by Cydney Posner

Reporting on an industry conference sponsored by the U.S. Chamber of Commerce, the WSJ advises that SEC Chair Mary Jo White is considering whether to restrict the use of non-GAAP financial measures. In a speech to the conference, Chair White advised the audience that “[y]our investor relations folks, your CFO, they love the non-GAAP measures because they tell a better story….We have urged for some time that companies take a very hard look at what you are doing with your non-GAAP measures. We have a lot of concern in that space.”

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.

The use and impact of non-GAAP financial measures may well be increasing. A 2015 study from the Associated Press, discussed in an AP article from June 2015, demonstrated a strong resurgence in the use of non-GAAP financial measures, most often reflecting numbers that were 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, showing that the spread between GAAP and non-GAAP earnings has grown substantially over the past five years.  For example, for 21% of the companies in the study, non-GAAP profits reported in the first quarter were higher than net income by 50% or more, compared with only 13% of companies five years before.  Similarly, although 72% of the companies had non-GAAP profits that were higher than net income in both the first quarter of 2015 and five years earlier, the spread has widened: adjusted earnings were 16% higher than net income in the 2015 quarter 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, in the study, 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 have continued to draw 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.”

That the SEC has been wagging its finger about non-GAAP information for some time is certainly not an exaggeration. In December 2015, at an AICPA national conference,  White emphasized the need to ensure that the current rules on non-GAAP financial measures were being followed and that they are “sufficiently robust in light of current market practices. By some indications, such as analyst coverage and press commentary, non-GAAP measures are used extensively and, in some instances, may be a source of confusion.” (See this PubCo post.)  At the PLI Securities Regulation Institute in October, Corp Fin Director Keith Higgins cautioned that if a company labels a non-GAAP financial measure as reflecting a non-recurring event, but the event is recurring, that can be problematic. (See this PubCo post.)  And back 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.” (See this PubCo post.)

So the question remains, is this just another brush-back pitch from Chair White, or are new rule amendments on the way?

Posted by Cydney Posner