VideoWhen the Securities and Exchange Commission issued Regulation G in January 2003, some people thought the death knell had been sounded for the abuse of pro forma numbers.
From that date on, any non-GAAP number used in an earnings release had to be accompanied by — and reconciled to — the "most directly comparable" GAAP number. Anything excluded from the pro forma metric had to be disclosed. At the same time, the SEC also amended existing rules to narrow the field of what could be excluded from pro forma measures in filed information.
Today, though, there's little evidence that Reg G has had much effect on pro forma reporting. About 60 percent of companies continued to report non-GAAP information in their first-quarter earnings releases this year, according to a National Investor Relations Institute (NIRI) survey of 360 companies, down from the 70 percent that reported doing so in the quarter before Reg G took effect. Of those that stopped using pro forma, only about a quarter attributed the move to Reg G.
Some observers, in fact, charge that abuses of pro forma still flourish. "There seem to be a lot of companies that are pushing the envelope on Reg G," says Chuck Hill, former director of research at Thomson Financial First Call. While few are blatantly breaking the law by omitting GAAP equivalents or reconciliation tables, Hill says some companies are taking advantage of the relatively lax enforcement of regulations on press releases to spin their numbers in ways that would be illegal in official filings.
Consider Intuit, a Mountain View, California-based provider of business and financial software. Pro forma earnings have actually moved higher up in the company's earnings releases since Reg G took effect, with this year's third-quarter release (dated May 19) headlining a 14 percent growth in pro forma earnings per share. GAAP EPS, which was higher in absolute terms but reflected a decline from last year's numbers, shows up immediately below, halfway down the page. And the difference between the two is explained only in general terms in a footnote to the release, with details following in a separate file.
Such placement, charges Hill, may not be a technical violation, but it "is definitely a violation of the spirit of the law" requiring that GAAP numbers get equal or greater prominence than pro forma. He adds that "everybody ought to at least start in the same place — GAAP — before moving into adjustments."
Intuit is hardly alone; a host of other companies, particularly software and biotech firms, continue to give pro forma first place, according to Hill (see "Pro Pro Forma," at the end of this article). But they do so at their own peril, in view of what many securities lawyers advise. "Given that the SEC says non-GAAP financial measures can lend themselves to being misleading, it's important to put them in context," says Katharine Martin of Wilson Sonsini Goodrich & Rosati. "I would personally not recommend that you use non-GAAP financial measures in the lead, because there's a chance that it could get more prominence, particularly in wire stories."
A Recurring Issue
Companies that routinely exclude recurring items, such as restructuring charges, from pro forma calculations are also coming in for criticism. "You still see items like restructuring charges going in, and you look at the reconciliation tables and you've got [charges] across all years," says Lynn Turner, former SEC chief accountant and now principal with San Francisco-based Glass, Lewis & Co. "Investors need to realize these really are recurring charges."
Again, the practice is not a technical violation of Reg G. Companies can adjust earnings for recurring items in their press releases, according to SEC spokesman John Heine, so long as they provide a chart reconciling the adjusted numbers to GAAP with the release. (Such adjustments to GAAP are only prohibited in a company's 10-Ks and 10-Qs, which are covered by an amendment to regulations S-K and S-B that was written concurrently with Reg G.)
However, the SEC continues to have wide latitude on what it considers misleading. Beginning an earnings release with pro forma results and burying GAAP numbers, for example, "of course would be a violation of Reg G," according to one SEC official. "Even before Reg G, we brought a case on that issue," referring to the 2002 cease-and-desist order levied against Trump Hotels & Casino Resorts Inc. for touting a pro forma profit without revealing that it excluded one-time charges but not one-time gains until it made an official filing with the SEC.
With no SEC enforcement actions on Reg G to date, attorneys say the agency has so far been sympathetic to the complexities of the law, which imposes detailed requirements such as posting reconciliation tables on the corporate Website for any non-GAAP measures used in an earnings call and giving the Website address to analysts before a presentation. "I think the SEC staff understands this is complicated," says Martin, and generally gives companies in violation a chance to fix the problem before imposing penalties. However, the agency "is definitely looking at Reg G compliance as part of its periodic reviews."
To be sure, some companies have dropped non-GAAP measures altogether. But going cold turkey has its disadvantages as well. Louis M. Thompson, NIRI's president and CEO, points out that most analysts continue to make estimates on a non-GAAP basis. As a result, "some of the companies that go to GAAP-only find themselves penalized by the market when they come in lower than First Call mean [estimates]," making it seem like they missed their numbers.
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