Last year I wrote about the hazards of “non-GAAP disclosure creep,” which can occur as companies become increasingly aggressive with their use of non-GAAP financial measures or simply become bogged down as more and more adjustments are layered on without considering regulatory and common sense limitations. (See this Doug’s Note.) I noted also that, over the years, the SEC has taken a relatively benign approach to the proliferation of non-GAAP disclosures. However, several recent pronouncements indicate that those days may be coming to an end.
The non-GAAP basics…
A non-GAAP financial measure is a numerical measure of financial performance, financial position or cash flows that:
- excludes amounts that are included in the most directly comparable GAAP measure of the company, or
- includes amounts that are excluded from the most directly comparable GAAP measure.
If a company uses a non-GAAP financial measure in an SEC filing, Item 10 of Regulation S-K requires:
- equally prominent presentation of the comparable GAAP measure,
- reconciliation of the differences between the non-GAAP and GAAP numbers, and
- disclosure as to why management believes the non-GAAP measure is useful to investors and, if material, the additional purposes for which management uses the non-GAAP number.
If a company discloses non-GAAP financial measures in a non-filed manner (for example, in a press release or website or social media posting), Regulation G imposes similar requirements, absent the statement of management’s beliefs.
The SEC’s cautionary drumbeat seemed to gain volume last December when Chair Mary Jo White gave the keynote address at the 2015 AICPA Conference in Washington, D.C. During her remarks, Chair White stated that “[b]y some indications,…non-GAAP measures are used extensively and, in some instances, may be a source of confusion.” She also pointed out the need to ensure that the current rules are “sufficiently robust in light of current market practices.”
Then, in early March, James R. Doty, Chair of the PCAOB, when reviewing the status of the audit process during his 2016 budget presentation to the SEC, stated that “[w]arning signs abound. Companies’ use of unaudited and non-GAAP metrics proliferate.”
At that same PCAOB budget meeting, SEC Commissioner Kara M. Stein quoted “some in the industry” as referring to customized adjustments to GAAP financial measures as “earnings before bad stuff.” She further stated that “[t]his is a trend that we all need to focus on.”
Merely six days later, on March 22nd, in a speech at the 12th Annual Life Sciences Accounting and Reporting Congress, James Schnurr, Chief Accountant in the SEC’s Office of the Chief Accountant, offered his perspectives on non-GAAP measures, which he said continue to receive “attention” from the SEC. He noted that “[t]he 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 [as] prominence that the analysts and media have accorded such measures….” Mr. Schnurr added:
“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….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. …In addition, companies should ensure that the measure is prepared in a manner that includes appropriate controls and oversight procedures.”
There is no question that some companies have become overly aggressive with the nature and scope of their non-GAAP adjustments. Inconsistencies can arise between marketing-oriented earnings and other financial releases and actual SEC periodic reports, particularly regarding the prominence and nature of non-GAAP measure presentations. Similar problems can arise with regard to investor trade conference presentations, whose slide decks are frequently posted on company web sites and non-GAAP financial measures posted on social media. And occasionally the purposes behind a company’s use of non-GAAP disclosures are less than honorable.
Based on the comments mentioned above, it is fair to anticipate that the staff will be focusing on non-GAAP financial measure reporting in its three-year reviews and registration statement reviews. And remember that these reviews include information on the company web sites, in press releases and posted on social media.
It also would be reasonable to expect additional SEC guidance regarding the appropriate use of non-GAAP measures and perhaps even additional rulemaking, though the latter is unlikely in the near-term.
In the meantime, here are some tips to consider:
- Try to manage the process away from meaningless non-GAAP numbers that will lead to cumbersome, counterproductive reconciliations and disclosures,
- Eliminate non-GAAP measures that have become obsolete over time,
- Consider whether key personnel would benefit from a training refresher on this topic,
- Confirm that your disclosure controls and procedures function to preclude a reporting glitch,
- Be sure to revisit from time to time, and stay within the spirit of, Item 10 of Regulation S-K and Regulation G, and
- Confirm that your rule-mandated explanations for management’s use of non-GAAP measures have kept up with the reality of your company’s operations.