The Acceptance of Non-GAAP Measures

Anthony Scilipoti:

There's always uncertainty. Knowing that the management team can prepare themselves for that uncertainty gives, again, more comfort that me, as an investor, goes, "Yeah. You know what? These guys know what they're doing. They're walking with their head up and looking to anticipate the play."

Narrator:

Welcome to Accounting for the Future, a BDO Canada podcast for financial leaders to navigate change and achieve business growth. We'll uncover the challenges financial leaders may not have dealt with yesterday but will definitely have to manage for the Future.

Armand Capisciolto:

Hello, and welcome to Accounting for the Future. I am your host, Armand Capisciolto, BDO Canada's national Accounting Standards partner and leader of Accounting Advisory Services. On today's episode, I'm joined by Anthony Scilipoti. Anthony is President and CEO of Veritas Investment Research and has been active in accounting standard setting for many years, including currently being a member... Actually not a member, co-chair of the Capital Markets Advisory Committee, which provides the international accounting standards board with input from the perspective of users of financial statements. Anthony, welcome to Accounting for the Future.

Anthony Scilipoti:

Armand, it's really a pleasure to be here.

Armand Capisciolto:

I'm quite excited about this conversation, and I think it's a conversation that is going to bring a very interesting and different perspective to our listeners. Our listeners, they tend to be preparers of financial statements, CFOs, controllers of medium size enterprises. I think sometimes companies and their auditors; I'm going to put up my auditor hand here and admit this. We forget the reason why we prepare and audit financial statements. It's so people like you can use those financial statements to make capital allocation decisions. I think if a company is not meeting the needs of people like yourself, a user of financial statements, they may not get the capital allocated to them that they want or need to move their strategies forward.

Anthony Scilipoti:

It's been a bee in my bonnet since I started. It really is what got me passionate about getting involved with accounting standards that I've been involved since 2003. This issue dates back to the Macdonald Commission, if we go back to the early '70s, all about the expectation gap. I often will ask management teams when we'll ask them questions about their disclosures, their presentations. My favorite answer is, "Oh, it's all in the notes. Everything you need is right there." I know I'm onto something when I get that kind of response because I would like to say that I'm probably a little bit better than the average reader of financial statements. So if I don't understand it, it's probably because you don't want me to understand it. And that's okay, but then I'm going to make my own decisions, and I'm going to draw my own conclusions. That's one thing to keep in mind.

The other thing to keep in mind and I use this as a means for improvement. If we think of who our users are, it's a known and proximate user. Well, what's that mean? There's people reading financial statements, and I get the challenge. Employees, customers, competitors, I get it. I have my own company/ I have my statements. I'm concerned that other people might read them too. Now we're a private company, so there are not quite the same number of issues, but I understand it completely. So, I always challenge the management team, and I would say this. "Why don't you have someone that is not in finance read this note and see if they can understand what exactly you're trying to say. Because if they can't, you should go back to the drawing board."

I can always tell when I read a sentence, and it's so perfect. This is what I tell users. I said, "Do you know how many hours were spent to put that note together that you don't bother reading? Then you get upset when there was something missing. Well, read the thing," I tell users. On the preparer side I said, "Get someone not in finance." I always say, "We write reports for a living." So what I'll tell my analyst to do, I'll say, "Get your spouse, significant other, who may not be involved in the financial markets or accounting, to read the report. If it's not clear to them, go back to the drawing board."

Armand Capisciolto:

I love that, Anthony. I think as accountants, and I'm again going to admit to this, we use a lot of jargon. We put a lot of words in there that, forget the average person, the average informed business person isn't going to understand. I always love to say... I love to talk about financial instruments, and I love to talk about bifurcating financial instruments. How many people understand what I'm saying when I say I want to bifurcate this financial instrument? No one understands that, other than other accounting nerds like myself. I really like your suggestion of-

Anthony Scilipoti:

Not only that, you want to bifurcate it a certain way. I want to bifurcate it another way. The best part is, both of us think we're right. The user reads the financial statements, and they have no idea where we started from.

Armand Capisciolto:

Exactly, exactly. No, it's really good advice there. You mentioned your reports, your reports that you write. You've been involved in this business for a lot longer than this. I really became aware of your work and the work of Veritas in 2016. You issued a report on the use of non-GAAP measures. It was a really, really interesting report, quite a bit of coverage in the financial press. I think the first place I read about it was probably in The Globe. There was an article kind of summarizing it. Could you give us just a quick overview of some of the highlights of that report?

Anthony Scilipoti:

It all started back after the dot-com bubble. That was the start of... I remember speaking at a CFA conference in 2001. I said, "We have a problem because we're using all these non-GAAP metrics." It was earnings before all the bad stuff. It got so there was so much bad stuff that ultimately, they started with just this revenue, and that became price to sales. Well, fast forward 21 or so years, or 20 years, and we still have the same problem. We're still valuing these companies at price to sales with a dream. Not even a hope but a dream that they'll generate cash. Then they wonder, and investors scratch their head, "Wait a minute. Why is the stock going down?" Well, if the prospects for earnings, which are far into the Future, become constrained because interest rate changes, that drives the cost of capital into levels which make that investment of less value. Because the present value of those dreamful cash flows becomes much lower.

Then they came up with Regulation G in the US in 2004. Of course, not to be outdone, notice that was a regulation, then in Canada, we had a guideline. Now, I'm not sure what a guideline means. It kind of says, "If you do it, maybe do it, maybe don't do it." I'm not sure. But, anyway, that's what we had in Canada. I made a lot of noise throughout, saying, "You've got to have regulations. You can't tell me, 'This is what you kind of should do,' and then get upset when I don't do it." Anyway, I also have a saying that says, "Once you tell me what I can't do, you've also told me what I can do." So if you want to talk about why I like flexible rules and not bright lines, but that's for perhaps another discussion. In any event, let's go right to the... Now we're getting to the report that we wrote, which was in 2016.

It had reached proportions that I was quoted by saying, and I will continue to say, "Non-GAAP metrics are the root of all evil in financial reporting." Because what happens is it creates a false sense of security. That false sense of security is coming on a number which is not audited. There are no standards. It can change at the whim of the management team. That leads to, unfortunately, potential for a lot of problems. Now the report that we did looked at the S&P/TSX 60 and the S&P 500. What we assessed was the proportion of companies that included a non-GAAP earnings metric in their regulatory filings. That's very important because it came in the regulatory filings and not just press releases. What we found were essentially four things.

One, non-GAAP metrics are upwardly biased. They're not comparable, and they differ materially from GAAP metrics. There's a greater proportion of members within the TSX 60 that present non-GAAP metrics versus those in the S&P 500. The proportion, approximately 35% of the TSX 60 members likely, in our estimation, were offside with the guidelines put place at the time by the securities regulators here in Canada. And the last point we alleged was that non-GAAP metrics, they matter for valuation, not just for accounting. We followed that up over the following years. It's kind of an annual ritual for us to go through the reports from the companies to see the proportion. What we saw at the most recent time, nothing's changed. In fact, the use of non-GAAP is in the same metrics, the same ballpark, in and around 75 to 80% of filers use and include a non-GAAP metric in their regulatory filings. So you have a situation where users they're strained for time. Investors want a quick answer. "We want the one number. Anthony, I mean, how many pages do we need?" 160 Annual reports today, they're 300 pages. Then there's a sub-pack. Then there's a presentation. "You're making my head spin. Just give me the number." "Okay, I've got the number. Here it is. It's magic. It's called EBITDA. I'll give it to you. Or maybe adjust it even, or maybe adjusted adjusted adjusted earnings. Cash earnings, I'll give you whatever you like, just one number." Then you go home, you tell your portfolio manager, you say, "Look, I got the number. This is the number. I feel good about it. Buy the stock. Everything's good."

Armand Capisciolto:

Oh, my goodness. The magic number, I love that.

Anthony Scilipoti:

The reality is, today's... And I know why this is happening. I've been involved in this industry almost 25 years. We're pressed for time. An analyst used to cover maybe 10 companies 20 companies. Today, analysts on the sell side might cover more than 20 companies, okay. On the buy side, there are portfolio managers that cover their entire, they're covering the whole market by themselves. So they have to rely on analysts to give them the one number, and it becomes a cycle, and it just continues.

Armand Capisciolto:

Okay, Anthony. So much to unpack there. A couple things that I just wanted to pick up on what you said that I found really, really interesting. One that really surprises me the prevalence of these non-GAAP is more so in Canada than it is the US, I think, comparing the TSX 60 to the S&P 500. Was there any reason for that?

Anthony Scilipoti:

Yeah. If you think back to the time of 2015 2016, you're coming off a downturn of the oil market, and energy prices collapsed. So what do resource companies have to do? They have to take write-downs. Those write-downs are bad. We'll exclude those. So now you have adjusted earnings.

Armand Capisciolto:

Okay, yeah. Your typical income before the bad stuff that you're referred to, right?

Anthony Scilipoti:

Yes. In the resource industry, it becomes very prevalent. So if you think about the fact that our index has a higher weighting, a higher number of registrars that are in natural resources, that will cause the issue.

Armand Capisciolto:

Okay. The other thing, when you're talking about this magic number, people wanting a number. And the lack of time analysts have, the lack of time users have, is any of this also caused by the data aggregation and plugging numbers into models? Is there an underlying, there's both a supply-side problem and a demand-side problem.

Anthony Scilipoti:

I worked on a survey of investors. This one was with PWC, and it was on the use of financial statements. So we asked Institutional investors, we asked them a number of questions, essentially starting with, "Do you use financial statements to make investment decisions?" Invariably with a high near 100%, was "Yes. It's the basis of our decision-making." Great. So where do you start? Do you start with the notes? Do you like to read the balance sheet first? Where do you start? "Oh. You mean like the... Well, I go to Bloomberg. Then I get the data. Or maybe FactSet or Refinitiv. Then I have the numbers. Then that comes from the financial statements." I've given many a presentation that shows that the number on Bloomberg will be different than the number on Refinitiv.

To no fault, I'm not saying Bloomberg did something wrong or Refinitiv did something wrong. They have sometimes their own metrics that they'll calculate EBITDA and free cash flow, et cetera. They also will have, it's very prevalent in companies that will report net revenues, net perhaps of government subsidies, et cetera. Some of them will treat that as gross. So you look at revenue, you just see the gross number. Another one will show the same thing. It'll show the net revenue. Now, of course, you unsuspectingly don't notice that, and you may make some mistaken conclusions.

Armand Capisciolto:

It's interesting. Yes, they use the financial statements, but they use the financial statements as presented by the data aggregator versus actually reading the financial statements.

Anthony Scilipoti:

To give you an example. The way we do our work, our analysts hate to use those systems because here's what happens. We're reporting now 2021. Well, 2021 statements they're presented in a certain way. Then there's this little note that shows up at the bottom. "Comparable figures from 2020 may be represented or changed to conform with current year presentation." But wait a minute, now I've lost the trend. You did some magic with this year, and then last year you made the magic work with this year, but that wasn't the same magic that happened from the previous year. So I now have every two years, you'd be amazed at how much change there is. Now it's not material, but material is a word we can fight about. I've been in court talking about what's material, right? That's why we look; I want to know what was originally reported. Show me that number, and then we can make some better decisions. In fact, it might be interesting to see how they changed.

Armand Capisciolto:

Yes. Which actually brings us to my next question. The original report in 2016, you are updating it, looking at it. Looking at the trends, things that have changed since then, and a lot has changed. We'll talk a little bit about accounting standards that have changed in a bit, but let's start first with regulation. So the Canadian Securities Administrators issued their National Instrument 52-112, which replaced that staff notice or guideline that was previously there. That became effective last year. It sets out those disclosure requirements related to non-GAAP, including reconciling to the GAAP numbers. Telling stories if anything has changed. I think you've already said you haven't seen a drop in the use of non-GAAP numbers, but have you seen an improvement in what's being disclosed as a result of the new regulations?

Anthony Scilipoti:

Honestly, I think we're a little too early to tell. We'll get that by the time we get the annual numbers. I am very much in favour of the changes that took place. In fact, in Canada, we've actually gone a little bit ahead of where the US is on the non-GAAP regulations. Which I think I give kudos to our friends over at the OSC. I know Cameron worked hard on this, and so did Alex Fisher. I think it's great that we've done that. I'm keeping a careful eye. I'm still seeing a number of issues within the... I could go through various things in the REIT space. The FFO, there's still wide variance of how that's shown. Then AFFO and NAV calculations are done differently. In the telco space, they report free cash flow differently. They might change it. EBITDA same thing. In the rail industry, how you report the operating ratio is different among peers and can change over time.

Then, of course, there's the whole stock-based comp, how we deal with that in EBITDA. Should it be included, should it not? I'm going to borrow from someone with more grey hair than me, who's been around a long time. Warren said, "If it's not an expense, then what is it?" That's Warren Buffett if you didn't pick that up. I echoed that from the treetops. So now we're starting to see that. Companies that were looking to pay their employees with stock options are seeing a double whammy effect. A those stock options you gave me are now not worth the paper that they were printed on. B, I need some cash to compensate me moving forward. And the company's stock price is so far down the company doesn't generate cash, and now needs to figure out how they're going to pay it and support their employees.

Armand Capisciolto:

Okay, Anthony. A couple things I just want to follow up on because I think it was really interesting. You bring up stock-based compensation, which is a non-cash expense that people refer to. You brought up FFO, Funds From Operations, AFFO, Adjusted Funds From Operations, free cashflows. Is that one of the reasons why there's all these non-GAAP measures, is because these non-cash expenses that the accounting standards require us to record? And rightfully so, because they truly are expenses. Is that one of the drivers of non-GAAP measures?

Anthony Scilipoti:

That's oversimplifying because accounting is an accrual-based system. So, thou must understand that the number you're going to get for income includes some cash and some non-cash. That's not good or bad; it just is. So if thou wants cash flow, we created a cash flow statement. And the cash flow statement gives you clarity on cashflows. But very few people, I think, properly understand what the cash flow statement is telling you and how to interpret it. And so when they look at operating cash flow, as an example, and they want to just calculate free cashflow, they take operating cashflow, they deduct CapEx. Magic, I have free cashflow. "Just give me the answer, Anthony."

I said, "But wait a minute. Is this company growing? Is this company shrinking? Does this company capitalize assets called other deferred costs of some kind, that don't go into CapEx? Does that mean you should consider those? But wait a minute, did this company give out a whole bunch of stock options? Now, should we consider that as part of our free cashflow? Oh my gosh, wait a minute. The company just factored some of its receivables. Magic. We created a whole bunch for operating cashflow that flows into your free cashflow." I got a new one. This is the latest magic. This one brought tears to my eyes. For all of those that have seen our work, we did a whole study on it. I have a whole training session we did on Corillian.

This is a fantastic... I love the word fantastic, because fantastic means something that's supernatural. This is supernatural accounting. What we do is we basically have a payable, we find a finance company to finance that payable. The supplier gets their money in advance. I have this payable that looks like it got paid. Magic. Now, I have my operating cashflow look better. Everything looks smooth. And yet I have this off-balance sheet-ish obligation to deal with this finance company, who prepaid my payable for me. It doesn't show up as debt. Magic. Now when I look at my operating cashflow, you see everything is fine. And everything is fine, so long as the business doesn't get worse. Because these sort of tactics always come in a time when a company's under pressure. So the first thing I always tell analysts when they're looking at a company is to look where is the pressure coming from.

Now I can tell you the pressure is economic stress. Top line is slowing down. What are we going to do? Well, we can't miss the numbers, so we're going to start playing some games. You don't play games unless you have to. If the numbers are rosy, you just give them out as they are. In fact, create some cookie jars so you can draw in that income when it's not there. I know how to do that too. But in the time when you're under pressure, which is where we're headed right now, now's when the greatest risk in investing and interpreting numbers comes about. I'm not just saying that because we're in the midst of this discussion. Given the macro headwinds that are in place, and call for recession, call not recession. I don't see that there's any way we don't have a recession. But the fact is, that's going to put pressure on companies to ensure that they don't miss their numbers, and now we'll see them play.

Armand Capisciolto:

It's interesting. I really like what you said there because you were talking earlier about magic numbers and people wanting a number to grab onto. As you were talking about the statement of cashflows, but then the other questions about what's happening with the company. What I take from that is you can't rely on one number. You can't rely on that magic number. You need to read everything. You need to read the statements. You need to read the notes. You need to read the MD&A to get the holistic picture of what's happening with this company.

Anthony Scilipoti:

Definitely, I think you're just reemphasizing my point. That's why we know when companies will say, "Oh, the statements are already too long." One of my favourite pet peeves is when people say there's information overload. It's like just because you don't understand it, doesn't mean it shouldn't be there. Someone else might be using that information to make a different decision. Don't tell the company, "Oh, you know what? You don't have to provide that information." Because you know what? Very few people understand it. Well, if I understand it, and I need it to make my investment decisions, and it's required disclosure, put it in there. In fact, I find what happens is information is put in there. And that statements are longer than they need to be because they don't want to address the key issues.

Like for example, the number one thing right now is all about segmented reporting. It's horrific, for lack of a better word. The statement says it should be based on how the key decision maker makes their decisions. And I challenge many a management team to convince me that they would actually make a decision about their business based on that type of segmented disclosure. And so, then you run the question of, well, you want me to be your partner. I'm buying shares. I'm taking my money, and those investors that I have a fiduciary duty to, and investing in your company, and you don't want to give me the same information that you have, so when you invest in your company. I don't know. I think that's where we don't have to make this complicated. That's where the disconnect lies.

Armand Capisciolto:

Yeah, interesting. Segmented reporting is definitely a topic that gets talked about a lot. There was an interesting article in The Globe this week, the week that we're recording. About not investors but others not being able to get the information they need related to some of the grocery stores, and their margins, and kind of what's happening right now in this inflationary times. It's interesting you bring up segmented reporting.

Anthony Scilipoti:

The other thing we need to be aware of, and it hurts us, US disclosure is much, much better in this area. The standards are near identical. And yet, what this does is we think we're being smart by saying, "Oh, we don't need to provide this information because we're more of an oligopolistic environment. There's our key competitors. We don't want to really tell them." It's like, okay, but at the same time, you want capital. Well, capital is today not constrained to buy Canadian companies. So when companies complain to me, "Why is our discount... We're trading at a discount to peers in the US," and all this kind of thing. I say, "Well, they give us a lot more information." So that lowers their cost of capital because investors have more comfort in the information being provided.

Armand Capisciolto:

I'm going to skip ahead to one of my questions I planned on asking you later because I think this is a really good segue into that. Because again, as I mentioned earlier, our listeners are typically the preparers of financial statements. Why I really liked you as a guest is bringing in this kind of user perspective. You talked about using plain language and having people read it earlier. Is there anything else that you would recommend to a preparer of financial information so that they're telling their story, so that whether it's an investor, a creditor, whatever, is going to provide them with that capital they need to move their business forward?

Anthony Scilipoti:

I guess I would just stick to the story that they want to hear, that they think about when they wake up in the morning. When I do our podcasts, which we call the fact Finders, I always focus on people's why. The why is so important. Because, yes, people do things for money, but the money comes after. If you truly want to be successful, this is my belief; you're doing things because you love to do them. You're passionate about them. The money comes after. So when I think about a management team, and they want to tell their story because everyone has a story, what is it that drives them to wake up in the morning? Why do they believe and they work for their company? Then focus on that because there's a reason why they come together, and work nights, and spend long hours pouring over trying to determine how to run their business.

What is it that made them make that decision and kept them on in those tough times? Instead of focusing on, "Oh, we missed this number. We can't have a mistake," and so on. The world is not a straight line from the lower left to the upper right of the graph. Just like life is not from the lower left to the upper right. The only thing constant is time. The seconds tick the same way for all of us, and each day we're going to get older by one day. But in business and everything that affects life, it's not a straight line. It's got all kinds of bumps. So why not focus on the bump, and say, "We had this bump, and here's how we dealt with it, and here's how we made our business better. Next year, you can expect the following, we believe, because of that."

Armand Capisciolto:

I really like that, Anthony. Another thing that I like to talk about with people about financial statements is they're not a compliance document. People see them as, "I have to comply. I've got a checklist I've to fill in. I've got to get a check mark beside all of these things." But they're really a communication document. I think what you're saying there, the way you described it, describing the bumps, describing how you dealt with that bump. That's really just about communicating with the people that are using your financial information, such that they know what you did, and how you addressed those challenges. And to be honest, if you've addressed those challenges and addressed them well, I would assume that investors want to hear that. That's going to give them a better sense of how the company, how management is taking care of the assets that an investor is going to potentially give them.

Anthony Scilipoti:

For sure. And, I think if we take a longer-term perspective, that will probably play out and drive those decisions and communications better. We're seeing it now. Companies will have just reported their Q3 numbers a few weeks ago. I've seen a few examples of companies coming out and lowering their guidance within weeks of just reporting their numbers. Sure, time changes and life moves quickly, and the business in the environment we're in is ever-evolving. For sure. Okay? But the fact that you didn't know within weeks what was going on suggests to me that you don't have good metrics internally for running your business. Instead of leaning to the side of positivity, why not lean to the side of more, let's call it objectivity or conservatism? And say, "You know what? We're prepared for a number of outcomes here. It could get very bad. If it gets very bad, our cashflows and earnings could be this. We're prepared in the following ways. If things turn out to be benign, you know what? This is how we're positioned for that. That's how things could end up." There's always uncertainty. Knowing that the management team can prepare themselves for that uncertainty gives, again, more comfort that me as an investor goes, "Yeah, you know what? These guys know what they're doing. They're walking with their head up and looking to anticipate the play."

Armand Capisciolto:

I love that. I really do. I think that it's kind of that objective transparency of what you're facing and how you're going to face it. I think if companies do that, and they tell their story, and they tell that story accurately-

Anthony Scilipoti:

Right.

Armand Capisciolto:

That's all we can ask for as users of financial information.

Anthony, thank you so much for taking the time today. Your insights on this topic have been absolutely wonderful. Myself our audience appreciate your time and expertise. I'd also like to thank you, our listeners, for tuning in today. I'm Armand Capisciolto, and this has been BDO's Accounting for the Future. Please let us know if you've found this topic interesting and useful, and remember to subscribe if you liked it. We'll see you next time.

Anthony Scilipoti:

Thank you, Armand. And thanks, everyone.