Investors, analysts, D&O insurance underwriters, and others responsible for identifying risks among public companies may want to pay close attention to the ways that companies report their financial results. According to a recent analysis, companies that make heavy use of non-GAAP reporting – such as tailored figures like “adjusted net income” and “adjusted operating income” – are more likely to encounter some kinds of accounting problems, such a restatements, than companies that stick to standard accounting measures. The research, by consulting firm Audit Analytics, is discussed in an August 3, 2016 Wall  Street Journal article (here), and in an August 4, 2016 post on the Cooley law firm’s PubCo blog (here).

The Audit Analytics study reviewed companies in the S&P 1500 index between 2011 and 2015. The study found that just 3.8% of companies using standard GAAP reporting metrics had formal earnings restatements during that period, while “heavy users” of non-GAAP measures (that is, those whose non-GAAP earnings were at least twice as high as their GAAP net income)  the rate was 6.5%. Similarly, 7.5% of the GAAP-only companies reported material weaknesses in internal controls, versus 11% for Non-GAAP companies.

For each accounting problem that Audit Analytics examined, the trend lines held. The problems occurred at relatively low levels in the GAAP-only group, at higher levels among all non-GAAP users, and at still-higher levels among heavy non-GAAP users.

The Journal article suggests that “heavy use of metrics outside of generally accepted accounting principles – sometimes referred to derisively as ‘earnings before bad stuff’ – could be a warning sign.” The article quotes one of the study’s authors as saying that “I would say an overprominent user of non-GAPP metrics would justify more attention and is a red flag.”

The use of non-GAAP accounting is hardly a new issue. These concerns have significant echoes of the same alarms that commentators sounded during the heady days of the dot-com era, when homebrewed financial metrics seemed to be the order of the day. Just the same, these old issues seem to be making something of a comeback. As was the case during the dot-com era, the use of non-GAAP measures may suggest that a company is concerned with managing market expectations. Perhaps overly so.  Indeed, the SEC has signaled its commitment to cracking down on the use of non-GAAP metrics.

To be sure, there are instances where non-GAAP reporting is arguably appropriate. The use of non-GAAP metrics is not necessarily a signal of aggressive accounting practices. The Journal article gives the example of companies using non-GAAP measures to show company results in constant currency. The trouble does not come from these more benign examples, however.

For D&O underwriters, these issues should ring some familiar alarm bells. Just as was the case during the dot com era, a company’s heavy use of non-GAAP accounting could be a warning of other issues. The two specific companies that the Journal article specifically discusses underscore the seriousness of this issue from a D&O underwriting standpoint. The two companies are Valeant Pharmaceuticals and LendingClub. Both of these companies have not only recently had high profile problems, but they have both attracted securities class action lawsuits (as may be seen here and here). D&O underwriters hoping to risk-select away from companies with a greater securities class action risk should exercise a bias in favor of companies using more traditional GAAP reporting. Companies making heavy use of non-GAAP reporting could well become disfavored from a D&O underwriting standpoint or at a minimum expect to pay a risk-adjusted premium.