Generally accepted accounting principles (GAAP) closes gaps in interpreting financial information, by providing rules for the financial reporting road. Consider your response to the following proposition as an example: you may turn left on a red right. Answer–maybe; it depends on the country in which you are driving. In North America, the response would be “false”. In Jamaica and certain other Commonwealth countries, the answer would typically be “true”, because they drive on the left– as opposed to the right-hand side of the road.
Due to this, and other differences, driving in a left-hand drive country is not the same as driving in a right-hand drive country, although there are fundamental similarities. For instance, each has a set of prescribed rules or a road code governing what is lawful and acceptable for drivers in the jurisdiction.
GAAP is similar to the different road codes which exist worldwide. Each country has its own GAAP, governing the rules of financial reporting; US GAAP, Canadian GAAP and others. They are not exactly alike, but there are certain fundamental similarities (including the fact that there are rules) however much specific principles may vary by country.
To be clear, GAAP is not without its shortcomings. For example, there is no universal or global GAAP to create global consistency, and this sometimes makes it difficult to compare financial results across borders. Although International Financial Reporting Standards (IFRS) is an attempt at global standardization, there is nothing mandating all countries to adopt IFRS, and in fact, countless countries have not adopted it.
However, GAAP does create for users, some degree of clarity, certainty and comparability about the calibre of the information reported using the applicable GAAP. At a minimum, one can often identify the dissimilarities between country-specific GAAP, which signals when financial results may need adjustments or reinterpretation because of these differences.
Currently, against this backdrop, the risks caused by the proliferation of non-GAAP, or alternative performance measures (APMs) present challenges for reporters, users, regulators and auditors of financial information.
A May 16, 2019 Wall Street Journal (WSJ) article entitled “CEOs Embrace Faddish Metric”, is illustrative in its exploration of an APM called Net Promoter Score (NPS). Reportedly used by many, including blue-chip companies in their securities filings, NPS purports to measure customer satisfaction and brand preference. Companies use it for everything from determining bonuses to justifying corporate investment decisions. The issue—it is typically calculated from a single survey question to customers at checkout, about their likelihood of recommending the organization’s products or services. That’s it.
The article explains that at the checkout register in-store or in email or a pop-up question online, companies ask customers to indicate on a scale of 0 to 10, how likely they are to recommend the company’s products or services to a friend. There is typically a follow-up question asking the respondents to explain their answers. The company then divides respondents into one of the three groups below:
- Promoters or loyal enthusiasts who will keep buying, are those who answer 9 or 10;
- Passives, who answer 7 or 8 are satisfied, but competitors could easily woo them; and
- Detractors are unhappy customers who answered 0 to 6.
Next, the companies subtract the percentage of Detractors from the percentage of Promoters, to calculate an NPS that could fall anywhere from -100 to 100. Passives do not figure into the calculation at all.
According to the article, critics of the NPS are many, including the Bain & Co. consultant who created the metric—he criticizes some of the ways in which companies are using it. Additionally, there are studies that have concluded that there is no correlation between NPS and revenue and that it is no better predictor of customer behaviour than other survey metrics. Some critics cite the poor sample sizes and inherent unreliability in determining a metric by subtracting one survey metric from another as factors making the NPS more error-prone.
NPS, like many other APMs, can be unreliable and may lack scientific rigour, partly because it is so easy to manipulate. For example, the WSJ article explains that because bonuses and other performance measures may depend on favourable NPS scores, checkout clerks admit to conveniently reminding only the happiest customers about the survey.
Nonetheless, as the WSJ article goes on to explain, the NPS has some value. For instance, it is simple and easy to communicate and apply. For its numerous adherents, this is likely part of its appeal.
The critique of the NPS would make an interesting case study on subjectivity and other challenges with creating, calculating and interpreting metrics, in Stats 101 or financial accounting and reporting classes.
Another article entitled “Expectations GAAP”, in the May 2019 issue of Accounting and Business (AB Magazine), published by the Association of Chartered Certified Accountants (ACCA), examined the many growing concerns associated with the increasing use of APMs. These concerns include the up to 30% profit variances between GAAP and APMs in some research, the ease with which APMs may be manipulated and may obscure reporting, and the resulting negative impact on clarity and comparability in financial markets. The article cites a PwC study in which 95% of UK FTSE 100 companies reported using APMs.
The AB Magazine article cites WeWork, an office rental company, which caused consternation by recently issuing a prospectus with an APM called Community-adjusted EBITDA, based on its assertion that existing GAAP metrics did not convey the essence of its business. As AB Magazine explains, the metric makes the unprofitable WeWork appear attractive, even as critics charge that the metric is corporate nonsense-speak.
Regulatory bodies including the United States’ Securities and Exchange Commission (SEC) has responded by providing guidance for users and preparers of financial information, for example, see: Non-GAAP Financial Measures. In September 2018, the Canadian Securities Administrators (CSA) issued a proposed national instrument entitled 52-112 Non-GAAP and Other Financial Measures Disclosure for public comments, as part of its plan to replace existing publications on the disclosure requirements for issuers disclosing non-GAAP and other financial measures. The proposed instrument, which is still under review, is a direct response to the proliferation of APMs which, as illustrated above, often lack standardized meanings, potentially creating misleading or confusing disclosure.
If you prepare financial information, ensure that the financial statements and associated metrics conform to GAAP. Ideally, this applies to both year-end and interim reports, for consistency, accuracy, reliability and comparability. If you are on the other side, assessing financial information, for instance for personal or business investment purposes, take APMs with a grain or two of salt.
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