In this video I am going to discuss

GAAP versus non-GAAP metrics,

which is the hottest topic

in financial reporting.

It affects the very core of a company:

what is the reality of its financial performance?

GAAP versus non-GAAP discussions impact investors,

analysts, financial journalists, company leadership,

employees, the audit committee and external auditors.

A lot is at stake here!

Here's an overview of how this video is built up,

so you can make your choice of watching

it all the way through from beginning to end,

or jumping straight to the part that is of

particular interest to you.

First section: What does GAAP mean,

and what is non-GAAP?

Basically: why should I care?

Second section:

What are "common" non-GAAP metrics?

What does it look like?

Third section:

Why are there concerns about non-GAAP reporting?

Fourth section:

Which guidance have regulators issued

to improve transparency?

GAAP means Generally Accepted Accounting Principles,

more specifically US GAAP (the accounting

standards used in the US) or IFRS

(the International Financial Reporting Standards used in

126 other countries across the world).

Using GAAP provides uniformity

in how companies report their financial performance.

Having accounting standards like US GAAP and IFRS

enables you to compare the performance

of companies within and across economic sectors,

so the standards are necessarily

generic in nature.

GAAP numbers should be neutral,

comparable and verifiable, and provide information that

markets can trust.

Non-GAAP metrics are alternative definitions

of (in most cases) profitability, that are

supposed to enrich the financial information

that investors receive about a company's performance.

In other words, free-of-charge additional information

to provide insights into the company.

That sounds like ordering steak at a restaurant

like you always do, and getting a free side order

of vegetables with it.

Many companies will include a footnote that states

that "non-GAAP metrics are useful to

investors in their assessment of

our operating performance

and the valuation of our company".

While the steak and vegetables analogy sounds good,

a better comparison would be to use

the classical optical illusion

of the old woman and the young woman.

What do you see?

A young woman, an old woman, or can you see both?

The young woman is on the left,

and her gaze seems to be away from us,

facing towards the top left.

The old woman is in the center,

with her gaze facing downward and to the left.

If that is too hard to see, try the duck and the rabbit:

is this a drawing of a duck with

its beak on the left, or a drawing

of a rabbit with its mouth on the right

and its ears on the left?

Having a company present you with both GAAP

and non-GAAP information, is very similar

to being asked to spot

both perspectives in these drawings!

It takes a bit of practice,

and some people are better at it than others.

How does one spot a non-GAAP metric?

Well, the words "adjusted" and "excluding"

often give it away: adjusted Gross Profit,

adjusted EBITDA, adjusted Net Earnings,

adjusted Earnings Per Share, Operating Profit excluding

special items, Net Income excluding

non-recurring items, and on and on and on.

By the way, some companies don't call

non-GAAP information "non-GAAP",

but speak of core profitability

normalized profitability,

underlying profitability, or "pro forma" measures.

Here's an example of a company that provides

a list of non-operational items that it excludes

to get to adjusted EBITDA and adjusted EPS:

Verizon Communications.

Its profitability according to GAAP was unusually low

in 2012 and 2014, and unusually high in

2013 and 2015, mostly due to unusual charges

or credits in an operating expense line called

"Severance, Pension and Benefit".

It was a very significant charge (or extra cost)

in the range of 6 to 7 billion dollars

in 2012 and 2014, and a very significant credit

(or "negative cost") in 2013 and 2015.

If I want to do a long-term trend analysis as an investor,

it is useful to have the company

provide me with these numbers

to "normalize" the trend and exclude the noise.

Verizon is a very profitable company,

both under GAAP and non-GAAP metrics,

and adjustments from GAAP to non-GAAP

can go either way: results can become higher or lower

when unusual items are excluded.

Here's a second example:

pharmaceutical company Valeant.

In their overview of non-GAAP adjustments

to get from the GAAP net income at the top

to the non-GAAP net income at the bottom,

Valeant has a long list of up to 15 items,

and every year the non-GAAP results are higher

than the GAAP results.

In 2015, the company had a GAAP loss of $292 million

but an "adjusted" non-GAAP profit

of $2.8 billion after stripping out

amortization of intangible assets, acquisition costs and

other expenses.

On a revenue of $10.4 billion,

that means the GAAP net profit margin

of -3% has turned

into a non-GAAP profit margin of +27%.

Quite a difference!

So why should anyone worry about

the proliferation of non-GAAP measures?

There are four main reasons for that:

First of all, non-GAAP financial measures

are not audited!

The leadership of companies could be tempted

to behave in a more opportunistic way in classifying

results and defining metrics of success.

Second: more and more companies

are using non-GAAP financial measures,

which defeats the purpose

of the word "General" in the term

Generally Accepted Accounting Principles.

The Wall Street Journal recently reported

that only 6 percent of companies in the S&P500 index

reported 2015 financials using solely GAAP measures.

According to research firm Audit Analytics,

this figure was 25 percent in 2006.

Third: analysts and the media

have given non-GAAP metrics more prominence.

Fourth and perhaps most concerning,

non-GAAP results are very often better

than those reported under GAAP!

And the spread between them has been growing.

S&P published a study of FTSE100 companies

showing that around 80% of the companies reported

an adjusted operating profit that was higher

than the unadjusted operating profit.

So the big question is: how do we avoid

non-GAAP measures becoming

"Earnings Before Bad Stuff"?

Fortunately, the issue is in the spotlight

with regulatory agencies and

accounting standards boards,

all the way up to the chairmen!

They have made some very clear statements

about the concerns:

Securities and Exchange Commission

Chairman Mary Jo White has said:

"Non-GAAP information is meant to supplement

the GAAP information, but not supplant it."

and "In too many cases, the non-GAAP information

has become the key message to investors."

Hans Hoogervorst

(Chairman of the International Accounting Standards Board,

in charge of IFRS) said:

"Non-GAAP measures represent

a selective presentation

of an entity's financial performance.

Often, that selection is not free from bias." and

"We have found quite a few examples

of financial reporting where the IFRS numbers

are overshadowed

by non-GAAP measures.

In some cases,

it's really difficult to find the net income line."

Not only have representatives of regulatory agencies

and accounting standards boards voiced

their concerns, they are taking active steps

to reverse the trend of non-GAAP prominence.

Let's remember the overarching principle

of financial reporting: financial statements

should be a "fair and accurate representation"

of the company's financial position,

results of operations and cash flows.

For both GAAP and non-GAAP information,

another key principle is that

information cannot be misleading.

The active steps that are being taken

can be at the individual company level,

with the SEC sending more comment letters

to companies questioning their use

of non-GAAP metrics.

On the aggregate level, the SEC has issued

formal guidance on this topic.

Here are some striking examples of that guidance:

A non-GAAP measure that is adjusted only for

non-recurring charges when there were

non-recurring gains that occurred

during the same period

could violate Rule 100(b) of Regulation G

When a registrant presents a non-GAAP measure

it must present

the most directly comparable GAAP measure

with equal or greater prominence

- in this element of the guidance,

the SEC really spells it out:

do not present a non-GAAP measure

using a style of presentation

(such as bold or larger font) that emphasizes the

non-GAAP measure over the

comparable GAAP measure;

do not place a non-GAAP measure before

the most directly comparable GAAP measure;

do not include only a non-GAAP measure in

an earnings release headline.

Explain what is the purpose of the non-GAAP measure,

and why management believes investors

would find the non-GAAP measure useful.

Improvement is underway.

Among the S&P 500 companies reporting results

since the start of July 2016, 81% have given

prominence to GAAP figures, an increase from

the 52% that did so when reporting first-quarter

results, according to an Audit Analytics analysis

conducted for The Wall Street Journal.

I hope this was helpful.

Thank you for watching!

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