by Cydney Posner

Potential misuse of non-GAAP financial measures may be causing some consternation once again…in the press at least.

In the wake of the Enron scandal and the dot-com bust in 2003, the SEC adopted Reg G and related amendments to Reg S-K to prevent public disclosure of misleading non-GAAP financial measures. Among other things, these rules require, when non-GAAP numbers are used, the presentation of comparable GAAP numbers with equal or greater prominence as well as reconciliations of non-GAAP to GAAP numbers, all aimed at putting non-GAAP financial information in its proper context. In addition, the amendments and related SEC guidance prohibit adjusting a non-GAAP financial performance measure to eliminate or smooth items on the basis that they are non-recurring when, au contraire, they are reasonably likely to recur within two years or did occur within the prior two years. The SEC has also expressly cautioned companies against using non-GAAP measures in an attempt to smooth earnings. 

A new study from the Associated Press, discussed in this AP article, shows a strong resurgence in the use of non-GAAP financial measures, most often reflecting numbers that are more favorable than GAAP numbers. The AP analyzed results from 500 major companies, based on data provided by S&P Capital IQ, a research firm, showed that the spread between GAAP and non-GAAP earnings has grown substantially over the past five years.  For 21% of companies, non-GAAP profits reported in the first quarter were higher than net income by 50% or more, compared with 13% five years before.  Although 72% of the companies had non-GAAP profits that were higher than net income in both the first quarter of this year and five years earlier, adjusted earnings were 16% higher this year compared with 9% five years ago. In the study, 15 companies “with adjusted profits actually had bottom-line losses over the five years.“  Moreover, the article contends, “the financial analysts who are supposed to fight corporate spin are often playing along. Instead of challenging the companies, they’re largely passing along the rosy numbers in reports recommending stocks to investors.”

Typically, the non-GAAP adjustments eliminated charges for layoffs, failed business operations or other restructuring charges, declines in the value of patents or other intangible assets, or charges related to employee equity comp. Whether or not these exclusions are fair, properly presented or even help investors see the financial results “through the eyes of management,” they are once again drawing the attention of critics. Indeed, former SEC chief accountant Lynn Turner is quoted in the article as contending that “companies are still touting ‘made-up, phony numbers’ as much as they did 15 years ago, perhaps more….” And one investor was quoted as finding the data “more confusing than it’s been in a long time, and the reason is all the junk they put in the numbers” and complaining of the time wasted “sifting through the same ‘nonsense’ figures…. confronted back in the dot-com days.”

In 2013, the head of the SEC’s Financial Reporting and Audit Task Force indicated at an AICPA conference, as reported by the WSJ, that the SEC was looking at the use of these non-GAAP measures “with an eye toward possible enforcement cases.”  In particular, they were reportedly concerned about “mislabeling,…when companies use common, well-defined terms to refer to their own performance measures”  and “trends and patterns that could indicate a risk of fraud, such as cases in which a company shows high reported earnings but has lower earnings for tax purposes, or when a company has a high proportion of transactions that are kept off its balance sheet.” While no big splashy cases have yet materialized as a result, frothy markets tend to invite the attention of concerned regulators, especially regarding issues that have attracted press scrutiny.

Posted by Cydney Posner