Tech's Addiction to Fuzzy Math
In the headquarters of technology companies, GAAP is becoming an endangered species.
There has been a spate of smart articles recently about the growing use of "pro forma," "adjusted" or "non-GAAP" earnings, which are handpicked profit numbers that don't conform to the (admittedly arcane) generally accepted accounting principles, or GAAP. Officials at the Securities and Exchange Commission have said they're keeping a close watch on companies that disclose two sets of earnings and whether the behavior distorts investors' understanding of corporate America.
SEC Chair Mary Jo White may want to book a special sightseeing trip to Silicon Valley, because gussied-up financial metrics are more popular in the tech world than pour-over coffee and kale juice.
Eighty percent of technology companies in the S&P 500 index used handpicked profit measures that revised their earnings higher in their most recent fiscal years, according to Bloomberg data. The collective yearly net income of the 70 tech firms 1 in the stock index was about $194 billion under generally accepted accounting principles. Using each company's preferred non-GAAP profit methodology, collective earnings were 23 percent higher, or $239 billion.
The point of non-GAAP financial metrics is to help investors better understand a company's core business without distortions like the costs to write off an unpromising product line or the hit from a tax penalty.
But now that non-GAAP is a financial reporting fixture for nearly all technology companies, the handpicked numbers are shifting from illuminating to obfuscating. The reliance on adjusted financial metrics that may change at a company's whim can distort valuations and makes it tough to compare companies with one another and historical norms.
Tech companies have typically preferred to strip out the expenses related to stock doled out to employees, even though the equity payouts are a regular cost of doing business. Some companies are going even further by adjusting financial numbers like revenue that should be fairly straightforward.
Salesforce.com is among the tech world's non-GAAP wizards. In its financial results for its just ended fiscal year, the software firm gave a 700-word explanation of the excess baggage it throws overboard to arrive at its non-GAAP profit. The company excludes stock compensation for employees, strips away the annual portion of costs for assets Salesforce has bought and substitutes a smoothed-out calculation of taxes for actual taxes paid.
The effect is drastic. Salesforce's reported net loss was $47 million going by the accounting rule book. Excluding those 700 words of adjustments, the loss transformed into a profit of $507 million. Magic!
The biggest chunk of the discrepancy was related to stock compensation. The company says stock pay "varies for reasons that are generally unrelated" to Salesforce's business and therefore shouldn't be part of investors' evaluation of its operations and financial health. But stock pay is a regular element of Salesforce's operations. In the last decade the company has consistently paid 7 percent to 12.4 percent of its revenue as stock to employees and others.
Like Salesforce, Facebook also strips out the cost of its employee stock compensation from its non-GAAP net income. Unlike Salesforce, Facebook also removes from its preferred profit figures the payroll taxes associated with employee stock options. The roster of adjustments increased Facebook's preferred profit measure to $6.5 billion in 2015, or 78 percent higher than its net income under GAAP.
Facebook's stock trades at 48 times the non-GAAP profits for the last year. The P/E ratio jumps to 84 using the company's GAAP net income. Does that mean Facebook is nearly five times more expensive than Apple, which didn't report non-GAAP earnings? Or is it eight times pricier than a share of Apple stock?
Some tech firms have pages and pages of explanations of their non-GAAP numbers, or use a grab bag of earnings adjustments. Intuit excludes from its non-GAAP profit its stock compensation, fees for bankers and other professionals working on deals, loss or gain on investments, the yearly portion of costs for acquired technology and for intangible assets, tax effects and discontinued operations.
And then there is Microchip Tech, whose most recent annual financial disclosure required nine different tables to break down the differences between sales and profit figures under accounting conventions and the company's handpicked numbers. The headline on table nine of nine is this doozy:
If a company is using nine tables and a headache-inducing headline to explain its unconventional accounting, we're no longer in the era of earnings enlightenment.
Technology firms make a strong case that their business operations may require nonconformist financial metrics to properly assess their financial health and prospects. And the tech industry is by no means alone in emphasizing profit numbers that hide away certain unpleasantries.
But tech companies do have historical baggage in this area that deservedly puts a Klieg light on their financials. In the dot-com days, tech stars were among the worst abusers of pro forma earnings whose widespread use spurred a crackdown by securities regulators. Once again, the GAAP gap in technology is growing too big to ignore.
The analysis included both the companies that make up the S&P 500's information technology sector, plus a selection of companies such as Amazon and Expedia that the S&P doesn't classify as tech but I do.
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