Some non-GAAP financial measures are more kosher than others, and the Securities and Exchange Commission is looking to provide better guidance on which types are sanctified or sanctioned.
At last week’s AICPA conference on current SEC and PCAOB developments in Washington, D.C., Mark Kronforst, chief accountant of the SEC’s Division of Corporate Finance, explained some of the commission’s priorities. In May, the SEC issued guidance in question and answer format in its Compliance and Disclosure Interpretations on non-GAAP financial measures. It has since followed up with comment letters to companies. Companies are finally getting the message they shouldn’t highlight the non-GAAP numbers over the GAAP numbers in their earning releases to investors.
Christine Davine, deputy managing partner of Deloitte & Touche LLP’s National Office, put together a panel discussion at the AICPA conference that included Kronforst, along with Microsoft chief accounting officer Frank Brod, Morrison & Foerster partner Martin Dunn, and CLSA Americas equity analyst Christopher Spahr, to get the perspectives of various types of constituents on non-GAAP metrics.
“If I think about what were the takeaways from the panel, it’s that non-GAAP measures are not prohibited,” said Davine. “You’re allowed to use them, and investors and analysts and registrants find quite a bit of value in non-GAAP measures, but they need to be high quality.”
The SEC is now trying to focus on what constitutes a “high-quality” non-GAAP measure.
“I think of a high-quality non-GAAP measure as one that has a well-defined policy, and that policy would describe what non-GAAP measures are appropriate for the company to use based on that company’s specific facts and circumstances and what adjustments would be permitted for that non-GAAP measure,” said Davine. “Another key for a quality non-GAAP measure is to consider strong disclosure controls and procedures around that non-GAAP measure. Another aspect of a high-quality non-GAAP measure is strong disclosures that explain the measure. That would include: how does management use the measure, why is it useful, a clear reconciliation between GAAP and non-GAAP that clearly outlines the adjustments and describes the adjustments, and a consistent application of the company’s policy from quarter to quarter.”
The next phase of the SEC’s project on non-GAAP measures will be trying to assure companies are using high-quality non-GAAP measures that are also clearer and more concise.
“One thing we discussed on the panel was the SEC acknowledged that good progress has been made by registrants, particularly in the prominence area,” said Davine. “Notwithstanding that, we’re still expecting more comment letters. They’ll continue to focus on prominence issues, but where they’re evolving now in this next phase is looking more at the troublesome practices.”
Those “troublesome practices” include the use of non-GAAP measures that are not considered appropriate, and whether there are any adjustments that might not be appropriate. “We did talk quite a bit on this panel about the nature of the adjustments and where the SEC was deciding and coming down on some of these adjustments,” Davine recalled. “Mark Kronforst, the chief accountant, gave his views of certain types of adjustments. He mentioned that currently they’re not objecting to stock compensation adjustments, or adjustments to a non-GAAP measure for purchase accounting. They are asking in some comments about restructuring charges and legal expenses, but he was clear that the staff wasn’t going to object as long as those restructuring and legal expense type adjustments are not constantly recurring every quarter. Some of the other adjustments we talked about were pension adjustments and derivative adjustments. For those adjustments, the staff is thinking about them, but they’re not actively commenting on those adjustments either.”
The SEC wants companies to avoid the use of any misleading non-GAAP measures. “Examples of that would be adjusted revenue or changes in your consolidation methodology,” said Davine. “That’s common in real estate, although the staff has been clear and has conveyed quite a bit of messaging that those types of adjustments would not be appropriate because they would be considered misleading. Then they’re also looking for normal recurring cash type operating expenses that might be adjusted.”
Davine believes non-GAAP measures will remain a focus for the SEC in the near term, even though there has been some good progress by companies since the guidance came out in May. More of them are now avoiding what the SEC clearly sees as inappropriate use and prominence of non-GAAP measures and prohibited adjustments.
To help companies assess the appropriateness of their non-GAAP measures, Deloitte has recently issued its own guidance, “A Roadmap to Non-GAAP Financial Measures,” which combines the SEC’s guidance on non-GAAP measures with Deloitte’s interpretation and examples.