Ethics Case Study of the Week: Misleading Non-GAAP Measure

By Gary Sarkissian posted 12 days ago

  

CFA Institute’s Code of Ethics and Standards of Professional Conduct codify the ethical guidelines for the investment profession that are critical to maintaining the integrity of capital markets and investor trust.  Members, candidates, and even firms make a commitment to uphold these standards as they help elevate ethical decision-making universally around the globe.  

As investment professionals, we are certain to face important ethical decisions in our day-to-day activities.  Some scenarios we encounter will be straightforward, while others may be more complex.  No matter what circumstances we face, continuous learning remains imperative in an investment industry that continues to evolve with products undergoing innovation and a regulatory environment continuing to adapt. 

For that reason, each week we will feature a sample case from CFA Institute’s Ethics in Practice Casebook.  Each case is built upon a real-life example that may involve a regulatory matter or even a CFA Institute Professional Conduct investigation.  At the end of the case is a multiple-choice question that addresses the ethical nature of the actions taken in that case.  

This week’s case involves Standard I(C) Misrepresentation. 


Misleading Non-GAAP Measure
Hutchins is the chief financial officer of Bloxmore, a publicly-traded real estate investment trust (REIT) that owns several hundred open-air shopping centers. In addition to following generally accepted accounting principles (GAAP) for financial reporting purposes, Bloxmore, like many other REITs, reports same property net operating income (SP NOI) as a supplemental non-GAAP financial measure to help investors and analysts understand and assess the company’s operating results. SP NOI represents the NOI of the pool of properties owned by Bloxmore as of the end of both the current reporting period and the same reporting period in the prior year (the “comparison period”) for the entirety of both periods. Bloxmore reports SP NOI as a dollar amount and as a percentage by which SP NOI has grown between the current reporting period and comparison period, which is known as the SP NOI growth rate. Because the SP NOI growth rate reflects the growth in the NOI of a static pool of properties, it is a valuable measure of Bloxmore’s ability to generate growth from its existing properties over the course of a year, as opposed to growth through the acquisition or construction of new properties.

Bloxmore touts its steady and consistent SP NOI growth rate to investors as proof that its business strategies are successful. To maintain steady growth Hutchins uses several accounting methods to incorporate lease termination income into SP NOI. Lease termination income is a one-time negotiated lump sum fee that a tenant pays Bloxmore to exit its lease early. Because this influx of income can spike the SP NOI growth rate, Hutchins amortizes the lease termination income over the period of the remaining term of the original lease. He incorporates the amortized amounts into SP NOI until Bloxmore finds a new tenant for the space. In addition, on a number of occasions, Hutchins reclassifies lease termination income as “Other Income,” which is recognized immediately, when additional income is needed to bridge the gap between the company’s actual SP NOI growth rate and its growth rate target. In this way, Hutchins eliminates Bloxmore’s income volatility allowing it to achieve its SP NOI growth rate targets. Hutchins actions are

A. inappropriate.
B. appropriate because lease termination income should be incorporated in the calculations to make SP NOI an effective comparative measure.
C. appropriate, as long as all of the income received by Bloxmore is recognized as part of SP NOI in some manner.
D. appropriate because SP NOI is a non-GAAP financial measure that is optional and does not need to be reported by Bloxmore.
E. none of the above.

What do you think is the correct choice?  Click the “Analysis” button below to see the analysis for this case, and feel free to discuss in the comments below.  The completion of this case qualifies for 0.25 hour of Standards, Ethics, and Regulation (SER) credit

This case relates to manipulation of accounting practices to misrepresent and falsely report company performance. CFA Institute Standard of Professional Conduct I(C): Misrepresentation prohibits CFA Institute members from making any misrepresentation relating to investment analysis, actions, or other professional activities. In this case, Hutchins uses improper accounting practices to smooth Bloxmore’s periodic earnings results, thus making it falsely appear that the company was achieving steady and consistent growth. Although all of the terminated lease income is accounted for, the inconsistent timing of its incorporation into Bloxmore’s financial statements misrepresents the nature of the income in order to maintain the narrative of consistent and predictable growth that is central to Bloxmore’s investment thesis. Amortizing the lease termination income makes it appear that Bloxmore is continuing to receive rental income as if the lease had never been terminated. Even incorporating lease termination income into SP NOI at all is fundamentally misleading.

Industry practice is to exclude lease termination income from the calculation of SP NOI because it represents a one-time payment that would otherwise skew the SP NOI growth rate as a comparative measure of the growth in SP NOI. Although SP NOI is a non-GAAP measure, investors and analysts rely on it to assess Bloxmore’s financial performance and as a valuable measure of a REIT’s ability to generate growth from its existing properties over the course of a year, as opposed to growth through the acquisition or construction of new properties. Under GAAP, terminated lease income should be recognized in full when the lease is terminated and the payment received, thus becoming a part of reported GAAP income for that quarter. Hutchins manipulative accounting practices leads to false reporting of Bloxmore’s SP NOI growth rate, misleading investors into believing that Bloxmore’s growth was strong and steady when in reality it fluctuated greatly. Choice A is the best response.

This case is based on a US SEC Enforcement Action in August 2019.




Image by Michal Jarmoluk from Pixabay  


© 2019 CFA Institute. All rights reserved. You may copy and distribute this content, without modification and for non-commercial purposes, provided you attribute the content to CFA Institute and retain this copyright notice.  This case was written as a basis for discussion and is not prescriptive of how a business situation or professional conduct matter should or should not be handled or addressed. Certain characters mentioned are fictional to facilitate discussion, and any resemblance to actual persons is coincidental.


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