One of many fond impressions London offers to visitors is the warning “Mind the gap” – a uniquely British way of cautioning subway riders not to trip over, or get their foot stuck in, that space between platform and railcar. Very polite and considerate. A stumble could be nasty.
The gap investor relations people must mind – pardon the pun – is the difference between earnings under Generally Accepted Accounting Principles and the measures that CEOs, as well as some investors, prefer for assessing the performance of businesses. The EBITDAs and Adjusted-Whatevers are so many and varied that investors and IR professionals must watch our footing.
A good primer on the issues is provided in “Where Financial Reporting Still Falls Short” in the July-August issue of Harvard Business Review. A couple of accounting profs look at GAAP and the gaps in terms of what investors should look out for, and to some extent what policy wonks might try to regulate next. For accounting is also all about regulation.
Issues they cover are disclosure matters that IR people need to “get”:
- Universal standards, with GAAP and IFRS converging (or not)
- Revenue recognition, especially for complicated products or services
- Unofficial earnings measures, Adjusted-How-We-Look-At-Our-EPS
- Fair value accounting vs. what you paid for an asset
- Cooking the decisions, not the books
The writers call this last item “the more insidious – and perhaps more destructive – practice of manipulating not the numbers in financial reports but the operating decisions that affect those numbers in an effort to achieve short-term results.” So a CEO (or other execs) seeing indications of a revenue shortfall will cut prices to move more product before quarter-end, or to save earnings will delay a discretionary cost like an R&D project or ad buy. Voila! Suddenly EPS meets expectations.
I’m not sure that’s new, or always insidious. When you judge people by numbers, they strive to hit the numbers – teachers teach to the test, sales people sell what they have incentives to sell, and CEOs try to hit their numbers. If the market wants to encourage long-term thinking, boards and perhaps investors can start judging CEOs by the change in performance over years, not quarters. Short-termism is an issue. But I am skeptical of policy makers (or accounting profs) tinkering with regulations to alter how executives make decisions.
The perceptions behind this article are more concerning: Investors don’t trust, with good reason or not depending on the company, disclosures they receive. GAAP or non-GAAP, trust is absolutely critical. Perceptions matter.
What can investor relations people do about this gap?
- Understand our own companies’ GAAP and non-GAAP metrics, not just to provide the mandated reconciliations but to be able to work through the numbers and clearly explain the rationale.
- Ask investors what they like (or don’t) about our financial reporting.
- Benchmark peer companies for insightful metrics and best practices.
- Challenge our managements if metrics are confusing or misleading.
- Be an advocate for simplicity and clarity.
Being transparent means giving information that enables investors to see what’s going on in the business. That doesn’t just mean more pages of accounting boilerplate and reconciliation tables. Perspective is one of the greatest values IR people can give investors.