Non-GAAP Measures – Useful Tool Or Red Flag?

Few IPO’s received as much publicity as Groupon’s. Unfortunately for Groupon, their pre-IPO publicity was due not to optimistic forecasts, but to questionable accounting practices. The SEC reviews all pre-IPO filings, and in this case the review did not go smoothly.

In a comment letter issued on June 29th, 2011, the SEC requested that Groupon provide justification for excluding recurring marketing expenses from their registration statement’s Adjusted Consolidated Segment Operating Income (CSOI). In addition to marketing expenses, Groupon had also excluded stock-based compensation and acquisition-related costs from their CSOI calculations.

These exclusions constitute what is known as a Non-GAAP measure: that is, a measure of a registrant’s financial performance that excludes certain GAAP charges. What made Groupon’s accounting practices questionable is that, under Regulation G, whenever a Non-GAAP measure is presented, the registrant must also present a reconciliation of the measure to the most directly comparable GAAP measure.

Item 10(e) of Regulation S-K prohibits using Non-GAAP measures to pass over charges that are identified as non-recurring, infrequent, or unusual, when the nature of the charge is such that it is likely to recur within two years; or when there was a similar charge within the prior two years.

However, Question 102.03 clarifies that a registrant can, and in some circumstances must, adjust even for charges that cannot be described as non-recurring, non-frequent, or unusual.

In its initial response to the comment letter, Groupon rejected the SEC’s criticism, stating that their exclusions were appropriate because they had only excluded expenses attributed to the acquisition of new subscribers. But after two months and three rounds of conversations, Groupon agreed to remove the metric.

So why did Groupon insist on using that metric in the first place? The reason is quite simple: it made Groupon look profitable.

Here’s how:

Reconciliation of CSOI To Income From Operations

As evident from the table above, Groupon incurred operating losses during all the periods presented. Worse than that, operating losses increased from 1.6 million in 2008 to 420 million in 2010. Yet their CSOI figures present a much more optimistic picture: the measure went from a negative 1.4 million in 2008 to a positive 60.5 million in 2010, giving an appearance of improved profitability.

In August 2012, Groupon received another comment letter, in which the SEC requested that Groupon disclose three major categories of the statement of cash flows when presenting Free Cash Flow, a liquidity Non-GAAP measure. This time, Groupon concurred without additional reservations, and included the requested disclosure in its 10-Q filing.

Groupon was not the only company that received Non-GAAP-related questions. In an 8-K filed on August 1st, 2012, Vonage presented a Pre-Marketing Operating Income (PMOI) measure that excluded from its reported net income certain marketing costs, customer equipment, shipping costs, and direct costs of goods sold.

In September 2012, the SEC issued a comment letter stating that, since the excluded costs were recurring,  such a measure was misleading and would have to be revised. Vonage responded that it had invested substantial funds to acquire its customer base, and that the PMOI was useful for evaluating profitability of an existing customer base. Nevertheless, the company agreed to remove the metric from its future filings.

The table below presents the number of Non-GAAP comment letters, and the companies involved, per year:

Non-GAAP Comment Letters

The 2010-2011 increase (both in number of companies reviewed and in number of letters received) may be attributed to two factors: wider use of Non-GAAP measures by companies, and a higher level of SEC scrutiny of the matter.