Much has changed since the days of Enron and WorldCom — two companies that flew under the radar for what was simple accounting fraud in the realm of billions of dollars. Most notably, the United States put forth Sarbanes–Oxley, which made executives personally responsible for the accounting numbers they publish.
While Sarbanes–Oxley holds management liable for accounting concerns, it doesn’t mean that all accounting numbers hold to scrutiny. In fact, the most recent “dot-com bubble” is reflating the bubble aggressive accounting and disclosure in quarterly earnings supplements.
Silicon Valley Accounting
Tech companies are in love with non-GAAP numbers; metrics which do not work within “Generally Accepted Accounting Principles.” Almost all up-and-coming tech names disclose non-GAAP numbers to make their quarterly earnings look better.
I should add that this isn’t necessarily bad. Real estate investment trusts also publish non-GAAP earnings because GAAP earnings are not directly related to REIT dividends. Since REITs generate significantly more cash than they generate GAAP earnings, they discuss investments and returns in terms of adjusted funds from operations.
But new tech stocks are by far the worst offenders in the non-GAAP department because their non-GAAP numbers are published exclusively for the benefit of management.
Case in Point: Facebook (FB)
Facebook’s use of non-GAAP earnings is particularly funny because unlike some firms, it has the audacity to show GAAP and non-GAAP earnings side-by-side. Facebook’s GAAP earnings rightfully include share-based compensation expense (the issuance of new shares to insiders, which dilutes the ownership of all other investors). Facebook’s non-GAAP earnings do not. Giving out stock option is an expense — a real expense. You can only ignore it if you break accounting rules.
Facebook deserves some credit for publishing both GAAP and non-GAAP numbers in its easily digestible earnings summaries. It’s not the worst offender — some only publish non-GAAP numbers — but it makes for a great example of Silicon Valley accounting because it publishes both.
From the last earnings report, Facebook earned GAAP net income of $373 million in the first quarter of 2013. Excluding the negative effects of new share issuance, Facebook can highlight $312 million in non-GAAP net income.
The difference between GAAP and non-GAAP earnings is huge. Non-GAAP earnings are nearly 50% higher than GAAP earnings. On the conference call, Facebook pushes its non-GAAP earnings in discussions involving the investment community.
Do Non-GAAP Numbers Matter?
Non-GAAP earnings show what Facebook would have earned if it could conveniently ignore the stock options it hands out like candy. Thus, non-GAAP earnings from Facebook are a worthwhile metric only if one believes in two possible outcomes:
- Facebook reduces payroll — If Facebook cut stock option issuance and did not compensate for larger salaries to displace the loss of stock options, it would post GAAP net income equal to its current reported non-GAAP net income. Of course, that is very unlikely, since incentives are difficult to cut back.
- Facebook goes private — Non-GAAP reflects how much money the company could make if it were managed by new managers who don’t want to issue new stock as compensation. Given that Facebook enjoys an exceptionally high market valuation, it’ll never go private at the current price, since there aren’t many (or any) rivals, funds, or banks that could fund such a transaction.
I should remind everyone that Mark Zuckerberg also has a majority of the voting power in Facebook, meaning that he effectively controls any and all possible decisions by the board of directors about compensation, going private, or paying out cash to insiders rather than diluting the existing shareholders with new stock options to insiders. A bet on Facebook is a bet that Zuckerberg will make decisions that benefit shareholders who cannot throw him out under any outside circumstances.
Non-GAAP numbers, in this case, aren’t especially beneficial to shareholders since the policies that affect compensation cannot be voted on by shareholders.
Non-GAAP earnings are most useful when they accurately reflect the results of the business and are not used to justify a high stock price. Investors should be very, very wary of any company that posts its non-GAAP numbers and makes frequent references to non-GAAP statistics. When you hear “non-GAAP,” think “dishonest,” since by their very nature non-GAAP earnings break accounting conventions, often to make a business look much better than it otherwise might.
In this case, Facebook’s non-GAAP earnings of $0.12 per share were a full 33% better than GAAP earnings at $0.12 per share for the first quarter of 2013. Dishonest? Well, it all depends on what you want to believe. Remember Groupon? Same type of accounting misnomers as well.
Just remember: not everything is as good as it may appear.
What are your thoughts on dot-com accounting — GAAP vs. non-GAAP?
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