Mind the GAAP: Seeking Transparency Through Disclosure Again

Securities and Exchange Commission

There has been a resurgence of concern about the misuse of financial measures and key performance indicators not based on generally accepted accounting principles (GAAP). Late last year, the Chair of the Securities Exchange Commission (SEC), Mary Jo White, addressed the 2015 National Conference of the American Institute of Certified Public Accountants (AICPA). She noted that non-GAAP financial measures “are used extensively” and can become “a source of confusion.” The SEC Chair warned that the “area deserves close attention” and that “strong enforcement” could commence “to ensure high-quality, reliable financial reporting.” To address this concern, the SEC published in May new Compliance and Disclosure Interpretations (C&DIs) on non-GAAP financial measures reported by public companies. These new C&DI’s are likely to have a significant impact on how public companies use non-GAAP reporting measures.

The changes largely impact earnings releases by setting parameters around ordering topics, using headlines, and the relative prominence and comparability of non-GAAP and key performance indicator (KPI) disclosures to their GAAP counterparts. Non-GAAP financial measures adjust GAAP measures, and include earnings before interest, taxes, depreciation and amortization (or “EBITDA”), adjusted EBITDA, and adjusted earnings per share. KPIs are figures that public companies believe are important to evaluate performance, including same store sales, average revenue per customer, or funds from operations. The new guidance requires SEC registrants that disclose non-GAAP measures—orally, telephonically, via webcast, or through other media—to include disclosure of the most directly comparable GAAP measure and to reconcile the two, giving equal or greater prominence to the GAAP measure. Registrants must also disclose the reason that the non-GAAP measure or KPI provides useful information, including how management uses the measure.

The CD&Is seek to reinforce the overarching principle of U.S. securities law that public companies may not make misleading disclosures or omissions—that we do not operate in a “caveat emptor” (buyer beware) system. Because GAAP is a reasonably well-understood set of rules about how to report financial performance, deviations from it must not be used to mislead the market. While management and the audit committee are essential to creating an environment in which these measures may be useful, SEC rules governing financial disclosures by public companies require transparency in financial reporting so that investors and other users of financial information may make reliable decisions. This article presents a historic context for the SEC’s new guidance, discusses certain disclosure trends, and sets forth best practices for the evaluation of non-GAAP financial measures and KPIs reported by public companies.

Regulatory Context

Regulation G and Item 10 of Regulation S-K were adopted in early 2003 (in the wake of the Sarbanes-Oxley Act of 2002), establishing rules for using non-GAAP financial measures in public company SEC filings or press releases. The regulations prohibit registrants from “mak[ing] public a non-GAAP financial measure that . . . contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure . . . not misleading.” SEC Release No. 33–8176, 2003 WL 161117. Generally, non-GAAP “cash” measures should be reconciled with GAAP cash flow from operations (from the cash flow statement), and non-GAAP “performance” measures should be reconciled with GAAP net income or income from continuing operations (from the income statement). Id.

Because GAAP is a reasonably well-understood set of rules about how to report financial performance, deviations from it must not be used to mislead the market.

But the regulations led to unintended consequences, according to Mark Kronforst, Chief Accountant at the SEC’s Division of Corporation Finance, who recently told attendees of a Baruch College accounting conference that “non-GAAP is at the forefront of our minds at CorpFin.” He explained that by 2010, the SEC had “relaxed” its vigilance and issued guidance that restored some previously banned non-GAAP measures. He told the New York audience that in 2016 “the pendulum has swung [back]” and “we are going to crack down.” Kronforst also told an advisory group to the Public Company Accounting Oversight Board to expect “an uptick” in SEC comment letters addressed to registrants because of concerns that non-GAAP metrics could mislead investors. “[T]he most common comment [letter] that our division will probably issue is about the usefulness of the measurement” because “usefulness disclosures [are] something we are very concerned about,” he said.

Trends In Non-GAAP Income Presentations

A recent report by investment adviser Jack Ciesielski offers a stark example of how non-GAAP measures can be misleading, an outcome that the SEC seeks to prevent. In “Wonder Bread: Non-GAAP Earnings Keep Rising in the S&P 500,” Ciesielski warns that “[f]irms now eagerly help investors make adjustments, feeding them fluffy ‘Wonder Bread’ non-GAAP earnings.” The report explains that “[o]ne firm’s ‘adjusted net income’ might sound like another firm’s ‘adjusted net income’ — the items included in their non-GAAP recipe might have similar captions — but what goes into those line items could be very different.” Thus, he notes, “[t]he firms make their bread, but you should wonder how.”

He backs up the warning with evidence that investors and analysts “can’t always see the ingredients,” even while they tend to readily accommodate differences in the reporting of non-GAAP income. Ciesielski reports that for “380 S&P 500 firms reporting on a non-GAAP net income basis in 2015, all-inclusive GAAP net income fell 10.9% from 2014’s $630.8 billion to $562.3 billion in 2015.” Exposing the ipse dixit of non-GAAP measures, it reveals that this “disturbing tale, . . . [when] told through the lens of non-GAAP income, . . . has a Hollywood happy ending: on a non-GAAP net income basis, earnings for the 380 companies increased 6.6 % to $804.2 billion in 2015.” (Emphasis added.) The report identifies $241.9 billion of expenses excluded for non-GAAP purposes as “fueling the gains,” a 96% increase over 2014’s amount.

Ciesielski also explains that non-GAAP adjustments to earnings have a “‘sector signature’ — a different dialect, dependent upon a firm’s sector membership.” For instance, health care companies make more acquisition activity-related adjustments than companies in other sectors; energy companies make more impairment adjustments; and information technology companies make more intangibles amortization expense and equity-based compensation adjustments. Investors and analysts tend to ignore these industry trends when evaluating performance, “ignoring expenses that are unflattering to the bottom line,” Ciesielski cautions.

Ninety percent of S&P 500 companies reported non-GAAP results last year, indicating the magnitude of the matter being reported to investors and analysts. Problems arise where non-GAAP measures have no apparent methodology and appear simply to create the illusion of greater profitability. The Wonder Bread study substantiates concerns raised by the SEC and in financial media about the use of non-GAAP measures.

Best Practices for Reviewing Disclosures

Widely accepted principles governing financial reporting harness those responsible for making representations to the yolk of accountability. Those principles, often contained in GAAP, were promulgated by the AICPA and the Financial Accounting Standards Board, adopted by SEC rules and judicial decisions under the securities laws, and govern the dissemination of public company financial information. GAAP provides the clarity that may otherwise be concealed by misuse of non-GAAP financial measures, and protects investors from improper practices that may mislead or confuse.

PricewaterhouseCoopers (PwC) recently published a guide called “Building confidence in non-GAAP measures and other KPIs” to show how such disclosures may avoid impropriety. PwC’s guidance provides a roadmap to best practices for investors and others seeking to evaluate and assess non-GAAP financial measures, as follows:

  1. Adequate Disclosure Controls – Investors should be mindful of whether a company’s disclosure controls and procedures over the calculation and presentation of non-GAAP measures are as robust as their financial reporting controls over GAAP financial statements.
  1. Transparency Through Disclosure – Investors should look for company disclosures that give equal or greater prominence to the most comparable GAAP measures; title non-GAAP measures in a manner that makes their nature clear; provide transparency to the non-GAAP measures’ usefulness, how they are calculated, and their components; and reconcile non-GAAP components to related GAAP numbers.
  1. Consistency – Investors should identify whether a company is disclosing its policies on non-GAAP measures, including how the measures are calculated, recognizing that policies facilitate consistency from period to period and across different investor communications. Non-GAAP measures should be identifiably used consistently, regardless of whether they make the business’s performance look better or worse.
  1. Comparability – Investors should consider whether a company discloses differences in related GAAP and non-GAAP measures, and should pay attention to those companies that work with industry groups to develop voluntary, industry-wide metrics to enhance comparability between industry participants.

Investors and other users of financial information mindful of these signature characteristics will better appreciate non-GAAP financial measures and KPIs in their proper context and mitigate the risk of their misuse.

Conclusion

Upholding an SEC enforcement action involving stock options backdating at Brocade Communications Systems in 2007, Judge Charles Breyer of the U.S. District Court for the Northern District of California noted that “[a]nalysts and investors frequently disregard nonrecurring, non-cash expenses when they evaluate a company.… In turn, many companies … have accommodated investors’ desire for a clear picture by providing ‘pro forma’ or ‘non-GAAP’ earnings statements.” The Court explained that “streamlined [earnings] statements are a supplement to, and not a substitute for, the financial results presented in accordance with GAAP.” Expenses excluded from non-GAAP income disclosures are no “amnesty for companies to deceive shareholders.” Mindful of the disclosure and reconciliation requirements for non-GAAP measures, users of public company financial information may be assured that the information is fairly presented and actually useful. By so doing, investors promote a philosophy of transparency in corporate disclosure and combat the philosophy of “buyer beware.”