Lurking within the financial statements and communications of public companies is a troubling trend. Alternative metrics, once used sparingly, have become increasingly ubiquitous and more detached from reality.

In 2011, Groupon Inc. announced plans for a highly anticipated initial public offering. But enthusiasm for the offering waned when the U.S. Securities and Exchange Commission (SEC) issued a comment letter questioning Groupon’s use of a profit metric it called “adjusted consolidated segment operating income.” To our knowledge, no company had ever used that metric before; it was intended to measure operating profit without including marketing expenses, stock-based compensation, and acquisition-related costs. Management argued that a $420 million loss from operations reported on its 2010 income statement should really be considered a $60 million gain.

For decades, companies have used custom metrics that don’t conform to generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS) as supplements to their official financial statements. (Although we use the term “non-GAAP” throughout this article, the arguments we make here apply equally to companies that report under IFRS and the related disclosure of “non-IFRS measures.”) Some common non-GAAP measures include free cash flow, funds from operations, adjusted revenues, adjusted earnings, adjusted earnings per share, adjusted earnings before interest, taxes, depreciation, and amortization (known as adjusted EBITDA), and net debt.

However, it’s not unusual for the alternative measures to lead to problems. Since companies devise their own methods of calculation, there’s no way to compare the metrics from company to company — or, in many cases, even from year to year within the same company. Lately, in the course of examining the financial statements and communications of thousands of public companies in at least a dozen countries, we have seen a troubling trend. Alternative measures, once used fairly sparingly and shared mostly with a small group of professional investors, have become more ubiquitous and further and further disconnected from reality. (See “About the Research.”)

References

1. A. Jagannath and T. Koller, “Building a Better Income Statement,” November 2013, www.mckinsey.com.

2. “An Alternative Picture of Performance: Alternative Performance Measure Reporting Practices in the FTSE 100,” January 2016, www.pwc.co.uk.

3. H. Hoogervorst, “Performance Reporting and the Pitfalls of Non-GAAP Metrics” (presentation at the Annual Congress of the European Accounting Association, Maastricht, Netherlands, May 11, 2016). There are occasional exceptions to this trend. For example, in 2015, GlaxoSmithKline PLC reported adjusted operating profit (a non-GAAP metric) of 5.7 billion pounds while operating profit (an official GAAP metric) was 10.3 billion pounds. The difference between these two figures was caused by gains on asset and business disposals that were removed in the non-GAAP measure.

4. D. Seetharaman,“Yahoo’s Marissa Mayer to Reap $187 Million After Verizon Deal,” The Wall Street Journal, April 25, 2017, p. B1; Trefis Team, “Groupon Misses on TopLine, but Beats on Profitability in Q1,” May 11, 2015, www.forbes.com; and E. Rosenfeld and D. Chu, “LinkedIn Plunges 40% in Early Trading, Erases $10B in Market Cap,” Feb. 5, 2016, www.nbr.com.

5. On p. 1 of PepsiCo’s 2015 annual report, chairman and CEO Indra K. Nooyi wrote, “Organic growth grew 5% in 2015.” However, official (or GAAP-based) revenue declined by 5%. “Organic growth” is defined by PepsiCo in this instance — it’s not an official number. Now turn to p. 59 of the PepsiCo Form 10-K included as part of the 2015 annual report online. The far right-hand column on p. 59 reconciles these two numbers. The key item is the line for foreign exchange translations of negative 10%. This accounts for the difference between the official income statement result (a reduction in net revenue of 5%) with organic growth of positive 5%. See “PepsiCo 2015 Annual Report,” 2015, www.pepsico.com.

6. “PepsiCo 2007 Annual Report,” www.pepsico.com.

7. M. Rapoport, “What Companies Strip Out of ‘Non-GAAP’ Earnings: Fines, Exec Bonuses, Severance, Rebranding Costs…,” Moneybeat (blog), Jan. 8, 2015, http://blogs.wsj.com.

8. M.E. Barth, I.D. Gow, and D.J. Taylor, “Why Do Pro Forma and Street Earnings Not Reflect Changes in GAAP? Evidence From SFAS 123R,” Review of Accounting Studies 17, no. 3 (September 2012): 526-562.

9. See M. Fahey, “Mind the GAAP: Buffett Warns of Deceptive Earnings,” March 1, 2016, www.cnbc.com.

10. M. Rapoport, “Tailored Accounting at IPOs Raises Flags,” Jan. 7, 2015, www.wsj.com.

11. F. Brod was a panelist on non-GAAP measures at the Association of International Certified Public Accountants (AICPA) Conference on Current SEC and PCAOB Developments 2016, Dec. 5-Dec. 7, 2016, Washington, D.C. See also E. Odoner and Weil, Gotshal, and Manges LLC, “SEC Guidance on ‘New GAAP’ Transition Disclosures and Non-GAAP Measures,” Jan. 14, 2017, http://corpgov .law.harvard.edu.

12. Microsoft closed the $26 billion deal in late December 2016. See J. Jamerson, “Microsoft Closes Acquisition of LinkedIn,” Dec. 28, 2016, www.wsj.com.

13. In fairness to Dudley, some of his 2015 pay was linked to an adjustment in the accounting rules that determine how pension benefits are calculated.

14. M. Rapoport, “SEC Has Reviewed Valeant’s Use of ‘Non-GAAP’ Financial Measures — Comment Letters,” Dow Jones Newswires, May 24, 2016; and U.S. Securities and Exchange Commission, comment letter re: Valeant Pharmaceuticals International, Inc. Form 8-K filed March 15, 2016, and amended March 15, 2016, file no. 001-14956, March 18, 2016, www.sec.gov.

15. N. Grover, “SEC Raises Concerns About Valeant’s Use of ‘Non-GAAP’ Measures,” Reuters, May 24, 2016, www.reuters.com.

16. S. Gandel and Reuters, “What Caused Valeant’s Epic 90% Plunge,” March 20, 2016, www.fortune.com.

17. U.S. Securities and Exchange Commission, “Final Rule: Conditions for Use of Non-GAAP Financial Measures,” Jan. 24, 2002, www.sec.gov.

18. U.S. Securities and Exchange Commission, “Non-GAAP Financial Measures,” May 17, 2016, www.sec.gov.

19. Comments by Brod at the Association of International Certified Public Accountants (AICPA) Conference on Current SEC and PCAOB Developments 2016.

20. T. McLaughlin, “Venezuela Roils Corporate Profits Around the Globe,” July 27, 2016, www.reuters.com.

i. H.D. Sherman, D. Carey, and R. Brust, “The Audit Committee’s New Agenda,” Harvard Business Review 87, no. 6 (June 2009): 92-99; H.D. Sherman and S.D. Young, “Where Financial Reporting Still Falls Short,” Harvard Business Review 94, no. 7/8 (July-August 2016: 76-84); and H.D. Sherman, S.D. Young, and H. Collingwood, “Profits You Can Trust: Spotting and Surviving Accounting Landmines” (Upper Saddle River, New Jersey: Financial Times Prentice Hall, 2003).

Acknowledgments

The authors would like to thank Andrea Ovans for her insightful editorial guidance.