Out go the artisan income statements: The Securities and Exchange Commission is turning up the heat on firms that emphasize bespoke performance metrics. The regulator released updated guidance in December for firms that stray from generally accepted accounting principles (GAAP), warning that such practices – i.e., presenting inconsistent metrics between reporting periods or excluding non-recurring charges without doing the same for one-time gains – would be considered individually tailored and therefore misleading.
Subsequently, the SEC has sent letters to 20 companies questioning their use of non-GAAP metrics, The Wall Street Journal reports, citing data from provider MyLogIQ, up from 11 such communiques over the first two months of 2022. That number will likely grow in the coming months, predicts Olga Usvyatsky, former vice president at Ideagen Audit Analytics, considering the SEC’s newfound emphasis on the topic and the fact that such correspondence is typically made public 20 days after resolution. Thus, inquiries from the quarter ended in December should see the light of day this spring.
Among the chastised cohort: Lyft, Inc., which invited SEC scrutiny for adding back reserves against potential future insurance claims to its in-house adjusted Ebitda metric. After the agency instructed the ride share firm to remove that adjustment from its calculations, Lyft reported negative $248.3 million in adjusted Ebitda over the three months through December, compared to minus $47.6 million in the prior year period, after increasing its insurance reserves by $375 million in the fourth quarter.
Some on Wall Street, at least, have welcomed the non-GAAP crackdown with open arms. “We see this as a huge positive for capital market efficiency,” Northcoast Research Partners’ Ryan Connors wrote on Jan. 30. Terming the practice “accounting principles made up by management,” Connors argued that non-GAAP “accounting has become increasingly abused with surprisingly little pushback from analysts and investors, effectively penalizing companies hewing to accepted, standardized accounting methods.”
Corporate incentives driving the propagation of adjusted results are easy enough to understand, as a January paper by Nicholas Guest, assistant accounting professor at Cornell’s Johnson Graduate School of Management, along with co-researchers S.P. Kothari and Robert Pozen of the MIT Sloan School of Management, reaches an arguably intuitive conclusion:
CEOs of S&P 500 firms that report high non-GAAP earnings relative to GAAP earnings receive substantial unexplained pay. Crucially, this result remains even after controlling for the level of non-GAAP and GAAP earnings.
Our results are consistent with the managerial power framework of Bebchuk, Fried, and Walker (2002). In their model, all executives have at least some power to extract rents whenever the company lacks a controlling or dominant shareholder to provide discipline. However, outraged boards and dispersed shareholders who recognize rent extraction can impose some constraints.
The trio identified other salient features associated with companies most inclined to tweak their results in an optically pleasing fashion:
Additionally, despite. . . lower GAAP [income] and return performance, these firms are more likely to beat the earnings targets specified in their compensation plans, which likely increases investors’ perceptions of core operating earnings and reduces outrage. Indeed, these firms face less dissent from shareholders and proxy advisors, and no additional media scrutiny.
To wit: Kenneth Broad, co-chair at Jackson Square Partners, pointed out in a Jan. 29 letter to the Financial Times that Salesforce, Inc. reported an 18.7% operating margin over the 12-months ended March 1, 2022 under its home brew, though that figure would shrink to just 2.1% under GAAP. Similarly, 46.3% of reported free cash flow in that fiscal year resulted from the issuance of stock-based compensation expense, while shares outstanding have expanded by a hefty 28.4% over the past three-year period. Noting that “many of Silicon Valley’s leading firms tout similarly misleading financials,” the investor termed SBC-induced dilution
“the financial equivalent of quicksand from a shareholder value perspective.”
In the case of Salesforce, shareholders at least have their say, as CEO Marc Benioff holds just under 3% of the outstanding total while the cloud software behemoth issues only a single class of shares. Yet the proliferation of management-friendly voting structures across the lynchpin technology sector may foment the C-suite largesse highlighted by Guest et al.
A Feb. 19 paper from law firm Fenwick & West LLP found that 25.5% of the 2022 Fenwick Bloomberg Law Silicon Valley 150 – an index tracking some of the largest names in tech and life sciences – utilized a dual-class voting structure in 2022, up from just 2.9% in 2011. That increase runs counter to corporate America at large, as the share of S&P 100 firms conferring such super-voting shares on insiders shrunk to 5% last year from 9% in 2011.
Tellingly, firms that came public during the Covid-era euphoria capitalized on those friendly conditions en masse. A cool 46.6% of the 118 technology IPOs in 2021 sported a dual-class structure, data from University of Florida professor Jay R. Ritter show, while a 23.8% share of the 193 non-tech IPOs opted for the same.