“Financial accounting metrics

Question -1. What arguments do companies makein favor of disclosing non-GAAP (pro forma) numbers?  Answer –    There hasbeen considerable debate about companies that use non-GAAP metricsfor executive compensation and whether these firms are manipulatingmetrics to boost C-suite pay. For investors who followenvironmental, social and governance (ESG) investing philosophy, asignificant component of the governance factor is executivecompensation and the metrics used to justify that pay. Theseinvestors and analysts need to be aware of non-GAAP metricssurrounding the debate, as excessive use of non-GAAP metrics andthe aggressive adjustments done to reach compensation targets cansuggest these firms are self-dealing and is a sign of poorgovernance.

The debate over non-GAAP executive pay metrics centers aroundtwo schools of thought. One argument suggests companies can usewhatever metrics they want, including non-GAAP, but those metricsneed to be transparently disclosed. The second school argues thatcertain non-GAAP metrics and adjustments are misleading and shouldbe banned.

Question – What should investors be concernedabout with respect to non-GAAP disclosures by companies?

Answer –  Non-GAAP earnings are analternative accounting method used to measure the earnings of acompany. Many companies report non-GAAP earnings in addition totheir earnings based on Generally Accepted Accounting Principles(GAAP). These pro forma figures, which exclude “one-time”transactions, can sometimes provide a more accurate measure of acompany’s financial performance from direct businessoperations.

However, investors need to be wary of a company’s potential formisleading reporting which excludes items that have a negativeeffect on GAAP earnings, quarter after quarter.company’s quality ofearnings is important, so investors need to consider the validityof non-GAAP exclusions on a case-by-case basis to avoid beingmisled.

Question – 3. What steps has the SEC taken tominimize the potential abuse non-GAAP disclosures?

Answer –

Rules implemented by the U.S. Securities and Exchange Commissionin 2003 impose additional disclosure and filing requirements onfirms publicly disclosing non-GAAP earnings. We find theregulations produced (1) modest declines in the frequency ofspecial- and other-item exclusions, (2) a decline in exclusionmagnitude, (3) a modest decline in the probability disclosedearnings meet or beat forecasts, and (4) a decline in theassociation between returns and forecast errors. Our resultssuggest that, while the regulations reduced firms’ use of non-GAAPdisclosures to improve performance perceptions, they also reducedfirms’ willingness to use non-GAAP earnings to convey permanentearnings.