It’s been over a decade, 12 years to be exact, since Isaac C. Hunt, Jr. then Commissioner of the SEC, delivered his seminal "Accountants as Gatekeepers" speech. Those of you with gray hair (or no hair) will recall this speech for Hunt’s attack on managed earnings and “pro forma” financials.” In venting his frustration with non-GAAP metrics (today’s descriptor for bad financial metrics), he reminded securities issuers of their responsibilities to “make full and fair disclosure of all material information.” Hunt’s speech is particularly noteworthy as it points out that “federal securities laws, to a significant extent, make accountants the ‘gatekeepers’ to the public securities markets.
Recently, several articles have appeared in the popular press highlighting “new” ways that companies are reporting performance. In one, “New Benchmarks Crop Up in Companies Financial Reports,” Emily Chasan discusses how some firms are complementing financial reports with nontraditional performance benchmarks. What’s my beef you ask? Well, my objections this time are consistent with my recent rants about Black Box’s new metrics, and Citigroup’s new performance measurement system. Simply put, these supposedly innovative and insightful performance measures are neither! In fact, in most cases, they are quite the opposite, and actually mask real operating performance.
My grumpiness on this “new” disclosure business has reached the boiling point. I am so hot about this that I’m calling out today’s CFOs, as well as the Securities and Exchange Commission (SEC) to stop this nonsense once and for all. I propose scrapping the SEC’s current Regulation G, which governs the use of non-GAAP measures. Let’s replace it with a requirement that companies disclose real operating data and metrics, not just financial measures. But there is one hitch: none of the operating metrics I have in mind can use, or be based in any way on any financial statement data, or any combination of numbers that come from the general ledger system! Let me explain further.
As Ms. Chasan reports, some companies are beginning to disclose relevant operating data, particularly as it relates to customers (e.g., paid membership rates, active users, cumulative customers, etc.). Unfortunately, many more CFOs continue to try to sell us the same old “snake oil,” namely, “innovative” metrics that are nothing more than repackaged financial statement-based illusions. You know them well, EBITDA, adjusted EBITDA, and the like. And this deception has continued unabated for years…some of us even remember a wonderful piece by Jonathan Weil titled “Companies Pollute Earnings Reports, Leaving P/E Ratios Hard to Calculate.” Nevertheless, the result is the same: financially-based, non-GAAP performance measures that have less to do with the nuts and bolts of daily operating processes, and more to do with today’s troubled accounting “standards.”
Why do so many CFOs promote the use of these non-GAAP metrics? They maintain that these metrics are needed because financial statements prepared in accordance with generally accepted accounting principles (GAAP), particularly the income statement, don’t provide a complete and accurate picture of a company’s performance. But are CFOs really being driven to more non-GAAP metrics so as to present a clearer picture of the future direction of a business as recently suggested by Professors Paul Bahnson of Boise State and Paul Miller of UC – Colorado Springs?
What troubles me is that many of these same CFOs are the ones that have lobbied and pushed accounting standard-setters into today’s GAAP. These CFOs are talking out of both sides of their mouths. On the one hand, they lobby for less restrictive financial accounting standards, then flip on us, to shun the very rules they lobby for as not adequately reflecting their operating performance. Is this complete hypocrisy, or absolute genius?
Over a decade ago, SEC Commissioner Hunt also criticized CFOs for using pro-forma earnings to describe companies operations as “we’d like it to be”, which always seemed to “paint a rosier picture than GAAP might otherwise allow.” Isn’t it just amazing that companies which report consistently strong profits and operating cash flows, don’t use non-GAAP measures? Why is that? Their strategies are sound and their business models actually work! So, when CFOs argue for better performance metrics, do they really mean it? Probably not…if they did, they would stop wasting our time revising, adjusting, and yes, manipulating GAAP financial results in vain attempts to transform these historically-focused performance measures into predictors of the future. As the saying goes, “that dog don’t hunt, son.”
While their approach might seem reasonable to some, this grumpy old accountant finds it flawed for one very important reason. Financial statements by their very nature are retrospective, not future-oriented. In short, they tell us what happened yesterday, regardless of whether they are US or IFRS GAAP, historical cost or fair value.
So what’s the answer to this dilemma? How can we meet analyst and investor demands for information with predictive value? The answer to this disclosure need has been right under the noses of CFOs (and regulators) for a quarter of a century: the Balanced Scorecard. This time-tested performance measurement framework encourages managers to supplement their financial metrics with forward looking non-financial metrics. One defining characteristic of these forward looking metrics is that they cannot rely on, or be derived from financial statement data. Rather, they are based on non-financial operating data generated by a company’s business model and related processes.
If the Balanced Scorecard is so wonderful, why haven’t CFOs widely embraced it? After all, it is widely claimed that the CFO’s role has shifted to a more strategic focus (from accounting and reporting) over the past decade, especially in large firms. Why are these strategy-driven CFOs still so consumed with financial metrics, rather than the Scorecard? There are a variety of reasons, and they won’t surprise you.
Could it be ignorance? Surely not, after all today’s top CFOs come from top MBA programs where the Scorecard is a staple of the required performance measurement course. So why is there this disconnect? While CFOs may be aware of the Scorecard, they just might not understand their business models very well, particularly given the shift in their backgrounds from accounting to strategy. Without a detailed knowledge of a company’s operations, meaningful non-financial metrics are not possible.
Could it be laziness? Absolutely, particularly since constructing effective non-financial measures is challenging, especially in a dynamic business environment characterized by transaction speed and complexity. Then let’s add to this the short-term performance horizon of today’s CFO. Do we really think they are willing to invest the time and energy to create “real” performance metrics if they plan on moving on to another “opportunity” in a couple of years?
Or could it be something more sinister? Maybe the zeal to transform weak GAAP results into something more positive is simply the need to increase investor expectations and stock price. That’s where I would put my money: greed and the intent to deceive. But then again I did love the X-files...
So what’s my solution? Well, as I indicated earlier, let’s start by having the SEC scrap Regulation G. Next, ban ALL non-GAAP metrics in all securities filings. Let’s eliminate non-GAAP, “everything but the bad stuff,” disclosures once and for all. This would mean that ALL financially related disclosures (including ratios) would be based on GAAP. If analysts feel that GAAP numbers need to be adjusted for some reason, let them do it themselves. Yes, I recognize the sell side analysts might need some help given their generally weak accounting skills.
But what about analyst and investor needs for predictive information? After revoking Reg G and banning non-GAAP measures, I would urge the SEC to permit and encourage companies to report non-financial metrics consistent with the Balanced Scorecard’s learning and growth, business process, and customer dimensions. For example, CFOs could address such questions as:
• How well are company investments in technology, people and other resources performing?
• How well is a company’s business model performing (market analysis; R&D; sales and marketing; procurement, production, and distribution; and after-sale customer service)?
• How much do a company’s customers appreciate its product and/or service?
Now remember, none of the above metrics can rely on or be computed using any financial accounting data from a company’s general ledger that ultimately makes its way to the financial statements. These new metrics must come from data generated from a business model’s operations. This should not be a problem in today’s “big data” world. And even small companies have access to inexpensive tools to collect such data.
My proposal offers a win-win situation for everyone:
• First, analysts and investors get the predictive information they need given the required non-financial nature of the metrics.
• Regulators no longer must police filings for adjusted EBITDA and other “flaky” non-GAAP metrics.
• Large accounting and consulting firms get new revenue opportunities (i.e., the next wave) as they install new non-financial reporting systems using “big data.”
• Strategy-focused CFO’s no longer have to feign interest (or knowledge) about accounting numbers.
However, there is one party disadvantaged by this grumpy suggestion: the popular press. Journalists will lose non-GAAP metrics as fuel for future articles, thank goodness. No longer will we have to listen to or read about how these perverse financial distortions are new, innovative, and meaningful. I vote for that!
This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.