In the past year, SEC officials have questioned public companies’ increasing reliance upon non-GAAP measures in quarterly earnings calls and press releases.
Regulators have been concerned that companies are using the numbers in a way that can mislead investors. Two researchers, in analyzing comment letters SEC staffers sent to public companies from July 1 to Oct. 31, 2016, say the most frequently cited problems stemmed from “undue prominence” given to the non-GAAP numbers, which tend to present companies in a healthier financial position than their audited, GAAP-compliant earnings.
Companies that have presented their non-GAAP numbers more prominently than their audited results have tended to see a boost in their stock prices when they release quarterly earnings. Regulation G, which governs non-GAAP metrics, says that the most directly comparable financial measure from GAAP must be presented with equal or greater prominence to the non-GAAP number. The rule also requires companies to reconcile the differences between the non-GAAP financial measure with the most directly comparable financial measurement from GAAP.
Audit Analytics of Sutton, Massachusetts, and R.G. Associates, a Baltimore investment firm, combed through 1,426 comment letters issued to 479 companies. More than 40 percent, or 207 companies, received 427 letters from the SEC staff that commented on the use of at least one non-GAAP measurement. The analysis, which was issued on Jan. 3, 2017, notes that most of the letters were related to filings from the first half of 2016. This means that many filings were submitted to the SEC before companies referred to the Compliance and Disclosure Interpretations (C&DIs) the agency issued in May. The interpretive guidance spelled out regulators’ views on the acceptable use of non-GAAP metrics.
The analysis found that 136 letters sent to 78 companies had to do with undue prominence. SEC officials have said companies have started to correct the prominence requirements.
“There are many other non-GAAP fails that might trouble those who actually use the non-GAAP earnings information, beyond glancing at the release and reacting to just the most visible information,” said Jack Ciesielski, R.G. Associates’ president. For example, companies have been increasingly cherry-picking items they exclude or include in earnings or have not been transparent when they change how they calculate some unaudited numbers, which makes it difficult for analysts to do a fair evaluation and comparison of the companies.
The next most frequently cited problems had to do with the presentation of non-GAAP measurements on a “net of tax” basis, with 50 letters to 25 companies. The researchers said that such presentations may seem investor-friendly because they quickly get to the bottom line effect of excluded expenses or gains. Some investors are 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,” the researchers said. “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.”
The researchers said Reg G does not spell out the acceptable use of individually tailored recognition and measurement methods even as it bans companies from misrepresenting facts either by direct statements or omission of facts. The May interpretive guidance made it a more explicit ban.
“This may be an effort by the SEC to nip bad behavior in the bud,” the researchers said. “The new FASB/IASB revenue recognition standard is just about 12 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.”
It is unclear what long term effect the SEC’s C&DIs and comment letters will have on earnings releases and other public statements, but Ciesielski believes companies will improve the quality of the financial information they release to the public.
“I think we'll see a bit of tightening up,” Ciesielski said. “Companies now know they are being held accountable: the SEC is watching, and I think they might be seeing some pushback from investors.”
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