Note: This post features a guest contribution from our friend Jack Ciesielski, the publisher of the Analyst’s Accounting Observer. Together with our friends at the Analyst’s Accounting Observer, we reviewed the first batch of the SEC’s Division of Corporation Finance non-GAAP comments. The blog below is the result, which is also posted on their blog.
The SEC’s Division of Corporation Finance (DCF) released its newest guidance on the “do’s and don’ts” of non-GAAP reporting in May with a shiny new Compliance & Disclosure Interpretation. Shortly afterward, the DCF’s Chief Accountant, Mark Kronforst, stated that “this next quarter will be a great opportunity for companies to self-correct.”
Presumably, it would be open season for the SEC to issue comment letters on potentially non-compliant presentations when that brief “self-correction” period ended with the June 30 quarter. Audit Analytics has pulled together an analysis of the SEC’s 1,426 comment letters issued to 479 companies between July 1st and October 31st of this year. 207 companies (or over 40% of all the companies reviewed) received 427 letters with at least one non-GAAP comment. Most of these letters were related to filings from the first half of 2016.
Companies tend to stretch non-GAAP presentations in more than one direction, so the categories above are not mutually exclusive. A company that tailors its metrics is likely to present them with undue prominence. Not much surprise there.
Almost half of the non-GAAP letters, and over half of the companies receiving them, related to just the first four issues. The four big problems that the SEC sees: undue prominence of non-GAAP measurements in earnings reports; net of tax presentations; exclusion of normal, recurring or cash operating expenses; and individually tailored recognition and measurement methods.
Undue prominence. It’s understandable that this issue heads up the list: Regulation G was very clear that non-GAAP measures couldn’t be displayed more prominently than their GAAP counterparts. Those violations should also be the easiest to catch, and also quite difficult for preparers to refute: there shouldn’t be a lot of grey areas about whether a non-GAAP measure is more prominent than a GAAP presentation. (Although font pitches employed might settle some arguments, if it came to that.)
Net of tax presentations. Such presentations might appear investor-friendly: they get them to the bottom line effect of excluded expenses or gains, with a minimum of fuss. What could be better? For some investors, nothing – they’re only worried about whether the adjusted bottom line was better or worse than the year before. That’s not all investors, however, and those investors trying to discern the operating effects of items isolated on a non-GAAP basis are disadvantaged. Presenting pretax figures and the tax effects separately benefits all investors, and helps deter managements from steering investors to a single figure containing minimal information.
Normal, recurring or cash operating expenses. This one speaks for itself: a performance measure is incomplete – “cherry-picked,” even – when it doesn’t include the kind of typical expenses that a firm incurs in its routine business operations. What’s troubling is that the SEC staff noticed it frequently enough to call it out in 9.7% of the non-GAAP companies examined. That’s not an insignificant level of non-compliance.
In fact, all these issues are troubling, because there are no deeply complex accounting concepts involved in them. They’re all simple matters, yet companies apparently have difficulty in complying with the bright lines laid out for them well over a decade ago – even with a refresher course last May.
The most eye-catching category is the next most-common one: individually tailored recognition and measurement methods. This is something that really wasn’t spelled out in Regulation G; it didn’t contain a commandment to the effect that “thou shalt not tailor accounting standards and measurement methods to suit yourself.” Regulation G did, however, prohibit firms from misrepresenting facts either by direct statements or omission of facts. This Regulation G excerpt (Section 100 (b)) demonstrates:
… A registrant, or a person acting on its behalf, shall not make public a non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading. [Emphasis added.]
“Tailored accounting principles” could be considered covered by this section of Regulation G, but it’s a somewhat vague concept. Registrants don’t like vague, so the May 17, 2016, Compliance & Disclosure Interpretation (Question 100.04) is far more explicit:
Question: A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites?
Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G.
This may be an effort by the SEC to nip bad behavior in the bud. The new FASB/IASB revenue recognition standard is just about twelve months away from implementation, and the Commission may be concerned that companies will try to “tailor” a reversal of its provisions in non-GAAP earnings reports. If an outright undoing of the new standard’s provisions isn’t what firms may seek, the Commission may be worried about any presentation that puts a better spin on the revenue recognition than the new standard allows. With two other major standards – dealing with leasing and credit loss impairments – coming down the pike in the next couple years, the Commission might not want an “anti-GAAP” trend to grow strong before the new standards arrive in shareholder reporting.
Regarding the other major “finds” of the SEC, again, it’s surprising that some of them exist at all. Per share presentations of liquidity measures have been barred for decades because they might induce investors into thinking they’re entitled to some form of share in them. The May 17 Compliance and Disclosure Interpretation reiterated this prohibition, yet it showed up in filings.
Likewise, that guidance explicitly required firms to reconcile EBIT or EBITDA to net income:
Question: If EBIT or EBITDA is presented as a performance measure, to which GAAP financial measure should it be reconciled?
Answer: If a company presents EBIT or EBITDA as a performance measure, such measures should be reconciled to net income as presented in the statement of operations under GAAP. Operating income would not be considered the most directly comparable GAAP financial measure because EBIT and EBITDA make adjustments for items that are not included in operating income. In addition, these measures must not be presented on a per share basis.
Yet the measures were reconciled to something other than net income. As for the issue of non-GAAP presentations of segment income or loss, it’s almost redundant: even in GAAP, the segment figures can be presented on a non-GAAP basis and reconciled to consolidated GAAP figures. It’s almost as if another layer of non-GAAP figures is reported.
We’re still in the early innings of this ball game. The vast majority of these letters relate to pre-May 17 filings – and that’s when the SEC drew the line. With 10-K season right around the corner, the SEC may have now caught the attention of registrants. Will that attention pay off with more tightly constructed non-GAAP presentations in fourth quarter earnings releases? We’ll be watching.