Mind the Non-GAAP

Visitors to London can’t help but hear, repeatedly, the recorded warning on the underground to “mind the gap” about the space between the train and the station platform. It’s become such a popular phrase that it’s reprinted endlessly on souvenir mugs and t-shirts.

Will the Securities and Exchange Commission soon follow the example and allow visitors to buy swag emblazoned with “mind the non-GAAP”? The recent level of regulatory action and talk suggests that “mind the non-GAAP” memorabilia should be on the agency’s to-do list.

The SEC recently updated its Compliance and Disclosure Interpretations (CDI) about the use of non-GAAP measures, signaling the Commission’s concern about the burgeoning use of such measures in corporate press releases and filings. To make sure no one missed the point, Mark Kronforst, the chief accountant of the SEC’s Division of Corporation Finance less than a week later told the Standing Advisory Group (SAG) of the Public Company Accounting Oversight Board that “we are sending a message” about what is and what is not appropriate use of non-GAAP measures and noted that he expects the SEC to start sending comment letters later this year to issuers making what the agency considers questionable use of non-GAAP measures.

Nor is the SEC a lone actor. The SAG scheduled break-out sessions to discuss how companies are using non-GAAP metrics. (Disclosure: While co-author Jon Lukomnik is a member of the SAG, this article does not represent the opinion of the SAG, the PCAOB, or its board members or staff.) The issue is even making waves internationally. The same week the SEC released its revised CDI, Hans Hoogervorst, chairman of the International Accounting Standards Board told the European Accounting Association, “While these are numbers for the American market, securities regulators in the world of IFRS are also concerned that non-GAAP numbers are getting increasingly detached from reality.”

In other words, in the space of a week, non-GAAP measures were in the spotlight of the SEC, PCAOB, and IASB.

What’s behind this sudden, intense, focus on non-GAAP measures? First, they are increasingly commonplace. About 88 percent of S&P 500 companies use some type of non-GAAP metric. Second, the non-GAAP measures tend to make companies look better. Of those companies reporting non-GAAP measures, 82percent show increased income compared to GAAP income. That combination has raised concerns about puffery at best, and misleading disclosures at worst.

But all the noise about non-GAAP is obscuring some basic facts.

First, non-GAAP measures come in at least three distinct categories. Non-GAAP measures that adjust economic performance by including or excluding certain categories of revenues or expenses, such as EBIDTA or adjusted earnings excluding one-time charges are very different from key performance indicators such as same store sales for retailers. [And both those are different from ESG disclosures, such as carbon emissions.]

Mind the non-GAAP. That will help you avoid falling through the space between acceptable provision of helpful transparency and a violation for misleading disclosure.

Second, the use of non-GAAP measures often is sought by investors, including sophisticated institutional investors. In fact, the release of GAAP earnings is often just part of a kabuki-like ritual dance. Companies take all their internal operating measures and quarterly go through a process to translate them to GAAP for their earnings releases and public filings of quarterly results. The process is necessary because no company that we know of actually runs its operations to facilitate GAAP. So what then happens is that investors try to reverse engineer the GAAP disclosures back into measures that reflect how the company really runs its businesses.

Non-GAAP measures, used well, are tools that provide increased transparency to investors and other stakeholders into how the company measures itself. But the danger is that since they are a) non-standard and b) non-audited, they can be used to mislead, either a little, or a lot, potentially to the point of fraud.

So what is it that determines a useful non-GAAP measure from one that will receive criticism?  The SEC’s CDI has a slew of compliance-type information to help stay away from being misleading, which would be a securities law violation. Clearly, compliance is necessary. But a review of recent comments from leading academics, issuers, investors, and regulators suggest that a broader consensus is emerging about best practices when using non-GAAP measures.

Know why you are using a non-GAAP measure, and explain it. What does it tell the reader? In so doing, remember: Context matters. Excluding acquisition costs when your company has not done an acquisition in a decade and doesn’t plan to do any more in the near future is different than if your entire business plan is to roll up small industry competitors with multiple acquisitions every year.

Reconcile with GAAP, or at least reference the differences. If it’s a financial non-GAAP measure, explain, using GAAP terminology, what has been adjusted. If possible, reconcile to the GAAP statements. If not possible, probably due to the fact that the financial statements are not sufficiently granular, at least explain how you calculate the non-GAAP metric using the financial statements as a reference point.

Consistency is the rule. If you are calculating same store sales one way in one reporting period, you should use the same methodology in the next. If you do change your methodology, be transparent about it, and explain why.

Be even-handed. The most famous misleading use of non-GAAP metrics was when Trump Hotels included a one-time gain in its pro-forma income, but excluded a one-time charge. That’s just wrong.

Get your audit committee up to speed. The members of the board should understand what non-GAAP measures you are releasing, how they are calculated, any changes made in the calculation methodology, and what controls you have around the information systems that generate them. The audit committee may want to have internal or external audit read the earnings report, prior to public release, for reasonableness.

Mind the non-GAAP. That will help you avoid falling through the space between acceptable provision of helpful transparency and a violation for misleading disclosure.