October 31, 2017

Investor Survey: “GAAP Means Nothing to Me”

Here’s an interesting survey from Clermont Partners. Building on a recent book that contends GAAP reporting is no longer useful to investors, the survey asked 56 institutions with active (as opposed to passive) investment strategies 14 questions relating to the usefulness of GAAP information.  Here are some of their responses:

– 74% of respondents said they rely on non-GAAP more than GAAP reporting
– 64% said they use non-GAAP 60% of the time or more when analyzing stocks as compared to GAAP
– 44% agreed that, over time, non-GAAP measures have become more important in evaluating a company’s financial performance, while 28% disagreed
– Only 36% agreed that GAAP paints a true picture of a company’s finances

The non-GAAP measures respondents most prefer are free cash flow, EBITDA or adjusted EBITDA, and adjusted net income or adjusted EPS. The survey asked for investor comments – and got an earful. Here’s a selection:

– “GAAP is rarely comparable and doesn’t show us the underlying trends in the business.”
– “GAAP means nothing to me.”
– “Cash flow is all that matters.”

Not all investors were this dismissive of GAAP. Here are some of their comments:

– “We look at GAAP. But for growth companies there are always adjustments that make sense.”
– “We look at both and blend together. We take GAAP and then back out truly non-recurring charges with adjustments to reflect reality.”
– “I start with GAAP and make small adjustments. I’ll ignore amortization of acquired intangibles if the company is good at R&D and buys long-lived assets. I’ll normalize the tax rate. I might look at maintenance capex instead of depreciation. I always leave SBC (stock-based compensbation) in as a real expense.”

I’m of two minds when it comes to GAAP v. non-GAAP. The capital markets lawyer in me thinks that GAAP numbers mean something important and are really indispensable to any financial analysis of a company. On the other hand, the M&A lawyer in me realizes that GAAP earnings mean nothing when it comes to how buyers and sellers approach valuation.

Maybe that’s why the investor comment that resonated most with me when it comes to GAAP v. non-GAAP was this one that essentially split the baby – “A large and persistent divergence between the two is a HUGE warning sign.”

ISS Updates “QualityScore” Ratings: Core Factors Increase to 21

Yesterday, as reflected in this press release, ISS announced methodology changes to QualityScore – with an increase from 6 to 21 of the core factors considered. There is a data verification period between November 13th-28th for the changes – and the new changes are effective December 4th. Among others, new factors include evaluation of independence of the audit, nomination & compensation committees; unequal voting rights; and vesting periods for option & restricted stock awards.

Audit Committees: Implementing New GAAP Standards

Here’s an excerpt from a recent speech by the SEC’s Deputy Chief Accountant, Sagar Teotia, about the role of audit committees in implementing new GAAP standards:

The process of implementing the new GAAP standards is a collaborative effort from different stakeholders, and the importance of the audit committee in promoting an environment for management’s successful implementation of the new GAAP standards cannot be overstated. Through its oversight function, audit committees play a key role in establishing the right “tone at the top” for a company. The tone at the top establishes the environment and culture within which financial reporting occurs, and is a key factor contributing to the integrity of the financial reporting process.

Audit committees should continue to set the tone for the adoption of the new GAAP standards. This should include actively monitoring the implementation efforts, including taking the time to understand, and assess the quality and status of implementation. Simply put, I believe the tone set by an audit committee can affect the quality of a company’s implementation, including judgments made by management, and, ultimately, the quality of information provided to investors.

The speech covers a lot of other ground when it comes to implementation of the new revenue recognition standards, as well as the new lease and credit losses standards that are just around the corner.

John Jenkins