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04/24/2007

Is It Just Me or is GAAP Completely Broken?

Pardon me while I descend into the inner circles of business/financial hell and discuss accounting for a bit.  As most will know GAAP, aka the Generally Accepted Accounting Principles, forms the bedrock foundation of the US financial reporting system.  The fundamental idea behind GAAP is a very good one: If everybody follows the same accounting rules, then all forms of business can be conducted with a reasonable degree of confidence that financial reports consistently reflect reality, or at least GAAP's version of reality.

Unfortunately, thanks to both the accounting profession's seemingly insatiable appetite for "continuous improvement" as well as creative CFO's equally insatiable appetite for financial obfuscation,  GAAP's version of reality has become so convoluted that almost every public company now feels compelled to report not just "GAAP earnings" but also "non-GAAP earnings".  What are "non-GAAP earnings"?   Well they are basically whatever a company wants them to be and not surprisingly they usually make a company's "earnings" look a lot better.

Counting The Reasons
To get a taste of why everyone from companies to investors to lenders increasingly view GAAP as broken, let me give you a few choice examples:

  1. Intangibles vs. Goodwill Accounting: Intangibles are sometimes known as the "soft assets" of a company. They are composed of things such patents, customer lists, and trademarks. Goodwill is also considered an asset, but it is really just a book entry that accounts for the difference between the purchase price of an asset and it's actual value. For example, if GE buys a company for $1BN and that company only has $300M in identifiable net assets, then GE magically creates $700M worth of goodwill and books it to its balance sheet to keep everything in balance. Back in the old days (i.e. mid 1990s), companies were required to depreciate both intangibles and goodwill under the theory that the value of both decayed over time. That rule was changed after a bunch of people complained and now only intangible assets depreciate. Why does this matter (I warned you we were descending into accounting hell)? Because there's a fair amount of leeway for companies to do what is called purchase price allocation. This means that two companies buying the same firm for the same price might come up with different values for how much of their purchase price was spent on intangibles and how much was spent on goodwill. Why does this matter? Because the company that allocates more of the purchase price to intangibles will have lower reported GAAP earnings while the company that allocates more to goodwill will have higher earnings, yet they both purchased the same thing. Make sense? Well it doesn't make sense to investors and that's why they have increasingly tended to ignore intangible related amortization expenses. Investor's willingness to look the other way has in turn encouraged many companies to strip out all amortization expenses from their non-GAAP earnings. It's gone so far that some companies actually have the balls to exclude not just amortization but also depreciation of hard assets from their "non-GAAP" results.
  2. Stock Options: One of the more entertaining battles of the last few years was the battle between Silicon Valley and just about everyone else over stock option accounting. Up until 2006, most companies that granted stock options did not actually book any expenses for those options, they just disclosed them and included them when calculating what's called their "fully diluted" earnings per share. The accountants argued, rightfully so in most respects, that these options did in fact cost something and that companies should be forced to recognize an expense during the period they were granted even though there was no real cash expense occurred. The accountants won the day and since late 2005 all companies that grant options have had to include some kind of "stock based compensation" expense. How does one calculate stock option expense? Well, basically by making a lot of assumptions. While there are guidelines for these assumptions, the reality is that there are large differences in assumptions across companies. This means that even if two companies grant the same amount of stock options at the same relative price they could have dramatically different stock-based compensation expenses, not to mention that in both of their cases this expense is a non-cash expense. To make matters worse, this expense can change dramatically from year to year even if the same # of shares is issued at the same strike price. The final absurdity is that these expenses are required to be allocated to the individual line items such as Sales & Marketing or Research &Development which means these line items can see big jumps or declines based not on actual operating expenses, but on a highly volatile theoretical non-cash expense that may or not actually ever be realized. What has been the response of investors and companies to this? Typically to ignore them by reporting non-GAAP earnings that exclude stock-based compensation expense. In the end, non-GAAP reporting has made all the fighting over stock option expenses much ado about nothing. It's ironic to think that the one accounting change that FASB has fought the hardest for in recent memory has done more to increase the prevalence of non-GAAP reporting than anything else.
  3. Deferred Revenues:  When a company receives payment for services they have yet to perform they end up having to defer revenue recognition on large portion of that payment. For example, if a customer pays a company upfront for 12 months of maintenance and support, the company typically only recognizes 1/12 of that revenue up front while the rest of the payment is booked as deferred revenue and recognized ratably over the ensuing months. This is a pretty elementary accounting concept but thanks to some new GAAP rules things can get pretty complicated in the event of an acquisition. Under the new rules, any deferred revenues that are acquired typically flow through the income statement at cost. That is the revenue recognized is equal to the cost of goods sold. The practical effect of this is to decrease both the revenues and the earnings of the combined company (sometimes very significantly), but only for a short time (usually 12 months or so). After that, revenues and margins shoot back up as the company renews its maintenance and support contracts (potentially creating the false impression of growth). This leads to the rather bizarre scenario where a $1000 yearly support contract is worth only $400 in revenues and $0 in gross margin one year, but $1000 in revenue and $600 in gross margin the next. What has this craziness led to? You guessed it, companies are now reporting non-GAAP revenues (which include the full amount of the deferred revenues) in addition to non-GAAP expenses.

These are just three choice examples that I run into almost every day as software investor, anyone with their own personal favorite is encouraged to leave a comment.

The Law of Unintended Consequences
The net effect of these convoluted accounting treatments based on idiosyncratic assumptions is that they encourage and indeed almost compel companies to report non-GAAP earnings because the actual financial health of a company can differ dramatically from what its current period income statement might suggest. Defenders of FASB may argue that all of the rules I have discussed have a solid theoretical basis (and indeed I admit they do… mostly), but they can't ignore the obvious: the rapid proliferation of non-GAAP financial reports is symptomatic of serious flaws in GAAP because if GAAP was really doing its job there would be no need for non-GAAP reports.

What's more, because there is no standard for non-GAAP earnings there is no way for anyone to compare "non-GAAP" performance across companies. As an investor I see this every day, especially when it comes it comes to Wall Street earnings estimates. For some companies, the analysts appear to have made some kind of secret pact to only make non-GAAP forecasts while for others they are still forecasting traditional GAAP earnings. This mismatch leads to a situation where trying to compare earnings estimates across companies is an exercise in futility. When some financial reporter solemnly intones about the "Forward PE" of this or that sector being at a record high or low I have to laugh because the sector PE probably has a 100 different definitions of earnings per share embedded in it.

There are other non-obvious consequences of this as well. For example, people wonder how in the world private equity firms can afford to pay 30 or 40 times earnings for a company. One of the biggest reasons (beyond cheap credit and lower underwriting standards) is that thanks to all these convoluted GAAP rules (and the large expense required to comply with them) there is such a huge disconnect between the income statement and cash flow statement that Private Equity firms can appear to pay huge earnings multiples when they are really paying much smaller multiples of normalized cash flow.

Is Cash Really King?
The result of all this chaos is that most financial analysts, and increasingly many customers and partners, seem to be spending a lot more time focusing on free cash flow. Valuation purists would argue this is where they should have been all along and it's true that the cash flow statement leaves much less room for interpretation, but income statements are there for a reason. Cash flow statements have their analytical limitations, especially when it comes to high growth companies that might consume a lot of working capital in their formative years. Regardless, the solution to GAAP's increasing flaws should not be to toss out the income statement altogether, but to try and fix it or at least create some additional standardized definitions of "adjusted net income" so that everyone can at least have a common basis for comparison.

April 24, 2007 | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.