There is a weak case at best for standardizing non-financial KPIs such as same store sales. Leave the rest of the existing regulation as is.
Regulators have long struggled with whether and how to standardize non-GAAP reporting. The SEC, via Regulation G and additional rules in 2016, put in common-sense rules on non-GAAP numbers requiring firms to reconcile the non-GAAP number to the GAAP number. In addition, the SEC requires that: (i) the firm cannot present misleading non-GAAP numbers, defined mostly as excluding normal, recurring, cash operating expenses necessary to operate a firm’s business; (ii) the firm cannot present inconsistent non-GAAP measure across periods; (ii) the non-GAAP measure cannot exclude gains; and (iv) non-GAAP numbers should clearly label the adjustment.
The policy question is whether we should go beyond this? The FASB has a proposal asking whether they need to do something about standardizing financial KPIs. One hypothesis would be that non-GAAP numbers are not all useless or fudged in that the exclusions and inclusions signal information (however costly). There is a fair amount of academic research supporting this perspective. Some complain that GAAP has become excessively restrictive, and we need to give firms leeway to communicate the idiosyncratic aspects of the business model via non-GAAP numbers. The opposing camp would argue that these adjustments to GAAP numbers are opportunistic, and the policy maker must protect the uninformed investors from such opportunism. So, what should the policy maker do?
The reality, I suspect, lies somewhere in the middle. Some exclusions potentially make business sense. One-time items, say a litigation settlement, potentially mess with an analyst’s projection of continuing performance. As long as that exclusion is disclosed, I can live with that exclusion.
However, excluding depreciation, interest expense and taxes, which are normal business expenses, personally make little business sense to me. I often joke in class with my students, “imagine a world where the student does not pay interest on student loans, does not pay NYC city, NY state and federal taxes, and pays no rent (loosely the capacity cost or DA in EBITDA). Of course, you are rich after these exclusions.”
I suggest a mid-way compromise: (i) leave non-GAAP numbers as is, as long as the firm reconciles the non-GAAP number to the GAAP number and follows the SEC’s earlier guidance on consistency; (ii) if there is no comparable GAAP number, such as same store sales or the number of subscribers and customers, there may be some value to standardizing what same store sales might look like, for instance, in the retail industry.
Consider same store sales disclosure for Home Depot in the 10-K of 2024 and compare that to Lowes, its closest competitor. Home Depot reports something called, “comparable sales,” defined as:
“Comparable Sales. Comparable sales is a measure that highlights the performance of our existing locations and websites by measuring the change in net sales for a period over the comparable prior period of equivalent length. Comparable sales includes sales at all locations, physical and online, open greater than 52 weeks (including remodels and relocations) and excludes closed stores. Retail stores become comparable on the Monday following their 52 week of operation. Acquisitions are typically included in comparable sales after they have been owned for more than 52 weeks. Our comparable sales results for fiscal 2024 exclude the 53rd week and compare weeks 1 through 52 in fiscal 2024 to the 52-week period reported for fiscal 2023. The method of calculating comparable sales varies across the retail industry. As a result, our method of calculating comparable sales may not be the same as similarly titled measures reported by other companies. Total comparable sales decreased 1.8% in fiscal 2024, reflecting a 1.0% decrease in comparable customer transactions and a 0.9% decrease in comparable average ticket compared to fiscal 2023.”
Lowes reports, in its annual report for 2024,
“A comparable location is defined as a retail location that has been open longer than 13 months. A location that is identified for relocation is no longer considered comparable in the month of its relocation. The relocated location must then remain open longer than 13 months to be considered comparable. A location we have decided to close is no longer considered comparable as of the beginning of the month in which we announce its closing. Operating locations which are sold are included in comparable sales until the date of sale. Comparable sales include online sales, which positively impacted comparable sales in fiscal 2024, fiscal 2023, and fiscal 2022 by approximately 50 basis points, 25 basis points, and 45 basis points, respectively. The comparable sales calculation for fiscal 2022 was calculated using sales for a comparable 52-week period.”
Even for two very similar, closely tracked peers such as Home Depot and Lowe’s, there are subtle differences in comparability in the “comparable” sales numbers:
- Is slightly less than 13 months the same as 52 or 53 weeks?
- Is Home Depot’s policy with store locations the same as Lowes’ policy?
- What does Lowes do with acquisitions?
One of the challenges of standardizing non-financial KPIs is that these KPIs are likely to differ depending on the industries using them. Retail uses same store sales. Streaming services and cable companies report number of subscribers. Airlines use available seat miles. Does the rule maker want to get into the business of regulating KPIs by industry?
Standardization can cause new problems
Trevor Harris, emeritus professor at Columbia Business School, my colleague worries, “standardization of non-GAAP numbers is going to cause more issues. I think part of the general problem is that people want everything in a summary statistic which cannot really work, and we assume all investors use the measures being reported. So, part of the answer is to put some of the responsibility back on investors instead of adding more regulation which will never cover everything.
When I created economically consistent measures in Model Ware at Morgan Stanley, there were many cases where I had to arbitrate and provide consistency. No regulation can deal with all the idiosyncrasies in complex companies.
Another dimension of this is why is comparability a holy grail? Lowes and Home Depot are more similar, but not homogenous. If people cannot adjust for 52 versus 53 weeks, why add more burden on the companies if they don’t operate that way?”
An ex-standard setter, who wished to stay anonymous, points out another important wrinkle – the constant pressure from industry to adopt income-increasing metrics or rules that make companies look good: “If I was in charge of the FASB, I might think twice about taking on such a project. An example was earnings per share. It was the first GAAP metric and at one time was viewed as critical to investment decision making. Because many believed it was critical to investment decision making, the gaming of the standard became a popular sport. So much so, that the FASB was constantly trying to issue guidance to address the most recent scheme to boost EPS. The literature became voluminous and complex. A former FASB Chairman told me that he believed the EPS standard was one of the FASB’s biggest mistakes and that in his view the FASB should not set standards for how to compute metrics used by investors.”
In sum, there is a weak case at best for some kind of standardization of non-financial KPIs. On balance, I suggest we leave Regulation G and the SEC’s 2016 rules as is. In my view, these rules strike a reasonable balance between giving firms discretion to tell their story and give investors information to detect managerial opportunism.