains, net gains/losses on debt-related, fair-value measurements; stock-based compensation; and third-party costs related to mergers and acquisitions. Swisher's GAAP violations enabled it to meet its targets for this critical non-GAAP performance measure.

Cabela's had its own non-GAAP metric that drove its violations. Its failure to eliminate an intercompany fee in preparing its consolidated financial statements had no effect on net income — a GAAP metric — because merchandise revenues of the parent company and operating costs of a subsidiary were overstated by equal amounts. It did, however, inflate Cabela's "merchandise gross profit margin," described by the SEC as "a key company-specific financial metric that signaled the profitability of the company and was referenced by the company in earnings releases and analysts calls." 

Why non-GAAP measures pose a risk

One of the most important ingredients necessary to objectively compare companies or to analyze a company's results over time is the consistent application of an agreed-upon set of principles applied to the preparation of the financial statements. In most jurisdictions throughout the world, these principles are referred to as GAAP. In addition to country-specific GAAP (such as U.S. GAAP, U.K. GAAP, Australian GAAP, etc.), many companies around the world now use IFRS.

But what happens when a company commingles GAAP/IFRS-based financial information with other financial performance metrics in its reports and press releases? These extra measures have no standards, and no one audits them. When investors make important investment decisions, should they rely on this additional information in the same ways they depend on the data that companies report in accordance with established accounting principles? Is the fraud risk heightened?

Non-GAAP measures have been described as "selective" and "biased." But is releasing selective or biased information an act of fraud? Hardly. If it were, we'd consider virtually every media release and advertisement fraud. (Though I suppose many pundits do.)

But when the information becomes "misleading," it enters the sphere of acts that might be considered fraudulent. In fact, we can view risks involving the use of non-GAAP performance measures on a continuum:

• When companies publish non-GAAP measures in press releases and reports alongside GAAP figures that have been audited, there's a risk that readers might mistakenly assign a higher level of credibility to the unaudited measures than they should.
• Because there are no formal standards applicable to non-GAAP measures, if a company changes how it calculates a particular measure from one year to the next, it's under no obligation to explain this change to readers. It can simply disclose whichever non-GAAP metric that looks good for that year along with a description of how it was calculated. Consistency from year to year is assumed under GAAP and inconsistencies (changes in methods) are required to be disclosed.
• When a company discloses reconciliations from GAAP to non-GAAP measures, risks associated with non-GAAP measures can vary based on the nature of the reconciling items. If the reconciling items consist solely of individual line items from the GAAP financial statements, the non-GAAP measures can be trusted more than when non-GAAP reconciling items are introduced to arrive at the non-GAAP metric. EBITDA is an example of this type of non-GAAP measure. Calculations of EBITDA are derived simply by backing certain items (interest, taxes, depreciation and amortization) out of the calculation of net income, and each of these items is presented as a line item in the audited GAAP/IFRS financial statements.
• Further elucidating the preceding point — the greatest risk of fraud exists in the reliability of the non-GAAP reconciling items used to calculate the non-GAAP measures. Non-GAAP measures like "underlying" net income and income "from recurring operations" (both explained further later) are examples of this because the amounts reported consist of specifically selected components of amounts reported in total in the audited financial statements. In theory, management has plucked out certain revenues or expenses that distort a comparison of one year to another, such as unusual charges, partial-year operations, etc. But readers have no assurance they did this accurately.

The non-GAAP measure can be reliable as long as a company clearly discloses and consistently follows the basis for calculating it. But readers must understand that these non-GAAP measures aren't covered by the auditor's opinion on the GAAP/IFRS-basis financial statements. And the same name for a non-GAAP measure is often defined and calculated differently from one company to another, which wouldn't be the case with GAAP and IFRS terms and measures.

Companies can easily create customized metrics to mask bad news that would otherwise be apparent if the analysts' focus remained on the GAAP/IFRS numbers. According to a March 11 report from FactSet of the Dow Jones Industrial companies that reported non-GAAP earnings per share (EPS) in addition to GAAP figures, the non-GAAP figure was on average 11.4 percent higher for 2014 financial reports. This difference rose to 30.7 percent for 2015 reports.

GAAP vs. non-GAAP reporting: a primer

Increasingly, companies are including a variety of non-GAAP financial performance measures in their annual and quarterly reports in addition to the GAAP/IFRS financial statements.

According to research from Audit Analytics, as quoted in a June 28 article in The Wall Street Journal, just 29 companies in the S&P 500 index — or 5.7 percent of the total — closed their books for 2015 using GAAP. Audit Analytics says that's a decline from 25 percent in 2006. (See Accounting Choices Blur Profit Picture, by Tatyana Shumsky and Theo Francis, The Wall Street Journal, June 28.)

And in a March academic paper, the authors noted that the frequency with which S&P 500 companies provide non-GAAP measures rose every year from 2009 (52.5 percent of companies) through 2014 (70.9 percent). (See Non-GAAP Reporting: A Comparability Crisis, March 2016, by Dirk E. Black, Theodore E, Christensen, Jack T. Ciesielski and Benjamin C. Whipple.)

Companies often include non-GAAP measures because they believe that including certain expenses or other items from an earnings calculation might distort views of their core operations. For example, excluding certain unusual, non-recurring expenditures that otherwise reduce GAAP net income results in an alternative net income (normally called something slightly different, like "recurring net income") and a non-GAAP/IFRS earnings per share (EPS).

A July 2015 report prepared by the Financial Reporting and Analysis Committee of the CFA Society of the United Kingdom demonstrated the rosier picture often painted by non-GAAP measures. Every year from 2008 through 2014, non-IFRS net income was higher than the reported IFRS income for members of the FTSE 100. And the difference wasn't small. For 2012, 2013 and 2014, non-IFRS net income was 144 percent, 140 percent and 148 percent, respectively. (See Non-IFRS Earnings and Alternative Performance Measures: Ensuring a Level Playing Field, July 2015, CFA Society of the UK.)

In addition to experiencing unusual or non-recurring transactions, another reason many companies use an alternative measure of profit — especially those that utilize IFRS — is the inclusion of fair-value adjustments resulting from asset revaluations in reported net income. Many view that excluding such gains or losses better reflects a company's operations.

Industry-specific needs drive some non-GAAP measures. For example, the Non-GAAP Reporting: A Comparability Crisis paper referenced earlier noted that use of non-GAAP measures is highest in the health care and information technology sectors — followed closely by utilities and materials.

Non-GAAP measures aren't limited to metrics involving profitability. Variations on cash flows reported in a GAAP/IFRS statement of cash flows are also common. Terms like "free cash flow" and "cash flow excluding exceptional items" are just two of many examples found in financial reports. Non-GAAP liquidity measures — "net financial debt" — are also sometimes reported to supplement the current ratio commonly calculated based on GAAP-reported current assets and current liabilities.

A global trend

Lest any readers think the non-GAAP measure issue is a "U.S. thing," we can find global examples of the accelerating trend toward alternative financial reporting disclosures. A search of U.K. financial reports quickly found companies disclosing both "reported" revenues, profits and earnings per share (based on GAAP/IFRS) alongside "underlying" figures for the same terms, plus some additional measures.

Often, the narrative sections of these reports focus almost exclusively on the "underlying" or other alternative figures. In one case, the "underlying" results were featured prominently on the first page of a press release along with a footnote directing the reader to page 24 for a definition of "underlying." This same company explains that "We believe underlying figures are more representative of the trading performance" than the "reported" numbers under IFRS.

The reporting and descriptions of "underlying" results can be found in other countries as well. In a guide jointly published by the Australian Institute of Company Directors and the Financial Services Institute of Australia, "underlying profit" is described as net profit determined in accordance with Australian Accounting Standards "as adjusted in order to present a figure which reflects the directors' assessment of the result for the ongoing business activities of the company." What? The "directors' assessment"? (See Underlying Profit: Principles for Reporting of Non-statutory Profit Information, 2009.)

Global use of non-GAAP performance measures isn't limited to use of "underlying" figures. A French company provided a list of nine "financial indicators not defined in IFRS," followed by its own definitions of each of these terms. As with the U.K. company mentioned earlier, the non-IFRS metrics were featured most prominently in its press releases.

In his March 2015 speech before the Korean Accounting Review International Symposium in Seoul, Korea, IASB Chair Hans Hoogervorst expressed concerns over the potential misuse of alternative performance measures. While pointing out that IASB has no fundamental objection to their use, Hoogervorst stated that "it is important to remember that non-GAAP measures represent a selective presentation of an entity's financial performance. Often, that selection is not free from bias."

Hoogervorst even cited a quote from Warren Buffett, who said "When CEOs tout EBITDA as a valuation guide, wire them up for a polygraph test" in the 2014 Letter to Shareholders from Berkshire Hathaway.

IASB has been studying the use of alternative performance measures as part of its Disclosure Initiative for several years.

Regulators chime in

In her keynote address at a conference in December 2015, SEC Chair Mary Jo White said the use of non-GAAP measures "deserves close attention." While acknowledging that non-GAAP measures can provide relevant and useful information, White noted that these measures can also be a "source of confusion."

In a March 2016 address at the 12th Annual Life Sciences Accounting and Reporting Conference, SEC Chief Accountant James V. Schnurr reiterated White's concerns, and he added that non-GAAP measures should "supplement the information in the financial statements and not supplant the information in the financial statements." But Schnurr elaborated on two important reasons why regulators are concerned.

First, the importance of non-GAAP measures relative to GAAP is alarming for regulators. "When the financial news networks report quarterly earnings, they frequently report the non-GAAP measure of earnings with no reference to the actual GAAP earnings, often not even identifying it as having been adjusted," Schnurr said.

This legitimate concern is exacerbated if analysts' expectations are established based mostly on non-GAAP measures. Potential solutions include changes or expansions to GAAP so it covers these measures or expansions to the scope of the audit, which places even more responsibility on auditors.

Schnurr's second concern pertains to the level of complexity in the reconciling items that take readers from GAAP to non-GAAP measures. Schnurr is "troubled by the extent and nature of the adjustments to arrive at alternative financial measures of profitability, as compared to net income, and alternative measures of cash generation, as compared to measures of liquidity or cash generation."

Indeed, the classic EBITDA calculation has only a handful of reconciling items from GAAP net income — for interest, taxes, depreciation and amortization (ITDA). But a quick review of filings reveals EBITDA measures with additional reconciling items, which the SEC previously has scolded other companies for doing. In 2007, the SEC objected to the disclosure of EBITDA by the company, Compagnie Generale de Geophysique-Veritas, in its Form 20-F annual report for 2006 when it calculated EBITDA by adding back stock-option expenses to net income in addition to ITDA. When the company filed its Form 20-F for 2007 it labeled this figure "EBITDAS" to distinguish it from EBITDA.

Regulators' enforcement and guidance

Of course, non-GAAP measures have been on regulators' radar for several years. The SEC's first enforcement action involving improper and misleading use of non-GAAP measures came in 2002 when it instituted a cease-and-desist proceeding against Trump Hotels & Casino Resorts. Trump Hotels issued a press release touting a net income figure higher than the GAAP figure. The company disclosed that the net income figure reported in the press release excluded a "one-time" charge, but it failed to disclose the inclusion of a one-time gain, which the SEC felt created a false impression that net income from its operations was higher than it really was.

Since then, the SEC has provided additional guidance on the use of non-GAAP financial measures. In 2003, it issued Conditions for Use of Non-GAAP Financial Measures, which described three disclosure models for non-GAAP measures. The model most commonly used, Regulation G, requires first and foremost that non-GAAP measures not be misleading and they be accompanied by the corresponding GAAP figure and a reconciliation between the two.

Also, quarterly and annual earnings releases are supposed to show GAAP measures with equal or greater prominence than non-GAAP measures, and companies must explain why the non-GAAP measures are useful for investors.

Quarterly and annual SEC filings that include non-GAAP measures must meet additional criteria, such as not excluding any costs from net income as "non-recurring" if a similar cost occurred with the two most recent years or is likely to recur in the next two and not using titles that are confusingly similar to titles used for GAAP purposes.

In May, the SEC posted updated guidance in a question-and-answer format on the use of non-GAAP measures. The May update added several sections to the previous guidance and examples of companies using non-GAAP measures that the SEC believes would result in misleading information. The SEC also provides examples of disclosures in which non-GAAP measures are "more prominent" than comparable GAAP measures — something the agency has prohibited.

Litigation over non-GAAP measures

The basis for legal actions involving GAAP/IFRS-reported financial information is usually clear. If a company claims that its financial statements have been prepared in accordance with GAAP/IFRS when the accounting doesn't really comply with GAAP/IFRS, it has committed a financial reporting fraud. (However, intent has to be established, which can be difficult. See my March/April 2015 "ACFE Cookbook" column, Proving intent proves to be tricky.)

The basis for legal action isn't so clear in the absence of a formally recognized set of principles for how amounts are to be measured. But this hasn't precluded litigants from claiming they've been misled with non-GAAP disclosures.

A complaint was filed earlier this year in connection with false statements allegedly made by Brixmor Property Group, a real estate investment trust (REIT) traded on the New York Stock Exchange. The suit, filed on behalf of shareholders, asserts that Brixmor "made materially false and misleading statements, and omitted materially adverse facts, about the Company's business, operations, and results." Language like this is not all that unusual in class-action suits alleging intentional violations of GAAP. But in this case, it is referring to a key non-GAAP measure.

Like many similar entities, Brixmor has historically published a figure for "same property NOI," (similar to the opening fictitious case). NOI refers to net-operating income, a non-GAAP figure that normally adds depreciation and amortization, interest expense, impairment charges and certain other reconciling items back to GAAP-reported net income. Same-property NOI also is net-operating income solely for properties that the organization owned and operated for the full reporting period.

The suit cites a Form 8-K filed by Brixmor in February 2016 that refers to an audit committee review, which concluded that "specific Company personnel, in certain instances, were directly involved and/or supervised persons directly involved in smoothing income items between reporting periods in a manner contrary to GAAP in an effort to achieve consistent quarterly same property net operating income growth, an industry non-GAAP financial measure." The February disclosure resulted in a one-day drop in Brixmor's share price of 20 percent (most of which the company subsequently recovered as of this article).

What next?

Many companies argue that GAAP/IFRS doesn't tell the whole story about their financial and operating results. But the rapid proliferation of non-GAAP performance measures has created a situation ripe for fraud that has caught the attention of regulators. We can expect regulators and standard-setters to further step up their oversight in this area and probably issue even more clarifications and guidance on the use of non-GAAP metrics.

In his May speech at the European Accounting Association annual meeting, IASB Chair Hans Hoogervorst reiterated his 2015 concerns I noted earlier (see above) and indicated that the IASB indeed might provide more detailed guidance on non-GAAP metrics.

In the meantime, we can also expect to see a rise in disagreements and litigation involving allegations that companies have used these metrics to deceive investors.

Regent Emeritus Gerry Zack, CFE, CPA, CIA, is an ACFE faculty member and was also the 2015 chair of the ACFE Board of Regents.