Approximately two-thirds of companies that make up the Dow Jones Industrial Average reported non-GAAP earnings per share, according to a study last year, and the Securities and Exchange Commission is beginning to wonder if the trend has gone too far.
Last month, SEC chair Mary Jo White told a U.S. Chamber of Conference audience that “we have a lot of concern” about the use of these measures and whether they may be confusing to investors and analysts.
Non-GAAP measures can provide meaningful information about important issues to management and investors, but they are also drawing increased scrutiny from regulators and investors. Deloitte recently released a report, “Top 10 Questions to Ask When Using a Non-GAAP Measure,” to explain how such measures should be used.
“There is more usage of non-GAAP measures by public companies, and there are more adjustments being made to the non-GAAP measures,” said Christine Davine, deputy managing partner of Deloitte’s Professional Practice Network, Accounting Services, who co-authored the report. “There is more of a disparity between the non-GAAP amounts and the GAAP amounts. Because of that you’ve seen the SEC focus on that more recently. The bottom line is that non-GAAP measures are permissible, but there are disclosure requirements and other considerations if non-GAAP measures are used.”
SEC chief accountant James Schnurr has also criticized the proliferation of non-GAAP measures. In a recent speech, Schnurr said the “SEC staff has observed a significant and, in some respects, troubling increase ... in the use of, and nature of adjustments within, non-GAAP measures” as well as their prominence. He cautioned that non-GAAP measures should “supplement ... not supplant” the information in the financial statements.
Among the questions that Deloitte encourages company management to ask before using non-GAAP measures are: “Is the measure misleading or prohibited?” and “Is the measure presented with the most directly comparable GAAP measure and with no greater prominence than the GAAP measure?”
“When using non-GAAP measures, some of the most important items to think about are ensuring that the measures are not misleading and the adjustments that are made are appropriate,” Davine told Accounting Today. “Another consideration is ensuring that the GAAP measure is at least as prominent as the non-GAAP measure, and then ensuring that you have transparent disclosures that explain why the measure is useful and the purpose for which management uses the measures.”
Among the most commonly employed non-GAAP measures are EBIT, EBITDA and free cash flow.
“The measures that are the most scrutinized are derivations of those measures, like adjusted EBITDA for example, or some type of adjusted earnings measure or adjusted cash flow measure,” said Davine. “There are a lot of different iterations of what the adjustments can be. That’s where the SEC’s curiosity is piqued, depending on how many adjustments there are to that earnings measure and what are the nature and extent of those adjustments.”
Some companies have attracted special scrutiny from the SEC for using non-GAAP measures in their prospectuses before going public. In 2011, the SEC pressured the group couponing site Groupon to change its prospectus, which touted a measure that it called “adjusted consolidated segment operating income,” prior to its IPO (see Groupon Adjusts Controversial Accounting Measure).
Some companies insist that such measures provide a more realistic picture of how they make money and the expenses they face, even if they don’t come from U.S. GAAP.
“To be fair about it, non-GAAP measures can be meaningful, and they can provide valuable information to investors and analysts because they provide insight into what management is focusing on and what’s important to management, and also insight into items that might be impacting comparability,” said Davine. “If you have a non-recurring item and it is impacting trends or performance, that would be useful to know. Not all non-GAAP measures are bad. When used appropriately and when they comply with the disclosure requirements, they can be useful.”
In other instances, though, companies may be touting the non-GAAP measures in their press releases to make their financial performance appear more favorable than it would under U.S. GAAP.
“A non-GAAP measure has to be balanced,” said Davine. “Used appropriately, if you’re adjusting for nonrecurring expenses, you would similarly need to adjust for a nonrecurring gain. It’s important for a company to have a documented policy of their defined non-GAAP measures and to consistently apply that policy.”
Clients need to be reminded how to properly use non-GAAP measures. “What we’ve said is that they can be useful and they can be informative, but they need to comply with the disclosure requirements and they need to have appropriate adjustments,” said Davine. “That’s how we focus on them.”
She advises companies to re-examine their non-GAAP measures this earnings season, given the recent scrutiny by SEC officials and in the press. “Ensure that the use is appropriate, that all the disclosures are appropriate and there is appropriate oversight by the audit committee,” said Davine. “Taking a fresh look is important this earnings season.”