The SEC’s patience is running thin with an accounting measure that WeWork, Peloton, and Uber are fond of. Here’s how it works and why it can be misleading.

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  • Before its aborted IPO, WeWork’s parent We Co used a measure known as contribution margin to suggest that its core operations were strong and profitable, to the tune of $340 million in the first half of 2019 — even though it had a net loss of $905 million.
  • At a December accounting conference, Patrick Gilmore, a senior SEC accountant, slammed an unnamed subleasing company over its use of contribution margin. The SEC has questioned Peloton about its use of contribution margin, and companies like Uber and Lyft have also featured the measure in their financials.
  • Non-GAAP measures like contribution margin don’t adhere to standard accounting rules for U.S. companies, but started with a legitimate aim: to show how companies would have performed without unusual items like acquisitions or big write-offs distorting their earnings. 
  • The number of big companies that use non-GAAP measures has skyrocketed. According to consulting firm Audit Analytics, 97% of Standard & Poor’s 500 companies use non-GAAP measures, up from 59% in 1996.
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Memo from the Securities and Exchange Commission: If you want to use contribution margin to tout how well your company is doing, you might want to think twice.

WeWork tried to brag about its contribution margin. Before its aborted IPO, WeWork’s parent We Co used the unofficial, customized measure to suggest that its core operations were strong and profitable, to the tune of $340 million in the first half of 2019 — even though it had a net loss of $905 million. The difference between those two numbers: Contribution margin excludes hundreds of millions of dollars in costs that WeWork incurs every quarter.

And WeWork isn’t the only high-flying, money-losing company that likes to highlight that kind of figure. Peloton, Uber, and Lyft have all touted their own version of the metric. 

But moves like that appear to have irked the SEC, to put it lightly. 

At a December accounting conference, Patrick Gilmore, a senior SEC accountant, slammed an unnamed subleasing company over its use of contribution margin. The company, he said, had used its own “tailored” way of calculating the number – even though its gross margin, a comparable “official” number, was negative. 

“It was eye-opening,” Gilmore said. The company spent a lot of space in its SEC filing justifying its use of contribution margin, he said, and if simply explaining why a company is using a metric is that complex, “you probably want to rethink that measure.”

According to a report from the Wall Street Journal, the SEC had warned WeWork before it scrapped its IPO that its use of contribution margin “could be misleading.”

WeWork isn’t alone. The SEC has questioned Peloton about its use of contribution margin, and companies like Uber and Lyft have also featured the measure in their financials.

Measures like contribution margin offer a more flattering view of a company’s financials

The fuss spotlights why some regulators and critics are concerned about companies’ increasingly widespread use of such customized measures. 

They can make companies look healthier than they really are by leaving out key details of how they operate. And companies can lay them out for investors alongside more standardized figures, making it difficult to understand what’s what. 

Companies argue that investors can get a truer picture of their performance from these “non-GAAP” measures – those which don’t follow generally accepted accounting principles, the standard accounting rules for U.S. companies. 

But critics deride them as “earnings before bad stuff”: They can strip out a company’s ordinary operating costs, from administration to new business development to marketing, to let the company claim it’s showing black ink instead of red.

“If you have an opportunity to measure your profits any way you want, you’re going to do so in the most flattering way you can get away with, and WeWork took that to an extreme,” said David Trainer, chief executive of New Constructs, an investment-research firm.

WeWork declined to comment. The company has said it regards contribution margin as useful measures of operating performance.

What contribution margin measures — and what it leaves out

Contribution margin is the revenue from a product or segment minus its variable costs, meaning raw materials, sales commissions, and other costs that can vary depending on how much of a product the company makes. Sometimes it’s expressed as a percentage of revenue. It shows how profitable a particular product can be, and how much gross profit it produces to cover fixed costs like machinery and rent.

It can be valuable in assessing a company – just not in the way some companies use it, critics say. It shows how much each product or segment contributes to a company’s results, and thus which segments are doing well or poorly. 

But since it excludes real costs of the business, whether it’s a valid measure of a company’s overall performance is another matter entirely.

“Contribution margin in and of itself is not bad, but it can’t replace bottom-line profitability,” said Chris McCoy, an assistant professor of accounting at William & Mary’s Raymond A. Mason School of Business. 

WeWork’s calculation of contribution margin when it prepped its IPO was especially striking because of the scope of what it left out. 

Its first-half $340 million contribution, producing a contribution margin of 25%, excluded more than $1.6 billion in regular operating costs – $370 million in what the company called “growth and new market development expenses” (finding new office-space locations and pursuing new markets), $255 million in costs to get locations ready for clients, $320 million in sales and marketing costs, and so on.

“If you exclude actual costs, you’re going to make a lot of money,” said Matt Kelly of Radical Compliance, a corporate-compliance consultant. 

WeWork has since shifted to using “location contribution margin” in an October investor presentation, a similar metric calculated slightly differently, that still shows a positive number. 

Other companies that made high-profile public debuts this year have used similar metrics

Peloton, meanwhile, has its own version of contribution margin. It reported “subscription contribution” of about $42 million in its fiscal first quarter that ended Sept. 30, a 63% contribution margin, even though it had a net loss of about $50 million.

Last summer, the SEC sent Peloton a series of comment letters before its IPO indicating the company should improve how it was presenting its contribution margin, and the company revised its disclosures. Peloton didn’t respond to requests for comment.

The big ride-sharing companies have used it also. 

Uber reported “core platform contribution profit” of $103 million from its ride-sharing and Uber Eats businesses for the first half of 2019, despite a $6.3 billion net loss, after omitting research and development, general and administrative costs, stock compensation, and other items. 

Uber, which has since replaced contribution profit with another similar metric, didn’t respond to requests for comment. 

Lyft had third-quarter contribution of $479.2 million, a 50.1% contribution margin, versus a net loss of $463.5 million. Lyft declined to comment.

More big companies are using non-GAAP measures, and the SEC is taking a tougher stance 

Non-GAAP measures started with a legitimate aim – to show how companies would have performed without unusual items like acquisitions or big write-offs distorting their earnings. But companies latched onto them, especially early-stage technology companies eager to claim profitability, and their use mushroomed. 

Now 97% of Standard & Poor’s 500 companies use non-GAAP measures, up from 59% in 1996, according to consulting firm Audit Analytics. 

The SEC allows companies to use their own customized numbers, so long as they’re properly disclosed and the companies detail how they differ from official GAAP numbers. 

But concerns over misuse has led the SEC to crack down on them in recent years. The commission sent a wave of letters to companies warning them to improve their disclosure, or not to tout their own measures more strongly than official numbers. In addition to Peloton, Parker Hannifin and Pier 1 Imports are among the companies that the SEC sent such letters to in 2019; the companies told the SEC they would revise their disclosures in the future. 

The SEC has also filed a handful of enforcement cases. In 2018, for instance, security company ADT Inc paid $100,000 to settle SEC charges it had featured non-GAAP measures too prominently. 

When companies use non-GAAP numbers in their earnings releases or regulatory filings, the SEC says they must include the comparable GAAP numbers just as prominently or more so — if a company promotes its non-GAAP earnings in the headline of a press release, for example, the GAAP number must be in the headline also.  

Sometimes companies start using non-GAAP measures because others in their industry do so, or at the behest of analysts who cover the company. But some observers think companies adopt measures like contribution margin for the simplest of reasons – because it makes them look good when nothing else does.

“WeWork could boost the contribution margin more easily than they could bottom line earnings,” said Patricia Dechow, a University of Southern California professor of business administration and accounting.

With WeWork’s IPO collapse, some hope investors will be more skeptical of companies’ use of customized financial measures in the future.

“When they push that envelope too far, they come up with malarkey,” Kelly said.

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