Companies providing non-GAAP financial information to investors—and there are plenty, based on recent studies—should note that regulators are raising the antenna on whether such reporting is getting out of hand.
Members and staff at the Securities and Exchange Commission are stepping up public remarks that they are concerned about the expansion in corporate use of accounting measures that do not follow Generally Accepted Accounting Principles, which are required in all corporate filings with the SEC. Chair Mary Jo White even pondered aloud whether the SEC should “rein in” use of non-GAAP measures through some kind of regulatory action.
An analysis by investment firm R.G. Associates shows 380 companies in the S&P 500 reported GAAP earnings in 2015 that fell 10.9 percent from 2014. But through the highest level of non-GAAP adjustments since 2009, the first year in the study, and almost double the adjustments made in 2014, non-GAAP earnings increased 6.6 percent. The study says 401 of the S&P 500 companies reported on a non-GAAP net income basis in 2015 compared to 269 companies in 2009. Non-GAAP reporting is growing “relentlessly,” the report says.
Benjamin Whipple, accounting professor at the University of Georgia who has studied non-GAAP reporting, says the reasons companies use such measures fall along a continuum. At one end, they want to provide investors with better metrics of core performance. In adjusting earnings, for example, companies often back out non-recurring items to try to arrive at a number that indicates how core operations are producing income. At the other extreme, however, companies may want to adjust numbers simply to make results look better than they really are. “So that would be opportunistic,” he says. “In truth, most companies ae probably somewhere in the middle.”
“Stick to the well-known, established indicia of performance. If it’s a very large, nonrecurring event, it’s justifiable to back that out. But don’t be cute.”
Laura Anthony, Founding Partner, Legal & Compliance
Use of non-GAAP accounting has “ebbed and flowed” over the years, says Peter Bible, a partner with audit firm EisnerAmper. Some if it makes sense, but some of it crosses the line, he says. “It’s ‘earnings before bad stuff’ that gets the SEC all fired up, and rightly so,” he says. “When you do that, you lose credibility with investors and the analyst community.”
While companies are not prohibited from providing non-GAAP information to their investors, the SEC adopted Regulation G in the wake of Sarbanes-Oxley to put some guardrails on their use. The SEC also provided further guidance through its Compliance & Disclosure Interpretations. They instruct companies that non-GAAP measures cannot be provided more prominently than GAAP numbers, they must be reconciled to corresponding GAAP figures, and they should be used and measured consistently if they are true and fair indicators of performance.
While the SEC is making noise about its displeasure with the trends in non-GAAP reporting, it’s not likely to change the rules anytime soon given the upcoming presidential election, says Jack Ciesielski, president of R.G. Associates. The Financial Accounting Standards Board is tuning into the discussion and considering whether there should be changes to performance reporting requirements within GAAP that would give companies better methods of reflecting their performance, but that’s a long process that could take years.
Below is an excerpt from SEC Chief Accountant James Schnurr’s speech before the 12th Annual Life Sciences Accounting and Reporting Congress regarding the use of non-GAAP measures.
Before I conclude today’s remarks, I’d like to provide my perspectives on non-GAAP measures, which is a topic that continues to receive attention from investors, those at the SEC, as well as the general news media.
The Commission adopted rules in 2003 addressing the disclosure of non-GAAP financial measures, both generally and with respect to inclusion in SEC filings. While the Commission’s rules allow companies to provide non-GAAP measures to investors as alternative measures that supplement information in the financial statements, the rules are clear that the non-GAAP measures must not be misleading. The SEC staff has observed a significant and, in some respects, troubling increase over the past few years in the use of, and nature of adjustments within, non-GAAP measures by companies as well prominence that the analysts and media have accorded such measures when reporting on the results of the companies they cover.
Non-GAAP measures are intended to supplement the information in the financial statements and not supplant the information in the financial statements. However, when the financial news networks report quarterly earnings, they very frequently report the non-GAAP measure of earnings with no reference to the actual GAAP earnings, often not even identifying it as having been adjusted. In addition, I am particularly troubled by the extent and nature of the adjustments to arrive at alternative financial measures of profitability, as compared to net income, and alternative measures of cash generation, as compared to the measures of liquidity or cash generation. In my view, preparers should carefully consider whether significant adjustments to profitability outside of customary measures such as EBITDA or non-recurring items or other charges to the business, such as the sale of portions of the business in order to provide the user with an understanding of how these events impact trends and future performance, are appropriate. As it relates to cash measures, I believe those measures should be reconciled to cash flow from operations.
Staff in the Division of Corporation Finance continues to monitor non-GAAP disclosures as part of its selective review process and regularly issues comments on this issue. The staff also provides guidance on the application of Commission rules through speeches and other mechanisms — and of course, staff comment letters are publicly available. You can expect that the staff will continue to be vigilant in their review of the use of these measures for compliance with the rules.
The proliferation of non-GAAP reporting measures among registrants, and reliance and reporting by analysts, should warrant increased focus by management and the audit committee. I believe the focus should go beyond determinations that the measures comply with the Commission’s rules and include probing questions on why, in contrast to the GAAP measure, the non-GAAP measure is an appropriate way to measure the company’s performance and is useful to investors. In addition, companies should ensure that the measure is prepared in a manner that includes appropriate controls and oversight procedures.
Any near-term regulatory action that would be most likely, in Ciesielski’s view, is an enforcement action from the SEC. The SEC’s last significant enforcement related to non-GAAP accounting was in 2009 with an action against SafeNet, says Michelle Gasaway, a partner with law firm Skadden, Arps, Slate. Meagher & Flom. The SEC has long held that if companies use non-GAAP measures to mislead investors, they could be subject to liability under anti-fraud provisions of securities law, she says.
Given the SEC’s focus and increasing use of comment letters on non-GAAP measures, companies would be wise to step up their caution in reporting non-GAAP numbers to assure they comply not only with the technical requirements, “but also the spirit of those rules and regulations,” says Gasaway. “Presentation of non-GAAP measures can be valuable to investors and analysts, and companies should be mindful of the need to present the measures in such a way that an investor can sufficiently understand the differences between a company’s GAAP and non-GAAP results.”
Here’s one area of reporting where auditors aren’t providing much help to public companies. Auditors do not audit non-GAAP information, nor do they pass any kind of judgment on whether it is presented in a way that complies with the rules. “As auditors we leave that to the company and the legal side of the house,” says Melanie Dolan, an audit partner with KPMG. “Our responsibility is to read other information in the 10-K and make sure it is not inconsistent with the financial statements.”
Marc Lichtman, audit leader for audit firm UHY Advisors, says less-seasoned public companies may not realize their auditor’s work does not provide them any kind of assurance on their use of non-GAAP numbers. “It’s possible some companies think their auditors are reading their earnings release and if they have concerns about non-GAAP measures would tell them,” he says. “For companies that are not as familiar with the rules, maybe they are counting on their auditor to bring up any issues.”
Brad Davidson, a partner at audit firm Crowe Horwath, says companies would be wise to review SEC requirements around use of non-GAAP measures to assure they are not presenting them more prominently than corresponding GAAP numbers. Assure they are properly explained, reconciled to non-GAAP numbers, and used and measured consistently from one period to the next, he says.
And engage the audit committee, says Davidson, if it is not already engaged. “They certainly have a role to play as gatekeepers to advise management when they believe a disclosure crosses the line,” he says.
Laura Anthony, founding partner with law firm Legal & Compliance, says where companies are committed to using non-GAAP figures, they should stick with measures that are readily accepted in the market. “Stick to the well-known, established indicia of performance,” she says. “If it’s a very large, non-recurring event, it’s justifiable to back that out. But don’t be cute.”