Recent statements and papers from regulators and advisory firms suggest lack of compliance with non-GAAP accounting rules could be perceived as a significant regulatory risk.
The Securities and Exchange Commission released an additional interpretation of Regulation G, which comprises the rules that govern the use of non-GAAP metrics in financial reporting. The release does not constitute new regulation, but instead clarifies the SEC’s position, in particular around the use of “misleading” financial metrics.
Recent SEC speeches have given a strong indication that, while the use of non-GAAP metrics is neither prohibited nor discouraged, the SEC will be reviewing non-GAAP disclosures in more detail. But companies that may be in violation of Regulation could have some breathing room.
On May 18, during a meeting of the Standing Advisory Group of the Public Company Accounting Oversight Board, Mark Kronforst, chief accountant in the SEC’s Division of Corporation Finance, stated that “this next quarter will be a great opportunity for companies to self-correct.” As part of the same meeting, the PCAOB released a white paper that discussed the auditor’s responsibility for non-GAAP presentations.
In light of regulatory focus on non-GAAP accounting, not surprisingly, many large law and accounting firms chose to proactively release briefings to their clients. To name just a few, see summaries released by Shearman Sterling and Deloitte.
Most of the recent discussions and speeches have addressed concerns about aggressive presentation of tailored metrics in earning releases, but non-GAAP measurements are also common in other corporate disclosures. For example, more and more proxy statements include non-GAAP language. In 2009, fewer than 20 percent of proxies had such language. By 2016, that rose to nearly 60 percent.
Many of these references are found in executive compensation sections. Given the overall increase in the use of non-GAAP metrics, it should come as no surprise that companies are electing to use non-GAAP metrics to set executive compensation benchmarks and targets.
In a recent Wall Street Journal article, “CEO Bonuses: How Pro Forma Results Boost Them”, author Justin Lahart discussed some potential dangers involved in using non-GAAP metrics to set compensation targets. One is that they could allow management to skirt bad decisions and poor performance. According to the article, some commonly excluded items, such as lay-off related charges, are in fact directly related to management’s performance and should not be excluded for the compensation purposes.
In another example, in February 2016, Brixmor Property Group (BRX) disclosed that, in certain instances, the company used “same store NOI” (a non-GAAP metric that excludes certain rent operating expenses) to smooth results over interim periods. The misstatement was not material to the GAAP results and restatement was not required.
Yet, as was reported in a Market Watch article, since a similar metric was used in the determination of executive compensation purposes, some analysts wondered whether executive bonuses possibly incentivized the smoothing. Three top executives were forced to resign subsequent to the misstatement, and, according to the most recent BRX proxy, the bonuses might be subject to clawback provisions should executives “breach certain provisions of the agreement.”
To be clear, there is nothing wrong with using custom targets. Executive compensation plans frequently combine GAAP, non-GAAP, and operational metrics. The performance targets aim to align executive payout with the long-term interests of shareholders and, in many cases, GAAP alone is neither comprehensive nor flexible enough to achieve this goal. Moreover, just as with GAAP, the inability to reach non-GAAP goals could lead to forfeited bonuses.
Interestingly, Regulation G has only limited applicability to the proxy statements. Different sections of the proxy statement have different rules regarding the use of non-GAAP. In the compensation section, for example, companies need only to explain how non-GAAP compensation targets are calculated. This differs from the requirements of using non-GAAP metrics in earnings releases, where companies must provide a table that reconciles the non-GAAP metric back to its original GAAP amount, and comparable GAAP metrics must be presented with equal prominence.
The use of non-GAAP metrics in other areas of the proxy statement must comply with rules more like those for earnings releases; for instance, in explaining pay-for-performance practices.
Question 108.01 in the most recent SEC non-GAAP Compliance & Disclosure Interpretations provides some clarity.
In some cases, companies even use modified non-GAAP metrics between their different SEC filings, asin Mallinckrodt’s (MNK) most recent proxy statement. Mallinckrodt uses adjusted EPS, net sales revenue, and free cash flow as performance metrics in executive compensation programs, but not in the same way as they are used in their earnings releases.
With all the confusion and variations in practice, it’s no surprise that non-GAAP issues just keep popping up.