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Non-GAAP Metrics in SAB 99 Materiality Analyses

The pros and cons of non-GAAP metrics have been discussed in more than a few recent articles. Proponents of non-GAAP frequently claim that GAAP contains many ambiguities and loopholes, and that non-GAAP metrics can be more current and relevant. Opponents sometimes derisively refer to non-GAAP metrics as “earnings before everything”, and argue that non-GAAP is a (misleading) step back towards cash accounting.

A recent Accounting Onion article offers some fresh ideas on the topic. Citing a need for tightened regulatory oversight, Tom Selling provided some interesting suggestions. One, which we covered recently, called for an explicit statement that SOX Section 302 “Disclosure Controls and Procedures” take into account non-GAAP metrics. He also proposed a requirement to provide audit committees with an independent auditor’s report on a company’s compliance with Rule 10(e) of Regulation S-K, which covers the use of non-GAAP financial measures in Commission filings.

As we discussed in our recent post, VEREIT, Inc (formerly American Realty Capital Properties) was the only company that explicitly referenced a non-GAAP metric in their SOX 302 Disclosure Controls assessment. The disclosure was triggered by a material weakness that caused VEREIT to incorrectly include “certain amounts related to its non-controlling interests in the calculation of adjusted funds from operations (“AFFO”), a non-U.S. GAAP financial measure, for the three months ended March 31, 2014 and, as a result, to overstated AFFO for this period”. The Audit Committee also believed that “this error was identified but intentionally not corrected” and that “other AFFO and financial statement errors were intentionally made”. Simply speaking, the only non-GAAP 302 Disclosure that we found was related to fraudulent accounting.

References to non-GAAP are slightly more common in 8-K Item 4.02, Non-Reliance on Previously Issued Financial Statements filings. Using a simple text search in the Audit Analytics Restatements database, we identified at least six cases since January 2014. The language below is part of an 8-K Item 4.02 filed by Phibro Animal Health Corp (PAHC) on 9/4/15:

The corrections will not affect revenues, operating expenses or cash flows and will not affect non-GAAP financial measures of adjusted EBITDA, adjusted net income or adjusted net income per share.

Please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations—General description of non-GAAP financial measures” in the Amendment for a description of non-GAAP financial measures. Adjusted net income per share is derived by dividing adjusted net income by the weighted average number of common shares outstanding during the period.

But what about less material (and unintentional) accounting errors – do companies use non-GAAP metrics when assessing materiality? SAB 99 does not explicitly reference them, yet it is not uncommon for companies to provide the impact of errors on commonly used non-GAAP metrics. For example, in a comment letter dated February 6, 2015, Ebay stated that an $88 million tax-related out-of-period adjustment recorded in the fourth quarter of 2014 “only impacts GAAP net income and no adjustment was required for our non-GAAP net income, which we believe is a key financial metric for our investors”. It sounds like the company is arguing here that the impact on non-GAAP metrics is more important than the impact on net income. That is, it appears to be using non-GAAP metrics as a justification for concluding that the error was immaterial.

Ebay is not unique in citing the impact on investors’ expectations as a reason to use non-GAAP metrics in their materiality analyses. Let’s look at a couple of additional examples below.

Whether the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise – The Company’s analysts’ expectations and estimates are all based on adjusted non- GAAP earnings as discussed above. There was no impact to the Company’s adjusted non-GAAP results. As a result, there was no failure to meet analysts’ expectations.” (Hackett Group)

The adjustment does not hide a failure to meet analysts’ consensus expectations. In addition to measures of financial performance presented in accordance with GAAP, analysts rely heavily on many other supplemental measures to assess the performance of the Company. These include comparable store sales growth, as well as non-GAAP profitability measures such as adjusted EBITDA, adjusted net income (loss), and adjusted net income (loss) per common share. The adjustment of the error did not impact any of these supplemental measures in any period.” (Container Store)

In each case, both companies state in their materiality analysis that the errors had an immaterial impact on non-GAAP income metrics. We have yet to see an example of an error that would be immaterial to net income, but material on a non-GAAP basis. We wonder what a company would do in such a situation. One important thing to consider is a fundamental aspect of Regulation G: non-GAAP metrics, whatever else they may provide, cannot appear to overshadow GAAP numbers.

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