Tailored Accounting at IPOs Raises Flags
Critics Say Companies’ Increased Use of Customized Earnings Measures Could Confuse Investors
Jan. 7, 2015 7:37 p.m. ET
Zoe’s Kitchen Inc. is serving up profits—but only after leaving some of its expenses off the menu.
Zoe’s, a chain of 125-plus Mediterranean-theme restaurants that went public in April, reported an adjusted profit of $13.2 million for the first nine months of 2014 under its own accounting treatments that strip out a variety of expenses. Including those expenses, as is required under standard accounting rules, Zoe’s reported a loss of $8.4 million.It is far from an isolated example. Forty companies went public in 2014 reporting losses under traditional accounting rules but showing profits under their own tailor-made measures. That is 18% of all U.S. initial public offerings for the year, according to consulting firm Audit Analytics, the highest level since at least 2009. Of 2014’s 10 biggest IPOs, nine used nonstandard earnings measures alongside the official accounting treatment to some degree.
Many companies prefer highlighting their own customized measures, saying they give investors a better picture of the company. That worries some experts, and the Securities and Exchange Commission has written letters to Zoe’s and other companies telling them the bespoke figures they use are given too much prominence in regulatory filings and asking for revisions.
Nonstandard metrics give investors “the best measure” of continuing performance, said Jason Morgan, chief financial officer of Zoe’s, who added that the SEC’s concerns were addressed in the company’s case by revising its prospectus.
But as the IPO market heated up last year, observers have raised fears that companies’ increased use of these nonstandard measures could confuse or mislead investors at a time when they are forming their first impression of a company.
“I think it’s a sign of frothiness” in the IPO market, said Brandon Rees, deputy director of the AFL-CIO’s Office of Investment. “Why investors tolerate it, I don’t know.”
Some say the costs that companies strip out of their nonstandard measures are increasingly things that should be counted in earnings calculations, such as executive bonuses, fees for stock offerings and acquisition expenses.
“I was just astounded at the wide variety of elements that people thought were appropriate to exclude,” said Curtis Verschoor, a DePaul University emeritus professor of accountancy. Investors should be aware that a company’s nonstandard numbers “are more likely to be slanted rather than balanced,” he said.
Companies must still prominently disclose their earnings under generally accepted accounting principles, the standard set of U.S. accounting rules, even if they also spotlight their earnings under “non-GAAP” measures.
“It’s knee-jerk to say that’s a place where companies put bad stuff,” said Mike Guthrie, chief financial officer of TrueCar Inc., an auto-buying-and-selling platform that went public in May.
For the first nine months of 2014, TrueCar had a $38.6 million loss under standard rules but a $6.6 million profit under “adjusted Ebitda”—earnings before interest, taxes, depreciation and amortization, modified further to exclude other costs, such as an $803,000 expense to acquire rights to the company’s stock symbol.
Mr. Guthrie said it would be more misleading for the companies not to present adjusted measures; the stock-symbol cost, for instance, was a one-time expense that won’t affect TrueCar’s future results. TrueCar closed Wednesday at $20.94 a share, up 133% from its IPO price of $9.
According to Audit Analytics data, 59% of the companies that filed for an IPO since 2012 have used nonstandard metrics, compared with 48% in 2010 and 2011.
Many go beyond the items that companies most frequently strip out of their preferred measures, such as employee stock compensation and foreign-exchange gains and losses. A PricewaterhouseCoopers LLP survey found 80% of IPO companies that made adjustments to their Ebitda from 2010 to 2013 had at least one adjustment beyond the more-common strip-outs, though PwC said it couldn’t comment on individual companies.
The growth in such reporting by IPO companies comes in part because more technology and service-based companies are coming public. Those companies are more likely to use accounting estimates and subjective measures when compared with traditional bricks-and-mortar companies, said Jay Ritter, a University of Florida finance professor who tracks IPOs.
The SEC has expressed concern in the past about companies’ non-GAAP metrics, notably with regard to daily-deals company Groupon Inc. Before Groupon’s 2011 IPO, the SEC raised questions about its use of “adjusted consolidated segment operating income,” a metric that excluded Groupon’s marketing costs to land new subscribers. Groupon scaled back its use of the metric in response to the SEC concerns. Groupon couldn’t be reached for comment.
In the past two years, the commission has sent comment letters to more than 30 companies, both pre-IPO companies and those already public, criticizing them for giving nonstandard earnings measures “undue prominence” in their securities filings.
Zoe’s received such a letter in January 2014.
Zoe’s had mentioned its adjusted Ebitda first in the “management’s discussion and analysis” section of its prospectus, four pages before providing an earnings table that followed standard accounting rules. The SEC also questioned Zoe’s exclusion of some cash expenses from its adjusted Ebitda, such as the costs of opening new restaurants and management and consulting fees.
Zoe’s prospectus had been filed under seal with the SEC at the time, and the company revised its filings to address the “undue prominence” criticism before it filed a public prospectus in March, the company’s finance chief, Mr. Morgan, said. Whether the expenses should be excluded “came down to an interpretation” of regulations, and the company didn’t change its methodology, he added.
Zoe’s stock closed Wednesday at $31.63 a share, more than twice its IPO price of $15.