Can non-GAAP measurements be misleading?
Securities Exchange Commission reporting companies are more frequently utilizing non-GAAP financial measures if they believe that they will more accurately and completely reflect their results of operations or financial position. Non-GAAP financial measures are used as a “complement,” like bread and butter, to supplement the earnings reported under GAAP. Because GAAP does not permit their inclusion in reported financial statements, an independent auditor’s opinion does not cover non-GAAP financial measures.
Non-GAAP financial measures:
- Are numerical measures that may include or exclude GAAP measurements regarding the historical or future performance of a company’s financial status.
- Are positioned as providing additional acumen or insight into the reported entity.
- Purport to “link” information that is standard under GAAP reporting with what is considered customary or “tailored” reporting for revealing growing trends in “specialized industries” (i.e., law firms, health care, aircraft, oil & gas, media, retail, etc.).
- Are not prohibited. Shareholders, investors and bankers find them a valuable analytical tool. They are meant to provide more transparency and complement GAAP reporting. They are viewed as metrics that are easier to understand, and facilitate financial statement users’ comprehension of the financial status of a company; particularly when used to evaluate a company in a “specialized industry.”
- Must have strong disclosure controls.
- Must have a clear reconciliation with GAAP that clearly outlines the adjustments.
Non-GAAP financial measures are perceived to be more rounded story-tellers of a company’s financial position and results of operations because they back out certain non-recurring or non-cash expenses from a company’s profitability measurements. They separate what are considered “organic” changes in a company from unusual, non-representative underlying trend changes in a company. Non-GAAP metrics are also synonymous with a company's internal performance indicators.
The SEC has been increasingly focused on the use of non-GAAP metrics. Its sentiment seems to be that non-GAAP metrics can be misleading to investors through painting a rosier picture than GAAP-based metrics. The SEC, under the Sarbanes-Oxley Act of 2002, adopted disclosure Regulation D, which “requires public companies that disclose or release such non-GAAP financial measures to include, in that disclosure or release, a presentation of the most directly comparable GAAP financial measure and a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure.”
The SEC defines a non-GAAP financial measure as a numerical measure of a registrant’s historical or future financial performance, financial position or cash flows that:
1. Excludes amounts, or is subject to adjustments that have the effect of excluding amounts; or,
2. Includes amounts, or is subject to adjustments that have the effect of including amounts, that are included in or excluded from, as the case may be, the most directly comparable GAAP measure in the registrant’s statement of income, balance sheet or statement of cash flows
Non-GAAP financial measures exclude:
- Operating and other statistical measures (unit sales, numbers of employees).
- Ratios or statistical measures calculated using exclusively GAAP financial measures (such as operating margin) or operating measures or other measures that do not constitute non-GAAP financial measures (such as sales per square foot and same store sales).
- Financial measures required to be disclosed by GAAP (such as segment profit or loss and segment total assets and pro forma financial information required by Regulation S-X).
- SEC rules or a system of regulation of a government or governmental authority or self-regulatory organization that is applicable to a registrant (such as measures of capital or reserves calculated for regulatory purposes).
On May 17, 2016, the SEC created an internal task force for monitoring the use of non-GAAP metrics and issued new and updated compliance and disclosure interpretations that clarify their guidance respecting non-GAAP measures.
Highlights of a few of the SEC’s “Answers of General Applicability” to non-GAAP financial measures are:
- 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 that adjusts a particular charge or gain in the current period and for which other, similar charges or gains were not also adjusted in prior periods could violate Rule 100(b) of Regulation G unless the change between periods is disclosed and the reasons for it explained.
- A non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period could violate Rule 100(b) of Regulation G.
- Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G.
A role for forensics
Due to disclosure and reconciliation requirements under the SEC and other regulatory agencies, forensic accountants can play an important role in non-GAAP reporting. They can more clearly explain the rationale behind the use of specific measures, make sure that a company is in compliance with SEC rules, and that it reports a comprehensive view of its performance from a litigation support perspective.
A forensic accountant can assist if there is an actual or potential litigation related to the use of non-GAAP reporting. The SEC has been clear in that their new enforcement actions will also impact risk in civil litigation. In December 2015, then-SEC Chair Mary Jo White stated that every audit committee ought to be ready to answer:
- Why are you using the non-GAAP measures, and how does it provide investors with useful information?
- Are you giving non-GAAP measure no greater prominence than the GAAP measures, as required under the rules?
- Are your explanations of how you are using the non-GAAP measures – and why they are useful for your investors – accurate and complete, drafted without boilerplate?
- Are there appropriate controls over the calculation of non-GAAP measures?
Businesses and their accountants need to be careful when determining whether the use of non-GAAP measures and the disclosure controls and procedures that are associated with it can be viewed as violating SEC guidance and raising accounting litigation red flags.