The Securities and Exchange Commission is taking a hard look at voluntary disclosures that don't adhere to conventional accounting methods, and it's taking an unkind view of those that seem to obscure the truth.
SEC staff has been on the hunt for several months for claims in financial statements that break with U.S. Generally Accepted Accounting Principles, as the SEC works to assure that investors aren't being misled. “The SEC doesn't really require or encourage the use of non-GAAP measures, nor does it prohibit them,” says Brad Davidson, a partner with audit firm Crowe Horwath. “But it does prohibit registrants from using misleading non-GAAP measures.”
SEC Chief Accountant James Kroeker carried the non-GAAP torch during a speech in May to an accounting conference in New York, where he called attention to non-GAAP measures the staff has spotted recently in pension accounting. A handful of major companies over the past few years have adopted new accounting policies for their defined benefit pension plans to follow an approach more like mark-to-market accounting, where reported earnings more closely reflect actuarial gains and losses rather than expected gains or losses.
Without naming specific companies, Kroeker said his staff has flagged at least one filing where a company adopted the policy, then steered investors' attention back to expected gains and losses without providing enough information to fully grasp the difference, giving an impression that the plan performed perhaps better than it appeared to perform under the new accounting. Kroeker explained the issue to illustrate how non-GAAP measures, if not fully reconciled, can produce a misleading message to investors.
Social media company Groupon provided perhaps the most glaring example in the past year of using a non-GAAP measure that raised the ire of the SEC, says Bruce Pounder, director of professional programs for training firm Loscalzo Associates. And it wasn't just the SEC that took notice: Investors, analysts, and the media went after Groupon when it submitted its registration statements for an initial public offering that included an accounting adjustment called “adjusted consolidated segment operating income” to back out routine expenses. “The investing community picked up on the fact that this was a bogus financial measure,” he says.
The company was trying to gloss over an operating loss by creating a new number that looked like earnings from operations, says Pounder. “The implication was if you just ignore some of these expenses we had, gosh, we're really profitable,” he says.
The recent SEC focus on the use of non-GAAP measures represents a swing of the pendulum, says Chris Smith, a partner with audit firm BDO USA. The SEC came down hard on non-GAAP abuses about a decade ago when it issued Regulation G and amended Regulation S-K, he says. The SEC took those steps to shore up abuses that contributed to the run-up to the Enron collapse and the burst of the dot-com bubble. Regulation G requires companies that use non-GAAP financial measures to reconcile those figures to GAAP measures, and amendments to Regulation S-K prohibit the use of some non-GAAP measures completely.
About three to four years ago, the SEC began noticing that the rules put a heavy chill on all use of non-GAAP measures, which wasn't the intention, Smith says. So the staff issued clarifying guidance through its Compliance & Disclosure Interpretation series meant to explain that non-GAAP measures have a place in financial reporting, he says, as long as they enhance an investor's understanding of a company's performance, are properly reconciled to GAAP measures, and are not used to obscure the truth.
“When you are considering whether or not to use a non-GAAP measure … it's important to assure the measure and the disclosures enhance an investor's understanding of the business and don't obscure important information.”
—John May,
Partner,
PwC
That opened the door to a flood of non-GAAP reporting once again, says Smith, some of it running afoul of SEC guidelines, he says. “So now the pendulum is coming back, and the SEC is trying to bring it into equilibrium,” he says.
Through speeches, comment letters, and conversations with the SEC Regulations Committee of the Center for Audit Quality, the SEC staff has conveyed a number of specific observations in recent months, says John May, a partner with PwC. They represent some powerful reminders to companies about where non-GAAP measures can get them in trouble.
Raising Red Flags
First, SEC staff likely will raise questions with a company that touts a non-GAAP measure more prominently than a GAAP measure, says May, and that includes presenting a full non-GAAP income statement. They'll also ask questions if a company uses terminology that might be confusing, such as adjusting an income number and calling it operating earnings. More red flags will rise, he says, if companies report liquidity measures such as operating cash flow on a per-share basis, or don't properly consider dilution in non-GAAP earnings per share when there's no calculated dilution of the GAAP measure, perhaps because the company actually had a GAAP loss.
SEC FAQS
Below is an excerpt from the SEC's frequently asked questions regarding EBITDA:
EBIT and EBITDA
Question 14: Section I of the adopting release describes EBIT as “earnings before interest and taxes” and EBITDA as “earnings before interest, taxes, depreciation and amortization.” What GAAP measure is intended by the term “earnings”? May measures other than those intended by the description in the release be characterized as “EBIT” or “EBITDA”? Does the exception for EBIT and EBITDA from the prohibition in Item 10(e)(1)(ii)(A) of Regulation S-K apply to these other measures?
Answer 14: “Earnings” is intended to mean net income as presented in the statement of operations under GAAP. Measures that are calculated differently than those described as EBIT and EBITDA in the adopting release should not be characterized as “EBIT” or “EBIDTA.” Instead, the titles of these measures should clearly identify the earnings measure being used and all adjustments. These measures are not exempt from the prohibition in Item 10(e)(1)(ii)(A) of Regulation S-K.
Question 15: If EBIT or EBITDA is presented as a performance measure, to which GAAP financial measure should it be reconciled?
Answer 15: Because EBIT and EBITDA exclude recurring charges, companies should consider the answer to Question 8 if they intend to use EBIT or EBITDA as a performance measure. If a company is able to justify such use, EBIT or EBITDA 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.
Source: SEC.
The staff also will take a closer look when a company adjusts a number to exclude the effects of non-recurring items or events, says Davidson. “If you call something non-recurring, that's one time, like an impairment charge or a restructuring charge,” he says. “But when you refer to something as recurring, the SEC will consider it misleading if the charge has occurred in the last couple of years or if it's reasonably possible it will occur again in the next couple of years. You can't imply it hardly ever happens.”
These recently raised concerns hardly mean that the SEC frowns on all non-GAAP measures, says Scott Ruggiero, a senior manager focused on SEC regulatory matters at Grant Thornton. Earnings before interest, taxes, depreciation, and amortization—or EBITDA—is a commonly accepted non-GAAP metric, for example, meant to focus attention on profits earned from the core business operations. Companies might present EBITDA adjusted for any number of issues that might be important to the company, he says, sometimes tied to debt covenants. “We've seen the SEC say they are fine with an adjusted EBITDA number as long as it meets the basic 10-K requirements for disclosure,” he says. “We've seen several of these in the past month.”
Companies take it too far, however, when they try to adjust EBITDA in a way that masks the truth, says Peter Bible, a partner with audit firm Eisner Amper. “It's abusive when people use it to position their stock in probably a better light than it should be viewed,” he says. “Earnings before bad stuff is where you get into trouble.”
The key to making non-GAAP disclosures that will pass muster with the SEC is to consider the ultimate effect of the disclosure on an investor's understanding of the business, according to May. “When you are considering whether or not to use a non-GAAP measure, and in particular one that excludes recurring items, it's important to assure the measure and the disclosures enhance an investor's understanding of the business and don't obscure important information,” May says.
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