As he walked readers through the financial results of Berkshire Hathaway, CEO Warren Buffett went off on a tangent on what he characterized as “the most egregious example” of how corporate executives fudge numbers to inflate profits.

“I suggest that you ignore a portion of GAAP amortization costs,” Buffett said of some line items that were depressing Berkshire’s own reported profits. “But it is with some trepidation that I do that, knowing that it has become common for managers to tell their owners to ignore certain expense items that are all too real.”

GAAP is short for generally accepted accounting principles and represent an attempt to promote uniformity in how companies report their financial performance. But income statements reported based on GAAP don't always reflect the ongoing performance of a company's underlying operations. For example, a company may write-down an asset, restructure its operations, or contribute to an underperforming pension fund. These actions usually come with large one-time costs that distort company profits and misrepresent long-term profitability. And so, a company will also provide an adjusted, or non-GAAP earnings number that excludes what are arguably non-recurring items.

Generally, investors and analysts will embrace these non-GAAP numbers. But some executives arguably exclude too much.

Stock-based compensation is compensation, isn’t it?

To be clear, Buffett also sometimes strays from GAAP in his effort to more accurately portray financial performance. But he cautions that the path away from GAAP is a slippery slope towards outright financial deception. And in his diatribe, he singles out one very real expense that executives love to ignore.

“Stock-based compensation is the most egregious example,” Buffett said. “The very name says it all: ‘compensation.’ If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?”

Buffett has been arguing this point for as long as companies have been excluding this expense from their income statements.

“This Alice-in-Wonderland outcome occurs because existing accounting principles ignore the cost of stock options when earnings are being calculated, even though options are a huge and increasing expense at a great many corporations,” Buffett said in his 1998 letter to Berkshire Hathaway shareholders. “In effect, accounting principles offer management a choice: Pay employees in one form and count the cost, or pay them in another form and ignore the cost.”

There are many reasons why a company may ask investors to ignore stock-based compensation. For one, stock-based compensation does not represent an immediate cash outflow from operations in the way that a salary or hourly wage will. And for options, it can be very difficult to estimate what the ultimate cost of this compensation may be since there’s no telling where the stock price will go and when the employee may exercise.

The sector most commonly associated with stock-based compensation and liberal non-GAAP based earnings is probably tech, where pay at young companies skews heavily toward options as managers are usually working with limited piles of cash. Tech companies with notably different GAAP and non-GAAP earnings include FireEye (FEYE), Splunk (SPLK), and Workday (WDAY).

Regardless, it’s challenging to justify why these items shouldn’t be accounted for like any other form of compensation. Unfortunately, even the Wall Street analysts who are supposed to be scrutinizing these numbers don’t seem to mind leaving them out.

“Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring ‘earnings’ figures fed them by managements,” Buffett said. “Maybe the offending analysts don’t know any better. Or maybe they fear losing ‘access’ to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.”

“For if the cost of stock options is not universally incorporated into the measurement of net income, companies that grant options will underreport compensation costs, and it won’t be possible to compare their profitability, productivity, and return-on-capital measures with those of economically equivalent companies that have merely structured their compensation system in a different way,” articulated professors Zvi Bodie, Robert Kaplan and Robert Merton in the March 2003 issue of the Harvard Business Review.

Bodie, Kaplan and Merton’s article was titled “For the Last Time: Stock Options Are an Expense.” And yet the debate goes on.

The gap between GAAP and non-GAAP is getting wider

Many believe that GAAP earnings represent a stringent yet fair measure of profitability. So it’s worrisome when the gap between GAAP earnings and the much bigger non-GAAP earnings gets wider, which is what’s happening in corporate America today. It’s something that’s been flagged by top Wall Street strategists including Deutsche Bank’s David Bianco and Bank of America Merrill Lynch’s Savita Subramanian.

Billionaire investor Carl Icahn warned of the perils of non-GAAP accounting in a chilling video he released last September.

“The earnings they are putting out today, I think, they are very suspect,” Icahn said.
“You haven’t really increased earnings for three years. GAAP earnings [for the S&P 500] have stayed at around $100 a share for three years.”

All of this is coming as more and more companies engage in touting non-GAAP performance.

"We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power," Bank of America Merrill Lynch analysts said in January.

Unfortunately, there isn’t a right answer for the GAAP vs. non-GAAP debate

“Even GAAP earnings are suspect,” Icahn said.
 
And he’s right, especially if everyone agrees that always abiding by GAAP doesn’t offer a fair and accurate representation of profitability.

"We have always argued that the best EPS measure lies somewhere between GAAP and non-GAAP EPS,” Deutsche Bank’s David Bianco wrote.

For investors who are concerned about any of this, the solution may be to just become more familiar with accounting and how the accounting process works.

"Accounting is the language of business," Buffett said a year ago in response to a question from actress Glenn Close. "You have to be as comfortable with that as you are with your own native language to really evaluate businesses.”

“Accounting tells you a lot and it can be used in many ways to deceive. You saw it at Enron for example,” he continued. “But you really have to understand what can be done with accounting when it gives you correct answers and when it gives you wrong answers.”