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As usual, Matt Levine offers some insight into the issue, which I tend to agree with. He offers the following three scenarios: 1. GAAP, which is a man-made set
by bko 11y ago
As usual, Matt Levine offers some insight into the issue, which I tend to agree with. He offers the following three scenarios:
1. GAAP, which is a man-made set of social conventions for how to present financial results, does not accurately reflect Company X's economic reality and continuing future earnings power, while the pro forma results do. (Or, less strongly, GAAP is informative, but the pro forma numbers are also informative, about a different aspect of the company's situation.) Investors know that it is a useful discipline to hold all companies to the GAAP social convention, but appreciate Company X's efforts to provide them with more insight into its real economic position, and use the non-GAAP numbers to inform their own models.
2. The GAAP numbers are more or less right, the non-GAAP numbers are just fake and flattering, but investors, whose job it is to make intelligent decisions about the future earnings power of the company, ignore the non-GAAP numbers and focus on the GAAP numbers, which are after all reported prominently in the same press release.
3. The non-GAAP numbers are fake and flattering and all the investors are chumps who believe whatever management puts in the big font at the top of the press release.
Pretty much every discussion of non-GAAP accounting focuses exclusively on Possibility No. 3, which, as both an efficient-markets fundamentalist and an accounting post-modernist, I find by far the least plausible of the three possibilities. Anyway, here's a column by Gretchen Morgenson with the pleasingly archetypal title "Fantasy Math Is Helping Companies Spin Losses Into Profits."
http://www.bloombergview.com/articles/2016-04-25/investing-robots-and-goldman-deposits http://www.bloombergview.com/articles/2016-04-25/investing-r...
- nostrademons 11y agoThere's a fourth possibility: 4. Companies increasingly occupy Extremistan, where a large portion of their financial performance comes from one-off, Black Swan events. Both the GAAP and non-GAAP numbers are true but useless; the future cash flows of the company depend upon unforeseeable events in the future. The description that the article gives of the non-GAAP results supports this. Take, for example, a lawsuit against the company that results in a $5B judgment, payable out over many years to survivors of an environmental disaster. GAAP results include this lawsuit, non-GAAP results exclude it. Which more closely represents the future financial performance of the company, from the POV of a long-term value investor? Well, that depends whether there will be future lawsuits like this one. It depends whether the verdict will be reversed on appeal. It depends how many survivors survive. The same goes for things like severance pay and patent lawsuits. Increasingly, it also applies to "normal" business, things like product introductions and the price of oil. In Zero to One, Peter Thiel mentions (and decries) that an increasingly large portion of America is adopting an "indefinite" worldview, where the future cannot be known and it's futile to try to predict it. I'm not sure folks really understand the potential implications of this shift. Does "investing" have any meaning when the assumption is that returns will be dictated by large, random events? Does "meaning" have any meaning? What does it even mean to be rational, when reason is a tool we use to predict and our assumption is that events are unpredictable?
- dv_dt 11y agoTreating environmental disasters as 'random' events is too kind. I think in just about every major recent environmental disaster you can without too much difficulty, trace back the disaster to cost cutting measures where decisions were made to put off long term risks in favor of short term profits. The BP oil spill, shortcuts were made in the safety of the drilling equipment emergency cutoffs, in the Los Angeles methane leak, the company had put off maintenance to try to make rate payers pay for improvements instead of out of profits to the company. The Northern California San Bruno pipe explosion - safety funds had been diverted to executive bonuses. Smart investors (and insurers of these companies) should be digging into long term risks. It is not that we cannot predict it - we are too cheap and profit oriented to pay to mitigate it.
- rco8786 11y agoI'm not sure that this is mutually exclusive from random. Random refers to the timing of them, not them being unexplainable.
- mjevans 11y agoMaintenance is a form of insurance.
- catnaroek 11y agoIf losses can be socialized (which they indeed can, if you're big enough), it's smart (albeit sociopathic) not to bother mitigating risks. It's much cheaper to PR your way out of disasters than to actually prevent them from happening.
- dv_dt 11y agoThough sometimes it seems like it's executives reaping short term gain while the company itself pays the long term cost at a later point after the execs have moved on.
- geofft 11y ago
- Avshalom 11y agoThere's a sort of obvious 4th option: The non-GAAP numbers are fake and flattering and most of the investors know this but believe all other investors to be chumps and so everyone acts as if the non-GAAP numbers are true hoping others will buy in and let them cash out handsomely... thus beginning a game of chicken.
- mcnamaratw 11y agoOh that doesn't happen anymore. It's 2016!
- deleted 11y ago[deleted]
- LukaAl 11y agoMatt Levine is a smart guy but often tends to oversimplify. It is not just one of the three, is all three at the same time. The number 1 is more or less true for a good number of companies. Number 2 and 3 applies to the rest of the companies depending on the investor you are looking at. The number of gullible investors is non-zero. Throws in that many companies are in option 1, and distinguishing between 1 and 2/3 became a complex problem. So, we have a subset of companies whose price is determined by the ratio between good and bad investors. Obviously, good investors will fly away from these companies. But these companies could make you a lot of money if you leave soon enough. And then in finance classes, they use to say: "the market could stay irrational longer than you could stay solvent." The results? Inflated Pro-forma statements stay around for enough time to do damage.
- Spooky23 11y agoI don't know what an accounting post-modernist is, but I do know that a consistent approach to keeping the books makes it possible to evaluate the positions of companies meaningfuly. Companies as varied as Bank of America, Groupon, and Kinder Morgan all find creative and fascinating ways to assert that their bullshit financial metrics are more meaningful than GAAP. Generally speaking, companies that aren't a shitshow and are actually making money don't bother cooking up new accounting schemes. Their CFOs focus on counting the profits, not heating air.
- deleted 11y ago[deleted]
- gooserock 11y ago> and all the investors are chumps who believe whatever management puts in the big font at the top of the press release Chumps, no. Humans, yes.
- KKKKkkkk1 11y agoWhat's wrong with GAAP that all of those companies feel the need to report non-GAAP numbers?
- princeb 11y agolong story short, different companies have different economic circumstances - different assets, different risks, different cashflow, supplier and customer arrangements, different operating structure, different expenses, etc that will all influence the nature of GAAP statements, being a common set of standards applied to ALL companies. It's like measuring all people with a single score like IQ. Experienced investors never take GAAP at face value - most of them will work with both the GAAP and pro forma (as well as any other public releases) and try to reverse engineer the individual lines in order to tease out more pertinent (in their opinion) factors that affect the value of the business. different investors value risks differently but the pro forma is created by management for a general set of investors in order to bridge the gap between GAAP and exact economic reality.
- vasilipupkin 11y agoExactly. Gaap doesn't necessarily perfectly reflect economics of the company's business. So, the non gaap measures are there to be used in conjunction with, not instead of, gaap
- KKKKkkkk1 11y agoMy understanding is that at least the IFRS standards are developed precisely with the goal to fit all businesses in all industries. Whenever concerns come up that this is not the case, the standard is amended. And so companies who are making claims that IFRS does not adequately describe their business are justly met with suspicion. If GAAP does not work that way then it's one more reason to move on to IFRS.
- asbromberg 11y agoI think its wrong to think that any accounting system can ever be made to be appropriate for all industries (GAAP, IFRS, or anything else). They each require 100s of decisions and assumptions that may bias or mislead investors one way or another; its not like any one of those decisions is the "right" one either. Its more important that we make sure investors are aware of what those pitfalls are. Not to mention, the cost of asking every US company to switch to IFRS would be enourmous (though i'm sure the big 4 accounting firms wouldn't mind). As a side note, GAAP definitely isn't industry agnostic. For example, FASB (the financial accounting standards boards) issues guidance on revenue recognition for all sorts of companies and the guidance for a software company is very different than the guidance for your generic widget manufacturer.
- huac 11y agowhat is post-modern accounting?
- kevin_thibedeau 11y agoIt involves an Italian bistro.
- __jal 11y agoAnd dense texts describing how the act of reading that 10K necessarily involves the reader in the narrative of the document. And some business about talking to a lion, I think.
- tamana 11y ago? You linked to another Levine article, about Goldman. Where's the Morgenson article?
- Havoc 11y agoBetter to have something standardised with known quirks and weakness than have a complete free-for-all. Yeah some of it will be an improvement but some won't and you can't easily tell which is which. Might as well not bother reporting anything then.