At a large financial reporting conference in December, several representatives of the Securities and Exchange Commission mentioned disclosures regarding non-GAAP financial measures as an area of concern. Over the past 15 years, the pendulum on how much enforcement was thought to be needed to regulate these measures has swung back and forth several times. It seems that once again, we are at a point where stronger regulatory actions may be coming.
Non-GAAP financial measures (also known as “Pro Forma” measures) are measures derived from the accounting records but calculated in a way that is not spelled out in Generally Accepted Accounting Principles. Perhaps the most common one is EBITDA (earnings before interest, taxes, depreciation, and amortization). SEC rules passed in 2003 require such measures be explained fully and reconciled to a relevant GAAP measure, but don’t prohibit their use. The goal was to ensure that non-GAAP financial measures would only be used if they provided insight and were not used in a misleading manner, as such measures had sometimes been used prior to that time.
I have written about non-GAAP financial measures in this column, and I encourage companies to use them when they provide additional information beyond that which would be provided by GAAP measures. For example, the presentation of earnings excluding non-recurring items, earnings based on “products and services delivered” where revenue must be deferred due to uncertainties, and “core earnings” that exclude the effects of financing and investment of excess funds can all illuminate certain points that GAAP may not highlight quite as well. I hope (and believe) that it is not measures like these that are giving the SEC concern.
What I suspect the SEC is concerned about are non-GAAP disclosures that appear to have a large dose of “earnings as if things went better than they actually did” or “earnings as if certain things didn’t happen, even though those things always happen.” I have certainly seen plenty of both. If you recognize elements of your non-GAAP disclosures in the discussion that follows, think about making changes now, rather than waiting for the SEC to take action later.
SEC rules require that when non-GAAP financial measures are included in an SEC filing, presentation of the most comparable GAAP measure is required “with equal or greater prominence.” While the “equal or greater prominence” provision does not explicitly apply to earnings releases, it is certainly a smart thing to do to avoid the perception that your measure is presented in a way that is meant to obscure GAAP results and thus mislead the markets.
Very often in press releases, and sometimes in periodic filings, the non-GAAP measure is clearly emphasized over the related GAAP measure. In fact, two minutes of clicking on Google search results while writing this column pulled up numerous press releases in which the non-GAAP measure was in the headline, but the GAAP measure was not. Once you’ve started like that, you aren’t presenting the GAAP measure with equal prominence.
What I suspect the SEC is concerned about are non-GAAP disclosures that appear to have a large dose of “earnings as if things went better than they actually did” or “earnings as if certain things didn’t happen, even though those things always happen.” I have certainly seen plenty of both.
In other situations, the discussion of the non-GAAP results is several pages, while the GAAP results are covered in a paragraph that focuses only on the items adjusted out for the non-GAAP presentation. That implies that the non-GAAP measure is primary and the GAAP measure is secondary. Instead, I think companies would be wise to reverse the order and discuss everything in the analysis of GAAP earnings first, and then cover in the non-GAAP discussion those additional pieces of information that the non-GAAP financial measures highlight.
What’s the Point?
The rules also require that when presented in an SEC filing (e.g., a Form 10-K or Form 10-Q), the disclosure must explain why management believes that the presentation is useful to investors. The idea here is to tell investors what insight the non-GAAP measure provides that GAAP measures don’t. When the adjustments are for unusual items, this is pretty easy to do. But many companies routinely adjust for items that are recurring, and even predictable. The SEC staff has, in my view, been very flexible in terms of the explanations provided in the past, but I suspect that might change.
For example, it is difficult to understand why a measure excluding normal, recurring, stock compensation expense is useful in most of the situations in which such a measure is presented. Why is it helpful to investors to know what your earnings would have been if you had been able to pay your managers and employees substantially less? Of course, some argue that this is an appropriate add-back because it is a non-cash item. But that’s already handled by the operating cash flow section of the Statement of Cash Flows.
I also see add-backs in non-GAAP measure calculations for things like consulting fees to private equity investors, amortization of debt discounts, losses on factoring of receivables, and other items that sound an awful lot like normal, recurring expenses. Adding these back typically sounds like a presentation of what earnings would have been if only expenses had been lower. Perhaps this might be appropriate if the company was receiving no benefit from the costs or losses, but that’s rarely the case.
It would not surprise me at all if the SEC staff began pushing harder on how these kinds of measures could possibly be useful. Moreover, if the SEC staff doesn’t agree that the measures provide useful information, it isn’t a big leap to consider them misleading, thereby exposing a company to other SEC action beyond just requiring that the non-GAAP measure be removed.
What’s in a Name?
Next on my list, the rules require that non-GAAP measures be presented in a way that is not misleading. In the past, some companies have presented EBITDA as a non-GAAP measure, but defined that measure as something other than “Earnings Before Interest, Taxes, Depreciation, and Amortization.” The SEC staff has pushed-back on non-standard usage of the term EBITDA, and now many companies use “adjusted EBITDA” as the name of the non-GAAP measure, excluding all of the things excluded from EBITDA plus other items. Since the adjustments often make this measure not comparable to EBITDA at all, it wouldn’t surprise me if the SEC staff begins to object to using EBITDA in the name of a measure other than, well, EBITDA. At least this will make it easier for users of the financial information to know whether they are dealing with a “standard” non-GAAP measure or a customized one.
Too Many Adjustments
Combining the previous two topics, when a company presents “Adjusted EBITDA” or something similar, there are often many adjustments. In addition to interest, taxes, depreciation, and amortization, there is often stock compensation, restructuring charges, legal settlements, unusual items, merger costs, foreign exchange effects, and other items as well. Even if it were possible to explain why a measure of earnings without each individual item might be useful (some are non-recurring, some are non-core, some are due to market fluctuations instead of transactions, some are non-cash, etc.), it is extremely difficult, I think, to describe what the actual measure itself represents. It is not a substitute for cash earnings, since it adds back interest and taxes. It is not a measure that excludes non-recurring items, since it adds back depreciation and amortization. And so on.
I’ve come to understand that at least some analysts have no idea what to make of these measures. And if professionals who do this for a living are confused by measures that include so many different adjustments, I suspect that the SEC staff may take a harder look at them. I would advise companies that use these measures to be ready to explain not just why each individual adjustment is being made, but what the result actually measures. And if “Adjusted EBITDA” is the best way to describe it, I’m not sure you’re there.
While it is clear we should expect to hear more about non-GAAP financial measures from the SEC, I don’t know in what form it will happen. Everything I have discussed here, though, is a concern that I think the SEC could raise under the existing rules, so I’m not necessarily expecting new rules.
Perhaps any SEC actions will just be in the form of additional comments and questions during routine filing reviews. However, I get the sense that it will be more than that. Perhaps some interpretative guidance from the Commission itself, rather than just staff action, or maybe even a concept release seeking input on what changes, if any, should be made to rules.
But don’t sit back and wait. Now is the time to look at what kind of non-GAAP financial measures your company is using, and make sure the justification for them is well thought-out and fully-disclosed. Like many other areas of financial disclosure, improvements can be made without new edicts and rules.