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Regulation G was supposed to end the abuses of pro forma reporting. Has it succeeded?
Alix Stuart, CFO Magazine
July 1, 2004
When 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.
To prevent such misunderstandings, Wellesley, Massachusetts-based PerkinElmer Inc. began including First Call estimates in its earnings releases last fall, making reference to the estimate in the opening of the release and providing it as a line item in its non-GAAP-to-GAAP reconciliation tables. "When the media spit out 'PerkinElmer misses' because they were confused, we had to do something," says company spokesman Dan Sutherby.
And many point out that pro forma numbers are still perfectly defensible, if used for the right reasons. In fact, John Kenny, CFO of Boston-based document-management firm Iron Mountain Inc., says it was at the SEC's request that the firm began to use the term "Adjusted EBITDA" for its primary earnings metric three years ago. After a routine review of the highly leveraged firm's filings, says Kenny, the SEC asked Iron Mountain to publish the adjusted form so that investors could better track the firm's performance against its bond covenants using that metric.
When Reg G emerged, however, Iron Mountain's adjusted measure suddenly became unusable, thanks to the new S-K/S-B amendment stipulating that neither GAAP nor pro forma results in filings may exclude items if similar ones have been excluded in the previous two years, or are expected to be excluded within the following two years. "The problem with Adjusted EBITDA was that some of the things we were adjusting out — the foreign-exchange gains and losses, some merger-related costs, and costs associated with refinancing — were occurring on a fairly regular basis," says Kenny.
As a result, the company dropped Adjusted EBITDA and introduced operating income before depreciation and amortization (OIBDA) in both its releases and its filings. This measure does not exclude any recurring charges, Kenny says, and is easier to reconcile to GAAP net income.
Given what seems to be a more judicious use of pro forma numbers — the spread between GAAP and operating earnings for the S&P 500 narrowed to 11 percent for 2003 and dropped to 4 percent in the first quarter of 2004 — and the rigorous disclosure that accompanies them, at least one longtime critic of pro forma is happy with the changes Reg G has sparked. "What we do have today is absolutely better than what we had before the regulation," says Turner, who dubbed pro forma earnings as "everything but the bad stuff" during his tenure at the SEC. "Now at least people are getting reconciliations to GAAP, and they're doing things consistently."
Alix Nyberg is a freelance writer based in Boston.
|Pro Pro Forma|
Some S&P 500 companies that continue to give prominence to pro forma.
|Company||Details for Most Recent Quarterly Release|
|BMC Software||"Net earnings excluding special items" ($40.8 million) leads the April 29 release, and is the basis for the company's forward guidance. GAAP earnings of $36.9 million come later in the first paragraph, with the difference explained only in an attached table.|
|Chiron||Headlines pro forma earnings of 22 cents per share, the 14 cents GAAP earnings show up later in the body of the April 21 release. Despite a lengthy discussion of the rationale for pro forma, the details of what is excluded are left to the attached table.|
|Hewlett-Packard||Puts $1.3 billion non-GAAP operating profit ahead of $1.1 billion GAAP in the May 18 release, but notes that both include a one-time legal settlement and follows with EPS based on net income. Guidance given on non-GAAP-basis only.|
|PeopleSoft||Pro forma net income of $62 million comes in the second paragraph of its April 29 release, with GAAP net income of $24 million following it, noting that the difference is partially due to purchase accounting adjustments for its J.D. Edwards acquisition. The two are reconciled in a table in the text.|
|Sabre Holdings||"Adjusted" EPS of 37 cents and GAAP EPS of 31 cents both get a headline, but the difference between the two is relegated to page 8 of the April 22 release.|
|Sanmina||While noting in the first paragraph that the reconciliations from GAAP to pro forma are attached, Sanmina gives the 5 cents per share pro forma gain a bullet point at the top of its April 20 release, while confining the 9 cents GAAP loss to a table that follows pro forma results in the text. Guidance given on a pro forma basis only.|
|Sources: Chuck Hill/Thomson Financial First Call; company Websites|