Bridging the Gaps in GAAP

Here are eight critical considerations for combating the creativity crisis in accounting.
David McCannOctober 16, 2019

In the Fall of 2011, my son was navigating a treacherous gap in a wall he was scaling during one of his 200 or so missions in Afghanistan’s Helmand Valley (see photo, right). Eight years later, he took the photo below while walking across the Brooklyn Bridge just this past Saturday — a bridge that not all that long ago he wasn’t sure he would ever get a chance to traverse.

He’s covered a lot of ground since 2011, both literally and figuratively. It’s been a journey that at times has felt absolutely ripe with uncertainty, risk, and fear of the worst outcome imaginable.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

Thankfully, my son made it to the other side — again both literally and figuratively. It suggests a lesson to me: regardless of what we can or can’t see ahead of us, there may be a bridge to cross that can take us to the other side where good things are in store for us if we adjust, try new routes, and keep our faith.

I believe that is a relevant thought in today’s financial climate of instability and volatility, amid the challenges we’re all struggling to manage given today’s overload of information. Some of it is perhaps credibility-challenged and so creatively packaged and presented that at times it can be a bear to comprehend.

In September, Drew Bernstein of accounting firm Marcum Bernstein & Pinchuk wrote a fascinating piece published on entitled “Has Non-GAAP Reporting Become an Accounting Chasm?” It was extremely well-written, thought-provoking, and in my opinion maybe just a bit controversial and troubling — in a very healthy way.

That’s what good writers do; they “bother” us, get us uncomfortable, make us think — about what we hold to be true, about our assumptions, and maybe the biases we all accumulate over time that can cloud our perceptual filters.

Drew suggested that we carefully contemplate the following critical considerations:

  1. Aggressive use of non-GAAP numbers is creating a crisis in how investors, analysts, and the media report financial performance and value companies. Moreover, he suggested that this “cannot be argued.
  2. We are on the verge of “systemic failure” in financial reporting.
  3. As a result, he wrote, we must critically question: “How should management and boards determine what amount of non-GAAP disclosure, if any [emphasis added], is most appropriate to employ in their financial disclosures?”

Drew and I aren’t so different, in that we’re both bombarded with an unmanageable plethora of business and financial information from extraordinarily diverse sources. To maintain my own sanity, I have a number of sources that email summaries of articles and listings of article topics, filtered by keywords I selected. It’s how I stumbled upon Drew’s piece. Much of this information is originated by accounting firms, through various press releases, social media postings, blogs, etc.

As we come face to face with the blurred lines between news and opinion, it’s really tough to discern “fact” from, well, not “pure” fact, as we try and keep ourselves adequately informed. That may be the central concern expressed in Drew’s article.

If that is an accurate summarization of his point of view, then indeed it appears we are actually joined at the hip, so to speak — at least, on that particular point.

The GAAP Gap

On the other hand, it’s paramount that we pause to contemplate whether what we are experiencing with the avalanche of so-called “advanced analytics” is rooted in a failure to follow GAAP.

Or, rather, might the problem lie in the inherent insufficiencies in traditional GAAP-based financial statements, which are persistently susceptible to weaknesses in the “independent” attest/audit approach to validation, confirmation, and corroboration?

Absent adequate analysis and amplification, financial statement packages are nothing more than a starting point. And for certain there is nothing remotely sacrosanct or infallible about generally accepted accounting principles.

A two-period, comparative set of financial statements is in essence a pair of snapshots — just two points in time — of very high-level summaries of a company’s financial position, results of operations, and flow of funds. This summary information is, at best, only slightly more enlightening and instructive than raw data.

Without the context and illumination provided by highly visible, rigorous transparency and analysis, the statements are woefully insufficient — and the audit opinion report incomplete and non-compelling — for providing the stories behind the numbers that so critical to those looking to be informed by them.

The “south end” of the loan portfolio is to a large extent where I’ve spent much of the past 25 to 30 years. The view from the bottom of the pile is frequently a life lesson in what not to do. Years of post-mortem perspective from the discontinued, dismantled, and dissolved remnants of enterprises has been eye-opening revelation, as has a career devoted to enterprise value — what creates it, how to measure and evaluate it, and what impairs it.

Maintaining the perspective of prospective acquirers and how they think about their cost of capital and required return, given uncertainty, volatility, and risk, is essential when it comes to ensuring transparent visibility to the critical value drivers at play.

Why? Because there is no fiduciary duty more paramount than the duty of management to produce and preserve a return on owner-invested capital that’s commensurate with risk.

Eight CCs for CFOs

To be clear, I’m not so naïve as to buy into the notion that the motives of management are always free from personal agendas, and certainly it’s human nature to desire to present things in their most favorable light. Without question, there can be real hesitation to be an open book.

That said, over the long run the market indeed rewards those committed to genuine transparency and compliance demonstrated by playing the game by the “rules” — i.e., GAAP. And by the same token, the market can be brutally cold and efficient in “punishing” those that don’t.

But in 25-plus years of providing contributions to distressed firms and their third-party stakeholders, not once have we encountered the most recent audit report (before we were engaged) containing a going-concern disclaimer. That’s so even though FASB has revised GAAP standards with respect to asset impairment numerous times since 2000.

In fact, the most recent GAAP revisions have taken us full circle to where we were not all that long ago regarding accounting for goodwill. The private company alternative has simplified the rules for testing for goodwill impairment while once again requiring it to be amortized.

I mention all of that not to indict third-party audit reports but to point out their limitations and inadequacies. The roadside is littered with noteworthy audit failures. If I were Drew, I might be inclined to focus my concern in that direction, and at the gaps in GAAP that must be bridged, rather than, well, more GAAP.

The growth in disclosures of non-GAAP information has been a response to demand from investors and the financial community, as well as increased regulatory requirements and scrutiny. By and large, this visibility and transparency is essential to successfully discharging the overriding fiduciary duty mentioned above.

To combat excessive creativity in reporting (intentional and otherwise) and to curb the resultant manipulation and potential crisis of misguided distortion that Drew rightfully warned us about, there are eight “Critical Considerations” (I call them CCs) that CFOs must address to ensure reporting is accretive to and does not impair enterprise value:

  1. Cost of Capital — Industry, market, and specific risk premia elements must be emphasized.
  2. Supporting non-GAAP information must be Consistently and Credibly presented.
  3. The package must be Comprehensive and C
  4. The inherent Constraints/gaps in the GAAP financial package and the limitations in the audit/attest confirmation process must be countered to instill C
  5. The drivers, details, and communication of Costs and Cash flow demand prioritization.
  6. Compliance with Controls — Scorecards demonstrating that adequate financial and operational controls are in place and functioning warrant a section in the package.
  7. Customers and Competitors — Visibility and prominence as to who we are serving, who we could be serving, how we’re serving them, and who else is trying to serve them is vital to decision-makers.
  8. The Cornerstone of the Capability premium — The pre-revenue, embryonic unicorns in development-stage industries, the multiples being paid for them, and the leverage taken on to chase their so-called “capability premiums” — capabilities that a company doesn’t have and wants to acquire rather than develop from scratch — are reflected in the absolutely extraordinary increase in private equity capital over the past dozen years, post-2008 in particular.

In my opinion, here, CC#8, is where the primary crisis potential lies, especially if the reforms momentum around “retail” investors accelerates so as to lower the bar/hurdle for so-called sophisticated investors.

The chase for capability premiums is in reality a fight for deals that’s driving up the prices/multiples being paid. The end result is substantial portions of purchase price being allocated to goodwill generally, and capability premiums specifically. If there was “irrational exuberance” back in the 1980s, there’s even more of it now.

For acquisitions generally, it is incumbent on the CFOs of acquiring companies to expand visibility and transparency to forward-looking information, and to bridge this back to trailing historical reporting to demonstrate to the users of financial information the critical assumptions underpinning debt service projections.

Private equity fund managers may resist providing such users with a sanity check, a very visible sensitivity analysis to the critical foundational assumptions inferred by the capability premium values on the balance sheet. But should there be a crisis, and should the crisis manifest in excessive and unwarranted creativity in the financial reporting, the pain will be most acute on the M&A front.

Tony Wayne is president and co-founder of IronHorse LLC, a specialty consulting firm providing solutions for complex commercial finance and legal problems, M&A capital sourcing due diligence, credit origination and administrative decision support, workouts and credit restructurings, and more. He holds a variety of professional certifications in insolvency and restructuring, business valuation, and financial forensics.