Investors wait expectantly every quarter for companies to report their revenues and earnings. These reports communicate companies’ historical financial performance and overall outlook going forward. As with anything, preparers need to use a common parlance. Historically, such reports included performance measures that were calculated based on generally accepted accounting principles (GAAP), to ensure everyone was on the same page.
Over the last three decades, however, financial preparers are also increasingly using non-GAAP measures to supplement their reports on their enterprises’ performance. And though several decades of research suggests this non-GAAP data is generally useful to investors, regulators are concerned that companies are sometimes opportunistically using them to misrepresent their financial performance. Thus, non-GAAP disclosures are subject to several regulations promulgated by the SEC over the past two decades.
University of Arkansas professor Zac Wiebe noticed a lack of clarity in the reasons companies chose to report non-GAAP measures of revenues. Prior research has generally concluded that non-GAAP earnings disclosures are informative to investors, but non-GAAP disclosures can encompass much more than earnings, and the motives for disclosing non-GAAP revenue are much less clear. Wiebe and his coresearchers, John Campbell of the University of Georgia and Kurt Gee of The Ohio State University, investigated why companies choose to disclose non-GAAP revenues and whether the disclosures are truly informative to investors.
In “The Determinants and Informativeness of Non-GAAP Revenue Disclosures,” the researchers find further support for the consensus of earlier research that non-GAAP reports are indeed useful for investors, on average. More specifically, Wiebe, Campbell, and Gee found that these reports were usually motivated by economic fundamentals and not opportunism like regulators fear.
However, the researchers also identified certain instances when companies seem to leverage non-GAAP revenue disclosure to misrepresent their positions. Their evidence is helpful to investors for understanding how to interpret companies’ reports and to regulators as they decide how to manage this new trend in financial reporting.
Why do companies report non-GAAP revenue data?
Almost 20% of all earnings press releases issued by U.S. public companies during 2015-2018 included a non-GAAP revenue disclosure, so it is a common practice that demands our attention. The researchers break the adjustments used in calculating non-GAAP revenues into four broad categories:
1. Foreign currency exchange adjustments
2. Adjustments for changes to the reporting entity
3. Satisfaction of acquired deferred revenue liabilities
4. Other, adjustments that don’t fit into the other three categories
Wiebe, Campbell, and Gee’s data show that the first two kinds of adjustments are by far the lion’s share of non-GAAP revenue adjustments, present in 73 and 50 percent of all non-GAAP revenue measures respectively. By adjusting for the effects of fluctuations in foreign currency exchange rates, companies that derive revenues from international sources are able to present core revenue growth on a constant currency basis. When firms engage in mergers, acquisitions, or divestitures, non-GAAP measures that adjust for such changes to the reporting entity can help highlight organic revenue growth.
The other two types of adjustments are present in a mere eight and seven percent of all such reports, respectively. When companies adjust for the satisfaction of acquired deferred revenue, they are trying to show revenue that GAAP would typically require to be recognized by standalone firms, but that goes unrecognized due to complex fair value accounting rules surrounding business combinations.
The last category, which the researchers labeled “other,” is the most concerning to regulators, and it is possibly the most misleading for investors. These reports may include “highly tailored adjustments,” and these kinds of non-GAAP revenue measures have drawn scrutiny from the SEC.
How GAAP and Non-GAAP Reports Compare
Unfortunately, we cannot just chalk these up to different accounting practices because there is a substantial difference between the reporting methods. For example, there is a nine percent difference in revenue growth between GAAP and non-GAAP reports. This difference doesn’t not always favor non-GAAP reports, but it often does.
Usually, firms use non-GAAP earnings disclosures to screen out one-time or nonoperating costs that do not present valuable data to investors, at least by their estimation. As such, supporters of issuing non-GAAP earnings say that these reports help to highlight the fundamental performance of a firm. Standard GAAP, they contend, includes transitory costs that are less relevant for forming expectations about future performance. In contrast to earnings which includes such costs (i.e., outflows), revenue reflects inflows from primary operations, and companies such as Tesla and Blackberry have issued non-GAAP revenue reports that have drawn scrutiny from the SEC and financial press. Many of these accusations glom onto what Wiebe, Campbell, and Gee call "other" reasons to use non-GAAP reports, the reasons for which even the researchers find particularly unclear.
In their sample of 414 firms, 26 received a comment from the SEC on their revenue reports. Interestingly, they found that in 23 percent of comment letters, the firm had issued a non-GAAP report for an "other" reason, despite such other adjustments being rare in the population. According to Wiebe, Campbell, and Gee, this difference is statistically significant, which contrasts with foreign currency, change to reporting entity, and satisfaction of deferred revenue reasons. In those cases, the differences between receiving a comment letter and not were insignificant, the researchers argue.
When firms do not have a clearly definable reason to issue a non-GAAP report, the SEC may question their motivations, and investors should think closely about what these firms are actually trying to do.
Implications for Regulators, Investors
Despite the potential for managerial opportunism depicted in "other" non-GAAP revenue disclosures, the researchers caution regulators to not be too hasty in nixing them. Rather, they found three key takeaways:
1. Firms usually use non-GAAP reports when GAAP revenue is incomparable to earlier quarters
2. Non-GAAP revenue is a better predictor of future growth than GAAP revenue is
3. Investors respond to non-GAAP revenue disclosures rationally in proportion to their predictive value
That is, the conditions for non-GAAP revenue disclosures are generally consistent with the underlying economic situation, not managerial opportunism. Moreover, they provide material value to investors, and investors seem to be able to distinguish any noise in the measures, on average.
The researchers say that these non-GAAP reports are usually “attempt[s] to inform rather than to mislead investors.” They do note, however, that both investors and regulators should treat each non-GAAP revenue disclosure individually because their idiosyncratic nature makes it difficult to say anything about them in aggregate.
As always, investors should use non-GAAP reports as one signal among many as they weigh investment opportunities. And companies would probably be served well if they were transparent about why they issue such reports.
