[07/06/17] SEC Thinks Investors Are Patsies


(I am back from a European Lecture tour. Particularly gratifying was the launch of the Spanish translation of my recent book, The End of Accounting… The Chinese, Japanese, and Korean translations are on their way.) And now to the blog:

“American Airlines Group removed certain ‘descriptive language’ from its financials at the behest of the Securities and Exchange Commission,…. The regulator directed the airline to stop telling investors that numbers inconsistent with standard accounting were ‘more indicative’ of company performance and ‘more comparable’ to metrics reported by other major airlines.” (The Wall Street Journal, June 28, 2017.)

So, the SEC is now gagging managers. Wouldn’t you like to hear from corporate leaders—people who know a thing or two about their companies’ operations—which measures reflect best their companies’ performance? I definitely would. But now the SEC prohibits managers from telling investors the best way to assess corporate performance. As if investors, mostly educated people, often using sophisticated investment techniques, cannot judge for themselves whether mangers-preferred performance measures make sense, or are just intended to deceive them. SEC sees investors as helpless and uniformed, patsies who should be spoon-fed with GAAP numbers, and shielded from alternatives. That’s what the SEC apparently thinks of us.

I would be more understanding of the SEC “protective shield” from alternatives if GAAP earnings were really reflecting corporate performance and were reliable predictors of future growth. But as I have extensively demonstrated in the The End of Accounting, and argued in previous blogs, reported GAAP earnings lost in recent decades, courtesy the FASB, most of their relevance to investors. The statistical link between GAAP earnings and stock prices is now tenuous at best, and the ability of reported earnings to predict corporate performance is nil. In an article with Feng Gu, forthcoming in Financial Analysts Journal, we demonstrate empirically, that even if you could predict for sure all the companies that will meet or beat the quarterly consensus estimate, and buy these companies’ shares three months ahead of the earnings release, your investment gains will be negligible. Hard to believe, but even a perfect prediction of GAAP earnings is no longer a winning strategy.

So, I definitely would like to learn from corporate managers which non-GAAP indicators best reflect their companies’ performance. I resent the SEC preventing mangers from informing me about the measures they use to run the enterprise. Those who suspect that mangers are out to deceive them with non-GAAP indicators are welcome to use GAAP numbers. Good luck. But what’s the sense of preventing other investors from using non-GAAP measures, and finding out what managers think about those numbers relative to GAAP.

The Wall Street Journal article quoted above also mentioned that “The SEC has been on a push to rein in the use of accounting figures that deviate from U.S. Generally Accepted Accounting Principles. Companies often use non-GAAP figures to give a rosier account of performance, and the regulator has been concerned the practice could mislead investors.” Rosier account? Misleading investors? Let’s look at the record.

A 2016 research by Edith Leung and David Veenman titled “Non-GAAP Earnings Disclosure in Loss Firms” (you can Google it), examined the “most egregious” non-GAAP earnings of all: Those released by companies which report a loss under GAAP, yet provide a profitable non-GAAP earnings. Surely, the SEC and its acolytes will consider such non-GAAP transformations of losses to profits highly suspect and likely deceiving. Well, the researchers beg to differ.

Based on a large sample of 2,100 cases where quarterly GAAP earnings were negative while the non-GAAP numbers showed a profit, the authors conclude: (1) In 89% of the cases, analysts agree with the non-GAAP numbers, as evidenced by their adjusted earnings which are close to the companies’ non-GAAP earnings. (2) GAAP earnings are uninformative about future cash flows (the major intended use of earnings), whereas the “rosier” non-GAAP earnings of these companies were “significantly positively associated with future cash flows.” The authors conclude: “The finding lends further credence to the conclusion that non-GAAP earnings disclosures provide useful information to investors.”

Why do non-GAAP earnings better predict future cash flows than GAAP earnings? Because GAAP earnings are riddled with numerous one-time items (restructuring charges, assets and goodwill writeoffs, etc.) which hinder the prediction of future performance. Non-GAAP earnings often eliminate some of these one-time items. Moreover, in many cases GAAP losses are due to the indiscriminate expensing of investments which enhance future cash flows (R&D, customer acquisition costs, etc.), rendering the GAAP numbers useless in predicting future cash flows, as the above research demonstrated.

So, my plea to accounting regulators:  Given the sorry state of GAAP numbers, don’t prevent corporate managers from sharing with investors the measures that matter, and the reasons for the importance of such measures. And my message to investors: Examine carefully the increasing amount of non-GAAP data (not just non-GAAP earnings) disclosed by companies, such as, pharma’s product pipeline, customer franchise data for subscription-based companies, or new patent disclosures (see my previous blog “Should You Buy Amazon Shares Now?”). These non-GAAP data are very relevant to your investment decisions.




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