One way of looking at the Securities and Exchange Commission’s increasing focus on companies’ use of non-GAAP metrics is as a good-versus-evil drama.
On one hand, such measures — generally arrived at by backing out certain nonrecurring or noncash expenses from profitability measures shown in GAAP financial statements — often enable a more precise telling of a company’s story than is possible using only the official numbers.
On the other hand, the potential for abuse — misleading investors by willfully painting a rosier picture of performance than is justified —i s great.
The SEC, whose main mission in this matter is rooting out misleading information, is worried that the more nefarious motivation is gaining momentum. Over the past year-plus, SEC officials have publicly and repeatedly stated their concerns about the proliferation of non-GAAP metrics, which show up in everything from earnings releases to annual and quarterly reports, to proxy statements, to registrations of securities offerings and company websites.
In 2015, just 12% of S&P 500 companies reported only GAAP numbers in their public filings. That was down from 25% in 2006, according to Audit Analytics. And greater usage of the unofficial measures may translate to more rules violations. “We’ve observed a deterioration in compliance with the non-GAAP disclosure rules,” says Mark Kronforst, chief accountant for the SEC’s division of corporation finance.
The kicker is that the gap between the official and unofficial figures is widening. For example, again within the S&P 500, GAAP earnings per share rose from about $50 in 2009 to just under $90 in 2015, an 80% gain, according to Investopedia. However, the rise for non-GAAP EPS — often called “adjusted EPS” — was significantly steeper, doubling from $60 to nearly $120 over the same period.
That indeed suggests that in some cases sleight of hand may be involved. EBITDA is a commonly used non-GAAP measure, of course, but it has a standard definition that all the key stakeholders — companies, investors, analysts, and regulators — understand. That’s not so for the oft-reported but variably defined “adjusted EBITDA,” or most any other financial measure designated as “adjusted.”
Speaking at a June conference, SEC chair Mary Jo White said, “In too many cases, the non-GAAP information, which is meant to supplement the GAAP information, has become the key message to investors, crowding out and effectively supplanting the GAAP presentation.”
How unhappy is the SEC with the presentation of non-GAAP metrics? In 2014, 13% of companies receiving comment letters from the commission in response to 10-K, 10-Q, or 8-K filings were taken to task over, or asked to explain, their non-GAAP presentations, according to Audit Analytics. Last year, that rate climbed to 16%. This year through October? 30%.
That means a company will have only itself to blame if the SEC opts to make an example of the company’s improper use of non-GAAP metrics, suggests corporate attorney Richard Morris of Herrick, Feinstein. “The SEC has repeatedly stated that it is not a ‘gotcha’ regulator,” he says. “It gives out advice and a very good map of the landscape. I look at what the SEC is saying here as, ‘Here’s the weather report. Be prepared.’”
Morris, who says a client company of his received a comment letter, notes that “some people are in a mood to be combative with the SEC on this. I find that interesting. This is the SEC trying to help us. And soon, those who don’t take the guidance seriously are going to be the recipients of enforcement actions.”
Indeed, nearly 8 in 10 companies (79%) made changes to their non-GAAP presentations in their publicly filed financials for the period ending June 30, just six weeks after the SEC issued new compliance and disclosure interpretations (see “Threshold for Enforcement?” page 26), according to a study of 100 companies by law firm Debevoise & Plimpton. That doesn’t necessarily mean, though, that those are all the changes necessary to fully comply with non-GAAP disclosure rules.
In fact, some observers think the SEC’s lack of strong enforcement to date — sending comment letters but bringing virtually no litigation — may encourage complacency in terms of compliance with the guidance.
“These are early days, and there’s probably a ways to go before some companies recognize that this is a material risk,” says Dan Zitting, a former auditor who’s now chief product officer at ACL, an anti-fraud-conspiracy and software firm.
On the other end of the spectrum, companies could over-react to the threat of enforcement, altering or removing presentations of non-GAAP measures to an extent that they’re no longer telling the full story of their value to investors, suggests Neri Bukspan, Americas disclosure leader for Ernst & Young.
“I can see some companies doing that,” Bukspan says. “But if you truly feel [your metrics] are appropriate and communicate important and salient information for investors, my suggestion is that you err on the side of sweating it.”
That raises the issue of the chicken-and-egg aspect to non-GAAP information. That is, why are companies providing more non-GAAP information these days? Is it to put the best possible spin on their financial performance? Or because stakeholders are demanding it?
“You’d like to think that the non-GAAP numbers are out there and presented as they are because investors and analysts want to see them,” says Susan Markel, a managing director at AlixPartners and a former SEC chief accountant.
Similarly, Morris points to changes in the way investment advisers are researching companies. “They’re looking at more non-financial-statement analytics,” he says. “As that kind of analysis has developed, so has the need for companies to provide that data.”
Others are more skeptical of companies’ motivations. If companies weren’t providing non-GAAP reporting, analysts would be coming up with their own measures anyway, and in fact, they do that now, notes Charles Mulford, an accounting professor at Georgia Tech University.
Suggesting another reason for the uptick in non-GAAP metrics, Mulford says, “You could argue that, in an environment where earnings growth is harder to come by, there is more pressure on companies to show growth.”
He allows that nonrecurring charges for things like impairments, restructurings, and asset write-downs occur more frequently than nonrecurring gains. Also, it’s the nature of GAAP to require more things to be written down than written up, he adds.
But even in times of strong earnings growth, “companies have a tendency to over-identify nonrecurring items,” Mulford says. “They take out more than they should, in an effort, I think, to sway perception of performance.”
A few years ago, Mulford was thinking about how he could compare on an apples-to-apples basis the impact of companies’ non-GAAP presentations, as there are many different methods of arriving at non-GAAP income. He came up with the idea of simply expressing such measures as a percentage of GAAP income.
Along with a graduate student, he undertook a study of the Fortune 100 firms’ fiscal-year 2013 financial presentations. The research, published in the July 2016 edition of the International Research Journal of Applied Finance, showed that 75% of the companies in the sample reported some type of non-GAAP income, and that for 75% of those, that figure exceeded GAAP income.
And those net positive adjustments weren’t small potatoes. For the 56 companies that burnished the view of their earnings, the average outcome was 129% of GAAP income, while the median figure was 118%.
The fact that the data for the study is now three years old is not relevant, Mulford states. “I don’t see any compelling reason that we would find major differences today,” he says. “The kinds of things companies were doing then are the kinds of things they’re doing now.” Except, companies are doing those things to greater effect: in 2015, according to Audit Analytics, the non-GAAP numbers that companies used in their official filings increased income 82% of the time.
Mulford, director of Georgia Tech’s Financial Analysis Lab, is a purist when it comes to accounting propriety, taking an even harder line on non-GAAP reporting practices than does the SEC.
For example, he has a dim view of companies excluding certain merger and acquisition-related expenses — most prominently amortization of acquired intangibles — even though the SEC generally allows it, given the proper presentation. The exclusion is disallowed if a company’s acquisitions are so frequent that they’re deemed to be recurring. (Under the rules, companies should not label something as “nonrecurring” if it occurred another time within the two previous years or is likely to occur in the next two years.)
“You could argue that amortization of acquired intangibles is nonrecurring,” he says, “but of course, the acquiring company includes the results of the acquired company in revenues and operating profit. So I don’t buy the argument. It’s not consistent to include income from an acquisition but exclude expenses of the acquisition.”
In fact, Mulford considers all exclusions of amortization and depreciation expense problematic when it comes to calculating non-GAAP measures. “Those are normal recurring expenses,” he argues, “and if you exclude them, that’s not what profits are.” That’s a strong position, considering that amortization and depreciation are components of EBITDA, which a large majority of companies report, even if adjusted in some fashion.
By the SEC’s lights, those exclusions are allowable, as they are not cash expenses — also true of stock-based compensation expense, another common and permitted exclusion.
Regardless, Mulford, simply put, is not a fan of EBITDA, period. “It’s a terrible measure of performance for shareholders,” he says. “It’s not profit. It’s a crude measure of cash flow available to service debt. But from a shareholder’s point of view, debt has to be taken [into account]. You’re trying to get at earnings that are available for the shareholders, and EBITDA is just not it.”
Unsurprisingly, CFOs aren’t exactly thrilled by views such as Mulford’s. “There are black-and-white guys, but there’s a good amount of subjectivity when it comes to depreciation and amortization,” says Tyler Sloat, finance chief at Zuora, an enterprise software firm. “You buy intangibles and amortize them over seven years, because you and the auditors agreed on seven years. But why not five years instead of seven? I don’t know.
“Whenever you apply subjectivity to accounting treatments upstream from actual results,” Sloat continues, “those results get diluted. Then how do you normalize them back to remove that subjectivity? That, I would argue, is a big part of the purpose of EBITDA.”
While Sloat, like any CFO, is regularly immersed in traditional financial reporting, he’s also very focused on a different kind of metrics. They’re not what many would think of as non-GAAP metrics, because there is nothing in GAAP to which they could be reconciled.
Zuora makes and sells software-as-a-service applications for the booming market of companies with subscription business models. Investors in such companies are far less interested in GAAP numbers than in other metrics that are keys to assessing such businesses.
The best example of such a metric, according to Sloat, is net customer retention rate. “In the subscription world, having a net retention rate over 100% is really important,” he says. “It shows that your upsell is outweighing your customer churn. It provides your investor base with enough information to know that if you spend a lot of money to acquire new customers, you’ll be able to keep and monetize those customers for a long time.”
Other concepts particular to subscription businesses include annual recurring revenue, churn, and customer acquisition costs. “None of these are GAAP numbers, yet companies are being run based on them, and they’re what management is being held accountable for,” says Sloat.
Morris, the corporate attorney, says he recently heard a presentation about a new subscription-based music-streaming service. “Throughout the entire analysis, not once did they talk about this service’s financials,” he says. “They were talking about market share, number of subscribers, and the size of their portfolio of music. And take some of the biggest companies we have now — when they were coming out, people weren’t looking at their balance sheets.”
The SEC intended not to create a complete road map for the use of non-GAAP metrics, but rather to articulate some key concerns. Still, given the divergent perspectives on this matter, should the SEC provide more guidance? Opinions vary on that, too.
In a poll of 160 board members at public companies by accounting firm BDO, participants were split almost evenly as to whether they’d like to see more guidance, with 51% in favor and 49% opposed. But the result doesn’t necessarily mean boards have radically different opinions, according to Paula Hamric, a partner in BDO’s SEC department. Rather, it may reflect that they’re not quite sure how to see it.
“Certainly, additional guidance would simplify the compliance effort,” says Hamric. “But right now, the SEC staff is still trying to figure out what constitutes ‘misleading.’ It’s easy for a company to correct issues of prominence in presenting non-GAAP metrics … you change the order of some text, you put the non-GAAP numbers closer to the GAAP ones. It’s much harder to define what’s misleading. More guidance around that would help.”
However, Hamric also observes that “having too much proscriptive guidance may end up reducing the usefulness of non-GAAP disclosures, because what’s meaningful for one company is not meaningful for another.”
For Markel, the former SEC chief accountant, the existing guidance is “pretty good” and gives the commission a framework for enforcement against companies that “take advantage” of the leeway the rules provide. If there is to be more guidance, it won’t come for some time, she opines.
Morris thinks otherwise. The C&DI’s issued in May were “really just the opening statement by the SEC,” he says. “There is a lot of discussion about this, both at the SEC and in accounting circles. This is not the end.”
David McCann is a deputy editor of CFO.
It’s not yet known how vigorously the SEC will ultimately enforce its rules on the use of non-GAAP measures. Until now, the commission has brought charges over such usage only twice, once in 2009 and once in September 2016, against two former executives of American Realty Capital Properties, a real estate investment trust now known as Vereit.
In both cases, the SEC charged the offending companies with presenting outright fraudulent non-GAAP measures. But many observers believe the SEC is now setting the stage to make examples of companies over what some may regard as less-serious infractions.
A series of compliance and disclosure interpretations released in May 2016 gave further guidance on the SEC’s views of how existing regulations governing non-GAAP usage should be interpreted. Key prohibitions addressed by the C&DI’s included the following:
• Presenting a non-GAAP measure with greater prominence than the presentation of the most comparable GAAP measure. “One of the primary objectives of our work in this area was to improve compliance with the prominence requirement,” says the SEC’s Mark Kronforst.
• Backing out “recurring cash operating expense necessary to run the business”
• Reconciling EBIT or EBITDA presentations to operating income rather than GAAP net income
• Presenting a measure inconsistently from period to period
• Excluding charges when calculating a non-GAAP metric while not excluding any gains
• Accelerating the recognition of revenue from customers that are billed up-front for products or services to be delivered over time
• Presenting liquidity measures of cash generated on a per-share basis
• Not clearly defining “free cash flow” —D.M.
Will the SEC ever be able to issue enough guidance on non-GAAP metrics that it’s clear to companies whether they are presenting the metrics correctly? Not likely. And CFOs know it.
A case in point: Hodges-Mace, a maker of employee benefits management software, this year hired external consultants to help revamp one of its products. Given the company’s relatively small size, the six-figure expense was material to its financial results.
The company categorized it as a nonrecurring expense and for that reason backed it out of GAAP earnings when creating a non-GAAP income measure.
“We’re not going to do that next year, so it’s a one-time investment in improving the product,” says Hodges-Mace CFO Ron Shah. “We needed outside expertise to evaluate the product’s functionality and scalability and deliver us a report, and our existing team is going to implement the changes. To me, it’s not the same as hiring more developers.”
Still, Shah acknowledged that others could take the opposite viewpoint — that since the company updates its software every year, the use of consultants versus internal resources doesn’t make the expense nonrecurring. “That would be a legitimate position,” he says.
Perhaps the Securities and Exchange Commission would take that view were it more focused on the activities of midsize and small private companies such as Hodges-Mace. For those companies, the audiences that count most are typically their equity investors and lenders. “I’ve had this conversation with them, and they fully support us on this,” says Shah.
He adds: “When I’m in the investor relations or lender relations role, I’m arguing the point that I believe supports my position. But I have a healthy respect for how someone could have a different perspective.” —D.M.
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