In the recent US election and in post-election period there has been a new phase coined in the media – “alternative facts”. It is worth considering the use of “alternative facts” in public company reporting and how it comes about.
Over time accounting standards have become much more prescriptive and public companies have had much less freedom to interpret transactions as they see them in their audited financial statements. Non-GAAP disclosures, often outside the audited financial statements became an emerging trend as companies communicated with shareholders and the market in a manner they believed to be appropriate.
Back when I started my career in the early 1980’s the concept of formal accounting standards was relatively new. The principles were captured in a handful of SSAP’s – Statements of Standard Accounting Practice. If I recall there were less than a dozen at the time and the numbers progressively increased as new issues arose. They were reactive in nature as the accounting bodies reacted to companies accounting for types of transactions in a manner that was considered inappropriate by the profession.
What I am saying is that the portrayal of “alternative facts” is nothing new. There was and continues to be “spin” applied to accounting reports. In fact, accounting academics have been discussing this issue for well over a century as GAAP (Generally Accepted Accounting Practice) developed.
These days there is a term given to these “alternative facts” – Non-GAAP disclosures. This is where a company produces a set of financial statements compliant with GAAP then tells the market that their actual performance should be considered as different to that disclosed in the financial statements. There are often valid reasons for these disclosures but it is a tool that could be misused.
In New Zealand regulators have been considering this matter for some years. Earlier this year the FMA updated its guidance in this area. The FMA noted that “Non-GAAP financial information can be useful for FMC reporting entities, investors and others, as it can provide additional insight into an FMC reporting entity’s financial performance, financial condition and/or cash flow. However, it has the potential to be misleading if inconsistently presented, inadequately defined, not reconciled to the most comparable GAAP financial information and/or used to obscure financial results determined in accordance with GAAP.”
Non-GAAP information is often found in transaction documents, management commentary and market announcements. Usually it is related to profit information and terms like underlying profit or normalised profit come to the fore. Not surprisingly, academic study reveals that in the majority of cases studied, the non-GAAP profit is higher than the GAAP reported profit. This finding should not come as a surprise as why else would a company take the time and effort to include non-GAAP measures a cynic might ask.
As a Certified Fraud Examiner, I am intrigued by these matters and what the motivations were for the non-GAAP measure. Was it to correctly and fairly inform the market of performance or was it coloured by a desire to boost or influence the share price or perceptions of the company? The later may arguably be heading into the realm of financial statement fraud as often senior executive remuneration can be linked to share price performance. Fraud occurs where a party misleads another to gain a benefit.
The Financial Markets Conduct Act contains several provisions that deal with misleading information including the prohibition on:
- Misleading or deceptive conduct
- The making of false, misleading or unsubstantiated representations
- Offering products to the market where there is any of the above in the offer documents.
Users of non-GAAP disclosures need to carefully consider the information they are being provided with. In particular, they should consider the nature of the adjustments from GAAP measure to the non-GAAP measure. This will reveal the inherent risk that the data may be subject to a financial reporting fraud risk.
Low risk situations typically show few non-GAAP measures and all reconciling items are fully disclosed in the audited financial statements. The non-GAAP measures should be clearly distinguished from their GAAP counterparts and there should be clear definitions of the non-GAAP measures which are consistently applied from year to year.
Moderate risk situations occur where there are increased numbers of non-GAAP measures with reconciling items that are unable to be directly traced to the audited financial statements. Often there are changes in disclosures or the composition of disclosures from year to year.
High risk situations occur where there are many non-GAAP measures with numerous adjustments that can’t be traced to the audited financial statements. In management commentary and releases there is heavy emphasis on the non-GAAP measures compared to the GAAP measures. The definitions or the nature of the adjustments often appear to change from year to year and one-off or non-recurring items frequently occur.
The regulators have been aware of this risk for many years globally.
The FMA in its guidance required that non-GAAP measures should not be given undue or greater prominence, emphasise or authority. Additionally, it should be explained and reconciled to the GAAP information, calculated consistently over time, and be unbiased and not used to disguise or remove bad news. Previously this reconciliation had to be contained in the same document as the non-GAAP measures. Now there only needs to be a reference to where the reconciliation can be easily accessed.
This change is, in my view, a significant step backwards as a user must search for the reconciliation rather than having it adjacent to the non-GAAP measures itself. It will mean the investor may be unclear as to whether the reconciliation has been audited as it will be in a different document. This change increases the risks for the investor rather than reducing the risks. It will diminish the comparability of financial measures promoted by the non-GAAP measures and lessen the credibility of the information and ultimately the trust in the capital markets.
The FMA has updated this principle to specify that the policy to exclude one-off / non-recurring items should entail all items of such nature, regardless of whether they are related. This avoids possible cherry-picking of the adjustments and ensures the non-GAAP financial information reflects the entity’s approach in its entirety.
The FMA has a difficult task. To outlaw non-GAAP measures will mean investors are deprived of potentially useful insights into a company’s performance but this also opens the door for manipulation of the data and portrayal of the company’s performance.
Boards, auditors, and users of the non-GAAP information need to be aware of the risks and ensure there is complete and open transparency into the adjustments made, the reasons for those adjustments, and have audit scrutiny of the adjustments, and the consistency and use of the data to ensure that the markets remain correctly and fully informed.
I return to the term “alternative facts” in closing.
Recently I stumbled across an SEC cautionary advice in a presentation at the Global Fraud Examiners Conference in a paper by Gerry Zach, a US CPA. The notice was issued on 4 December 2001 and cautioned companies and their advisors to consider carefully when releasing “pro forma” financial information. They believed it was “appropriate to sound a warning about the presentation of company earnings and operating results on the basis of methodologies other than GAAP.”
About six weeks later, the SEC announced its first pro forma financial reporting case where it “issued a cease and desist proceedings against Trump Hotels & Casino Resorts Inc for making misleading statements in the company’s third quarter 1999 earnings release.” The Commission found that the release “cited pro forma figures to tout the Company’s purportedly positive results of operations but failed to disclose that those results were primarily attributable to an unusual one-time gain rather than operations.”
In closing it is user beware out there. It is also clear that “alternative facts” are nothing new and that arguably leopards don’t seem to change their spots!
Graeme McGlinn is a Certified Fraud Examiner and forensic accountant at McGlinn Consulting Group Limited. He has over 35 years’ experience in accounting, auditing and litigation support in New Zealand and overseas. He can be contacted via his website www.mcglinnconsulting.com or by email at firstname.lastname@example.org