Creative Accounting Makes a Comeback

Short Article: Creative Accounting Makes a Comeback

By: David Milstead

Pub. Date: November 9, 2015 Access Date: September 24, 2021 DOI: 10.1177/2374556815618956 Source URL: http://businessresearcher.sagepub.com/sbr-1645-97431-2702222/20151109/short-article-creative-accounting-makes-a- comeback ©2021 SAGE Publishing, Inc. All Rights Reserved. ©2021 SAGE Publishing, Inc. All Rights Reserved. Critics deride companies' attempts to polish earnings reports Executive Summary

Companies increasingly are citing financial metrics that don't conform to Generally Accepted Accounting Principles (GAAP). Advocates of such non-GAAP measures say they more accurately reflect complex business models. Critics say such reporting is simply meant to put an unjustifiably optimistic spin on results. Full Article

Investors can examine dozens of financial metrics to evaluate a company's performance. The daily-deal company Groupon, however, seemingly created a new, head-scratching one in 2011 as it prepared to sell its shares to the public for the first time. The company eschewed both net income and EBITDA—a profit measure that leaves out a number of expenses—and instead trumpeted its “adjusted consolidated segment operating income,” or ACSOI, which didn't count its substantial marketing costs against its earnings. Results showed why Groupon preferred its homemade measure: For 2010, Groupon's ACSOI was a positive $60.6 million, but its operating loss was $420.3 million. 1 Groupon's attempt to massage its numbers was met with widespread derision, and the Securities and Exchange Commission (SEC) ultimately forced the company to drop the metric from its securities filings. But the dust-up was another clash in a long-running battle between companies on the one side, and regulators and investor advocates on the other, over the best ways to describe a company's results: Although regulators repeatedly have tried to tamp down the use of accounting adjustments, the practice has made a comeback in recent years. (See Data, "Non-GAAP Accounting.") Traditionally, net income (essentially income earned after expenses, the cost of goods sold and taxes) is calculated according to Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS) in much of the rest of the world. But when companies publicize their successes each quarter, they don't always highlight net income. Many use EBITDA, or earnings before interest, taxes, depreciation and amortization. Sometimes, companies make further adjustments and trumpet something called “adjusted EBITDA.” In making these adjustments, companies typically leave out items that are recorded as expenses but don't necessarily represent cash flowing out of the company. Depreciation, which reflects the use of assets over time, is one example. Sometimes, these items, such as the interest paid on borrowings, reflect how a company finances itself, rather than how the core business itself is performing. “As business models evolve and grow in complexity, and as those in financial reporting roles struggle to satisfy the growing appetite of a hungry investing public, non-GAAP measures are being used increasingly by smart companies … to communicate effectively and clearly their financial performance,” wrote Rick Smetanka, a partner at Haskell & White, an Irvine, Calif.-based accounting firm. “The use of non- GAAP financial measures is making a comeback.” 2 Critics see these “adjustments” in a different light. “It's just outrageous what the SEC will allow these firms to get away with,” says Michael C. “Chris” Knapp, a professor of accounting at the University of Oklahoma. “They have their [GAAP] numbers, and then they put out these press releases and say, ‘Oh, by the way, wink, wink, here is what we really earned. This is what you really should look at.’ I don't understand that—well, I do understand it. The financial reporting process has been compromised and captured by these huge corporate interests.” U.S. regulators and lawmakers cracked down on the practice once, more than a decade ago. In January 2002, the SEC brought its first “pro forma” financial reporting case—so-called because companies sometimes used the term to describe measures that did not conform to GAAP—against Trump Hotels & Casino Resorts. The SEC alleged the company “cited pro forma figures to tout the Company's purportedly positive results of operations but failed to disclose that those results were primarily attributable to an unusual one-time gain rather than to operations.” (The company settled the case without admitting or denying the SEC's findings, a common conclusion to the commission's enforcement cases.) 3 The 2002 Sarbanes-Oxley law called for accounting rules that required companies that use non-GAAP measures to include “the most directly comparable GAAP financial measure” and to show how the company arrived at its preferred measure. 4 That requirement had an impact—for a while. But as stock markets rose after the 2008 financial crisis and a new wave of technology companies stoked investor enthusiasm, non-GAAP metrics began a comeback. The use of adjusted earnings is widespread, particularly in the technology world. In summer 2013, investing newspaper Barron's found that tech companies Facebook, Google, Amazon,

Salesforce, LinkedIn and VMware were all excluding the costs of stock-based compensation—stock options and other share awards—in their preferred earnings metrics. “Investors probably should re-evaluate how they stack up relative to companies inside and outside tech that use standard earnings calculations,” Barron's said. 5 In late 2015, Valeant Pharmaceuticals Inc., a Canadian drug company, saw its market capitalization—the total value of its publicly traded shares—drop from $90 billion to $34 billion in three months as investors became concerned about the company's financial disclosures and about regulatory risks from the way it priced its drugs. Valeant, said New York Times financial columnist Gretchen Morgenson, “is among a growing number of companies that regularly present two types of financial results: those that adhere to generally accepted accounting principles, and those that help executives put the best spin on their operations.” The company presents a lesson to investors on “the perils of relying on earnings forecasts and stock valuations based on fantasy rather than reality.” 6 Dennis R. “Denny” Beresford, who served as chairman of the Financial Accounting Standards Board from 1987 to 1997, defends both the use of non-GAAP metrics and the SEC's treatment of them. Beresford, a former board member of consumer products company Kimberly- Clark, says that company reported several adjustments to its 2014 earnings. “Each of them were items that were arguably were not part of the continuing ongoing operations. You know, somebody who wanted to take a hard look at Kimberly-Clark and think, ‘What would be my expectations about what this company should be doing going forward?’ might make that analysis themselves.” He says, “I think the SEC is on the case and is looking at the ones that are egregious or are doing things that just don't make a lot of sense. But for the most part, companies that are showing non-GAAP measures are doing it according to the rules and in a way that is reasonable.” About the Author

A Denver-based freelance writer, David Milstead is a regular contributor to The Globe and Mail, the national newspaper of Canada. He has individually or jointly won nine national awards from SABEW, the Society of American Business Editors and Writers. He passed the Level I exam in the Chartered Financial Analyst program in 2007. In a previous report for SAGE Business Researcher, he wrote about pensions. Notes

[1] Shayndi Raice and Lynn Cowan, “Groupon Bows to Pressure,” The Wall Street Journal, Aug. 11, 2011, http://tinyurl.com/oyhnxsc. [2] Rick Smetanka, “GAAP or Non-GAAP?” Financial Executive, November 2012, http://tinyurl.com/nnbpe9w. [3] “SEC Brings First Pro Forma Financial Reporting Case: Trump Hotels Charged With Issuing Misleading Earnings Release,” news release, Securities and Exchange Commission, Jan. 16, 2002, http://tinyurl.com/ogzv934. [4] “Final Rule: Conditions for Use of Non-GAAP Financial Measures,” Securities and Exchange Commission, Jan. 24, 2002, http://tinyurl.com/6ju7qm. [5] Andrew Bary, “Beware the Hidden Costs in Tech,” Barron's, June 1, 2013, http://tinyurl.com/opcyetw. [6] Gretchen Morgenson, “Valeant Shows the Perils of Fantasy Numbers,” The New York Times, Oct. 30, 2015, http://tinyurl.com/o4molfb.

Page 3 of 3 Short Article: Creative Accounting Makes a Comeback SAGE Business Researcher