Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.

The Securities and Exchange Commission is letting a number of large companies get away with questionable accounting based on some pretty lame excuses.

Consider Coca-Cola Co. In September, the SEC contacted the soft drink giant about its use of an accounting metric that made its earnings look better than they actually were. Coke said its "structurally adjusted" pretax earnings in the second quarter rose 10 percent. Its actual pretax profits dropped 1 percent. To get to the increase, Coke excluded costs tied to a "productivity and reinvestment program," which the company said would take years to complete. So the SEC questioned whether the expenses were truly one-time items, which companies can exclude, or likely recurring expenses, which they cannot. Coke's response: The company never told shareholders the expenses were nonrecurring. It called them "items impacting comparability." See the difference? The SEC did. Just 14 days after contacting Coke, the SEC closed the inquiry.

Companies have long used adjustments or pro forma numbers to gussy up bottom lines. In the 1990s, commentators dubbed the adjusted numbers "EBBS," or "Earnings Before the Bad Stuff." The practice died down after the dot-com bust, Enron and the passage of account reform law Sarbanes-Oxley. Lately, those pre-"BS" results are back. Both Facebook and Twitter report results that don't conform to generally accepted accounting principles, as do a number of other companies. Valeant Pharmaceuticals is a heavy user of adjusted Ebitda.

Accounting experts and prominent market watchers have pressed the SEC to crack down on the practice. Warren Buffett has called the adjusted numbers "phony earnings" and has criticized Wall Street for embracing them. Buffett, a Coke investor, is particularly peeved by companies that exclude stock-based compensation, which Twitter does.

A little more than year ago, SEC said it was ready to act. It put out more concrete rules on what was allowed and not allowed when it came to the use of bespoke earnings. Letters went out. But in most cases, nothing happened. According to a study by accounting research firm Audit Analytics, the SEC sent comment letters to 529 companies last year about their non-GAAP accounting, a sign of just how prevalent the practice is. That was up from 272 in 2015.

Letter-Writing Campaign
Regulators stepped up the number of companies it warned about the use of adjusted earnings last year
Source: Audit Analytics

Still, in only 51 of those 529 instances did the SEC press the companies, implying that their use of adjusted earnings was misleading. Of those, just 16 companies have either stopped using or modified their adjusted earnings numbers. In the rest, the other 35 cases, after responses from the companies, the SEC dropped the accounting inquiries without acting.

Earnings Inflation
Companies that reported adjusted earnings tended to show bottom lines that were better than they would be under standard accounting rules
Source: FactSet

In late November, Shake Shack, the rapidly growing burger chain, received a letter from the SEC questioning whether it was misleading to exclude "pre-opening expenses" as well as executive salaries and other administration costs from the company's measure of "Shack-level operating profit," which rose 27 percent in the first quarter. Shake Shack's actual net income was up a more modest 15 percent. In January, Shake Shack's chief financial officer at the time, Jeff Uttz, wrote the SEC to say that the company would add a note to its earnings releases stating that the company's Shack-level results excluded a number "essential" operating and development costs, which might limit the "usefulness" of the company's preferred profit metric. The disclosure satisfied the SEC, which dropped the inquiry later that month. 

In a number of instances, the SEC flagged companies for removing rent from their adjusted earnings. Rent, after all, is by definition a regular and recurring business cost. Best Buy, for one, regularly points investors and analysts to a figure for return on invested capital. To get the figure, Best Buy subtracts rent and adds in nearly $4 billion in imaginary assets, which Best Buy says is the approximate property value of the retail locations it rents. After all, those assets would be on Best Buy's balance sheet if the company owned the locations, which it doesn't, instead of renting them, which is what it actually does. Best Buy's ROIC in its second fiscal quarter of last year, the one that caught the SEC's eye, was nearly 17 percent, up from a year earlier. That was more than double the company's nonadjusted return on assets, a more standard measure of performance, of 7.5 percent. In a response, Best Buy told the SEC it didn't think the adjustments were misleading or inappropriate. The SEC dropped the inquiry.

On their own, adjusted earnings aren't such a big deal. Companies still have to report figures based on standard accounting measures. And even adjusted earnings have to be reported on an apples-to-apples basis, meaning companies have to show what those adjusted earnings would have been a year ago, and the adjustments have to be consistent. That eliminates the worst cases of earnings manipulations.

But as more and more companies use adjusted earnings, those earnings figures, and not the actual ones, are sneaking into the aggregates investors use to measure the price of the overall market. Data firm FactSet, for one, uses a blend of GAAP earnings and non-GAAP earnings, based on what the companies and the analysts who cover those companies think best, to compute the total profits of the S&P 500. And those adjusted earnings are invariably larger.

Juicing the Dow
Nineteen companies in the Dow Jones Industrial Average that reported adjusted earnings in the first quarter
Source: FactSet

FactSet found that 19 of the 30 companies in the Dow Jones Industrial Average, or 63 percent, reported adjusted earnings in the first quarter. Those earnings were on average 54 percent higher than the nonadjusted ones. Assume those numbers hold true for the S&P 500, and its forward price-to-earnings multiple may be more like 26, and not the 18 that it appears to be.

If the SEC continues to allow companies to sneak the cost of not just the bad stuff but the everyday stuff out of their earnings, investors will have a tougher time gauging the health of not just individual companies but the collective condition of the broader market. That could be an invitation to some truly bad stuff.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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Stephen Gandel in New York at

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Daniel Niemi at