According to audit firm PwC, non-GAAP financial measures play an important role in financial reporting, “showing a view of the company’s financial or operational results to supplement what is captured in the financial statements,” and help to tell the company’s financial story, as the SEC has advocated in connection with MD&A, “through the eyes of management.” Yet, they also have the potential to open the proverbial can of worms, subjecting the company to serious SEC scrutiny and possible SEC enforcement if misused. Just a couple of weeks ago, the SEC announced settled charges against DXC Technology Company, a multi-national information technology company, for making misleading disclosures about its non-GAAP financial performance. According to the Order, DXC materially increased its reported non-GAAP net income “by negligently misclassifying tens of millions of dollars of expenses ” and improperly excluding them from its reported non-GAAP earnings. In addition to misclassification, DXC allegedly provided a misleading description of the scope of the expenses included in the company’s non-GAAP adjustment and failed to adopt a non-GAAP policy or to have adequate disclosure controls and procedures in place specific to its non-GAAP financial measures. Consequently, DXC “negligently failed to evaluate the company’s non-GAAP disclosures adequately.” DXC agreed to pay a civil penalty of $8 million. (See this PubCo post.) So what can a company’s audit committee do to help prevent the types of problems that have arisen at DXC and elsewhere? Audit committees may find helpful this recent article from PwC providing guidance for committees tasked with oversight of the use of non-GAAP financial measures.
PwC observes that, while non-GAAP measures have commonly been used for at least twenty years, in the last few years, they have regained the spotlight. Data from the Center for Audit Quality cited in the article showed that, in the first calendar quarter of 2020, 94% of S&P 500 companies included at least one non-GAAP financial measure in their earnings releases. And, as illustrated by the enforcement action described above, as well as the prevalence of comments from the SEC on non-GAAP measures and recent CDIs from Corp Fin (see this PubCo post), the SEC has not exactly lost interest in non-GAAP financial measures and their potential misuse.
GAAP offers the advantages of uniformity—not to mention being subject to internal control over financial reporting and an external audit—and widespread acceptance. Not necessarily so with non-GAAP financial measures. According to the CAQ, based on information gained from a series of roundtables held in 2017, one of the biggest challenges for investors with regard to evaluating non-GAAP financial measures is the lack of consistency among companies, making comparisons tricky, even within the same industry. PwC identifies as among the most common or traditional non-GAAP measures operating income that excludes one or more expense items; adjusted revenue, adjusted earnings, and adjusted earnings per share; EBIT and EBITDA, and adjusted EBIT and EBITDA; core earnings; free cash flow; funds from operations; net debt, which could be calculated as borrowings less cash and cash equivalent or borrowings less derivative assets used to hedge the borrowings; and measures presented on a constant-currency basis, such as revenues and operating expenses. However, PwC observes, newer industries and business models, among other things, have led to the emergence of more “non-traditional” non-GAAP measures. That, together with “the proliferation of non-GAAP measures generally, the majority of which show non-GAAP results exceeding GAAP results,” have propelled some to question “whether, in some instances, the alternative measures are painting too rosy a financial picture. These factors could lead to an overall lack of trust of non-GAAP measures.”
Just what is the role of the audit committee when it comes to non-GAAP financial measures? The CAQ has characterized the audit committee’s oversight role as an important one that positions the committee to “act as a bridge between management and investors,” assessing whether “the measures present a fair and balanced view of the company’s performance.” But non-GAAP financial measures present challenges for audit committees: why is management using this measure? Is it consistent with the measures used by the company’s peers? Is the disclosure adequate? In addition, to the extent that non-GAAP measures may be used in determining incentive compensation, audit committee oversight becomes even more critical.
PwC offers a number of questions for audit committees, in fulfilling their oversight roles, to consider asking management about the use of non-GAAP financial measures:
- “Why has management chosen to present the non-GAAP measure?
- What is the purpose of the non-GAAP measure?
- Which competitors and peer companies use non-GAAP measures and how do they compare to those used by the company?
- What questions or feedback has management received from investors or analysts on a specific non-GAAP measure(s)?
- What is management’s process to calculate the non-GAAP measure?
- What procedures are in place to ensure the calculations are accurate and consistent with those of prior periods?
- Is the process covered by management’s internal control over financial reporting or other disclosure controls? If not, why not?
- Has the company considered having internal audit perform a review of the internal controls over the derivation of non-GAAP measures to determine whether the controls are effective?
- What are the incentives for possible ‘earnings management’?
- What is the company’s policy on what will give rise to a non-GAAP adjustment? How is materiality considered in this policy?
- What are the areas of judgment?
- How do non-GAAP measures impact management compensation?
- How does management’s disclosure committee focus on non-GAAP measures and consider their appropriateness?
- Is the presentation and disclosure fair, balanced, and transparent?
- Are GAAP measures presented with equal or greater prominence?
- Is the disclosure descriptive and transparent or ‘boilerplate’?
- Has the company received an SEC comment letter focused on any non-GAAP matters?
- Do the measures comply with the SEC regulations and the SEC staff’s 2018 interpretive guidance [and the most recent CDIs]?
- Can the measures potentially be considered misleading?
- Are prohibited measures excluded?
- Are adjustments to arrive at a non-GAAP measure labeled as non-recurring, infrequent, or unusual expected to recur in the next two years?”
In addition, PwC indicates that, “[a]lthough auditors do not report on these measures, some management and audit committees may use the external auditor as an informal sounding board on whether the company has complied with non-GAAP regulations.”