Non-GAAP Measures – A double edged sword

Disclosure and transparency are the cornerstones of regulation governing public companies. The word ‘disclosure’ in finance parlance refers to the timely release of all information about a company that can influence an investor’s decision. Disclosures bring accountability to the governance of a company and assist stakeholders to make informed decisions. The Securities Exchange Commission (SEC) requires companies to provide timely information to investors and other users through periodic filings such as Form 10K and Form 8-K. These filings may include financial statements (and the accompanying notes to the financial statements), which are prepared in accordance with US GAAP (Generally Accepted Accounting Principles). Disclosures included in these financial statements provide additional information to enable improved and better understandability of the financial position of the company.

Beyond the GAAP

Since the 1990s, companies started providing voluntary disclosures in addition to the required GAAP based filings and disclosures. These voluntary disclosures provided additional insight into the operations of the company. While the GAAP principles provided a reliable framework to support understandability and comparability of financial statements, companies were increasingly using financial measures that do not conform to GAAP measures, to tell their version of the story. These were measures calculated and presented on the basis of methodologies other than in accordance with GAAP. They were tools to provide disclosure regarding the metrics used by the company management in their internal decisions and evaluations. They helped weave a narrative that is closer to the core operations of the company than what GAAP information would provide. Companies would generally make these disclosures in their quarterly earnings calls, webcasts, broadcasts, investor presentations, or also include them on their websites. They could also include them in an earnings press release or in periodic filings with the SEC such as Form 10K, registration statement, proxy statement, etc.

Common measures

Non-GAAP measure is defined as a financial measure which either excludes some item(s) included in a GAAP measure and/or includes an item(s) excluded in a GAAP measure. These measures usually exclude non-routine or irregular expenses such as acquisition, restructuring, or non-recurring balance sheet adjustments. They could also include adjustments in respect of non-cash items such as stock-based compensations. Some of the commonly used non-GAAP measures include adjusted earnings, EBITDA (Earnings before interest, taxes, depreciation, and amortization), EBIT (earnings before interest and taxes), and free cash flow. Financial statements are also sometimes presented on a constant currency basis to eliminate the impact of currency fluctuations and thereby facilitate period-to-period comparison of business operations.

Over the edge

While the practice of using non-GAAP measures to improve investor/analyst engagement began with good intention, lack of robust regulation led to abuse by some companies. Such companies exploited the discretionary adjustments to determine these non-GAAP measures to ‘paint a pretty picture’. Reported non-GAAP measures were generally more favorable to the company’s financial position/results than those reported under GAAP. The methodologies adopted to calculate these non-GAAP measures were also not applied consistently across periods and/or situations. Overall, companies were presenting an unbalanced, biased one-sided view through selective disclosures.

SEC’s involvement

This behavior caused concern to the SEC as it felt that the prevalence of the non-GAAP measures was misleading the investors rather than being useful. After the Sarbanes Oxley Act was introduced in 2002, SEC adopted new regulations and amending existing ones, the provisions of which were applicable to presentation and of non-GAAP measures depending on where the disclosures were being made. Regulation G was introduced in 2003 and was applicable to companies to any non-GAAP measures included in any public disclosures, whether orally or in writing. These include disclosures made in earnings calls, investor presentations, webcasts, or on their website. Item 10(e) in Regulation S-K was also amended to provide guidance on additional requirements if such measures were included in any filings with the SEC. Item 2.02 of Form 8-K was amended to update disclosure requirements for earnings releases under Form 8-K which are furnished to the SEC.

However, SEC’s focus on concern and regulation of non-GAAP measures did not end there. In 2010, SEC issued Compliance and Disclosure interpretations (CD&Is) providing guidance on the regulation. CD&Is are interpretations of the SEC staff, presented in a Q&A format. In 2015, SEC renewed its focus on non-GAAP measures and created a task force. In 2016, SEC issued updated CD&Is providing further guidance on the non-GAAP measures presented by public companies.

Some of the current disclosure requirements and prohibitions:

Role of the external auditor

The external auditor is engaged to express an opinion on the financial statements and on internal controls on financial reporting (ICFR). Since non-GAAP measures are excluded from the financial statements, these are beyond the scope of the auditor’s purview. Auditing standards require that the auditor read the other financial information, such as non-GAAP measures, presented in documents containing the financial statements for any material inconsistencies or misstatement of facts. While the auditor’s impact on non-GAAP measures is currently limited, one wonders if it will be the same in the near future.

Looking ahead…

Non-GAAP measures have gradually grown to be an integral part of the financial reporting process. The regulation and oversight of the presentation and disclosure of these measures have also grown over the years. Given SEC’s increased focus and watchful eye on these non-GAAP measures, companies would benefit to acknowledge the importance of healthy and transparent practices while reporting to the investors and stakeholders. While the audit committee is responsible for the preparation of financial statements and internal control over financial reporting, they could also be engaged to play an important role in improving the quality of non-GAAP measures. The management and those charged with governance should evaluate the relevance and reliability of such reported measures and establish a framework of non-GAAP policies while adopting strong disclosure control protocols. These steps will go a long way in improving the company’s credibility and increase its trust and confidence in the eyes of the investors.

Afterword

As we continue to evolve into the new normal presented by the challenges of the COVID-19 pandemic, companies are studying the impact of the pandemic on their current as well as future financials. SEC has also proactively relaxed the filing deadlines and continues to provide guidance in these uncertain times. New non-GAAP measures are expected to evolve in the coming times and investors need to consider the same in their analyses.