Concern is growing at the SEC about misleading or excessive non-GAAP financial measures in SEC disclosures. Intended to provide additional insights into a company’s business results or prospects, non-GAAP financial measures include pro forma earnings, EBITDA, funds from operations, adjusted earnings per share, and net debt. These adjustments to reported GAAP results are permitted if they are properly disclosed alongside GAAP measures, and they can be helpful if they clarify a company’s financial story. However, non-GAAP financial measures are open to misinterpretation and present a potential for prevarication or abuse that the SEC views with growing suspicion.
Non-GAAP financial measures are open to misinterpretation and present a potential for prevarication or abuse.
Usually made in good faith, non-GAAP measures can nonetheless be confusing or misleading. They are often not easy to compare between companies or industries, and the way in which non-GAAP metrics are determined is sometimes neither transparent nor consistent. Furthermore, the arbitrary judgment necessary to arrive at many non-GAAP measures opens the door for self-serving disclosures by companies. In CEO Bonuses: How Pro Forma Results Boost Them, Justin Lahart from The Wall Street Journal reports that among the companies in the Dow Jones Industrial Average, “about a dozen of the index’s 30 constituents had annual pro forma earnings well in excess of GAAP ones and used the pro forma ones in annual bonus calculations.”
Another problem is that non-GAAP measures are being overused. The number of non-GAAP disclosures by companies in SEC filings has expanded dramatically in the past few years, extending even to performance metrics in the proxy statement. According to research by Audit Analytics, fewer than 20% of the proxy statements issued in 2009 had wording indicative of non-GAAP measures, but almost 60% of proxy statements published in 2016 feature non-GAAP language.
Staff is “going to crack down” on non-GAAP financial measures
Wesley Bricker’s speech on May 5th at Baruch College’s 2016 Annual Financial Reporting Conference singled out non-GAAP measures as an object of scrutiny by SEC staff. The SEC’s deputy chief accountant, Mr. Bricker worries that adjustments applied by companies to their revenue do more than just modify the results from GAAP standards. In his view, “they change the very starting point from which other performance analyses flow.” He promised that SEC staff “will be looking to see if the reporting concepts within [GAAP] standards are supplanted by any number of company-specific non-GAAP alternatives.”
In a statement that should make filers sit up and take notice, Mr. Bricker declared: “[I]f you present adjusted revenue, you will likely get a comment; moreover, you can expect the staff to look closely, and skeptically, at the explanation as to why the revenue adjustment is appropriate.” He also asserted that the SEC is considering the possibility of rulemaking about non-GAAP disclosures. At the same conference, Mark Kronforst, the chief accountant of the SEC’s Division of Corporation Finance, added: “For lack of a better way to say it, we are going to crack down.” (For more, see SEC Leads Crackdown on Non-GAAP Measures by David Katz, CFO.com, May 12, 2016.)
“For lack of a better way to say it, we are going to crack down.”
These admonitions against misleading or overused non-GAAP financial measures were further reinforced by SEC Chair Mary Jo White. In a speech on June 27th at the annual conference of the International Corporate Governance Network, she said: “In too many cases, the non-GAAP information, which is meant to supplement the GAAP information, has become the key message to investors, crowding out and effectively supplanting the GAAP presentation.” Echoing her colleagues, she warned: “We are watching this space very closely and are poised to act through the filing review process, enforcement, and further rulemaking if necessary to achieve the optimal disclosures for investors and the markets.”
The SEC issues new C&DIs on non-GAAP financial measures
The SEC staff has published a revised set of Compliance & Disclosure Interpretations (C&DIs) to clarify its position on non-GAAP measures. It begins with a general point: Even if they are not actually forbidden, certain adjustments leading to a non-GAAP measure can still be misleading and therefore violate Rule 100(b) of Regulation G. “For example,” states a newly revised interpretation, “presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading.”
A non-GAAP measure can also be misleading if it is inconsistently presented, such as a non-GAAP measure that adjusts a particular charge or gain in the current period and for which other, similar charges or gains were not adjusted in prior periods. This may violate Rule 100(b) of Regulation G, revised Question 100.02 indicates, unless the filer both discloses the change and explains the reasons behind it. “In addition, depending on the significance of the change, it may be necessary to recast prior measures to conform to the current presentation and place the disclosure in the appropriate context.”
Another way in which a filer can violate Regulation G is by presenting adjustments selectively, in a manner that inaccurately or incompletely tells the company’s financial story. To illustrate this type of cherry-picking, the C&DI offers the example of “making adjustments only for non-recurring charges when there were also non-recurring gains that occurred during the same period.” Similarly, the impact of income tax related to adjustments must be disclosed separately, and it is inappropriate to present adjustments as “net of tax.”
Filers should place GAAP metrics ahead of non-GAAP metrics in headings or captions and must not … make them more prominent than GAAP results.
The SEC staff further warns against the use of any non-GAAP performance measure that replaces an important accounting principle with an alternative accounting model which is not appropriate to the company’s business. For example, with revenue that, under GAAP, is recognized ratably over time, filers should not apply a non-GAAP measure that accelerates the revenue to make it seem that the company earned the revenue when customers were billed.
In other interpretations, the C&DIs indicate that filers should place GAAP measures ahead of non-GAAP measures in headings or captions and must not emphasize non-GAAP disclosures so as to make them more prominent than GAAP results. This applies not only to text but also to tables, where non-GAAP measures should never be presented before or without GAAP measures.
Know where the acceptable line stands for non-GAAP measures
Given the competitive reality of the business environment, all corporate teams involved in disclosure have at least some interest in non-GAAP measures that shine a good light on the company’s financial picture. At the same time, filers need to understand how far the SEC will let a registrant stretch non-GAAP measures in its efforts to make the company look better. As the SEC scrutinizes non-GAAP measures with increasing skepticism, the need for caution should prompt a review of current non-GAAP practices even if they have not previously drawn SEC attention. Filers should revisit routinely used non-GAAP measures to ensure that everything complies with both the letter and the spirit of the SEC’s guidance.
For additional details and observations about the SEC’s new guidance on non-GAAP measures, see commentaries from law firms Davis Polk & Wardwell and Cooley.