Where there’s smoke, there may not be fire, but there will be firefighters. This year, there has been a lot of agitation in the press and among regulators about public companies using non-GAAP financial measures that look better than GAAP numbers.
In May, the SEC staff in charge of reviewing companies’ filings updated its guidance on non-GAAP financial measures, which meant changes for many companies in their earnings releases. In addition, the SEC enforcement staff would love to find some good enforcement cases to bring home to companies that they should be following that guidance and, perhaps, de-emphasize non-GAAP measures in earnings press releases.
Now that more than 150 comment letters on non-GAAP measures from the SEC filings review staff have become publicly available, here’s what public company CFOs need to know.
Most companies responded to the SEC staff guidance in second-quarter earnings releases by changing their presentation to comply with the updated guidance. The SEC comment letters made public since the May 2016 update provide additional guidance on how companies need to update their disclosure, though most of the comments were on disclosures that pre-dated the new guidance. Below are some of the areas of concern that the SEC staff has focused on in those letters.
Equal or greater prominence. The most common comment from the SEC staff asked companies to include the most directly comparable GAAP financial measure with “equal or greater prominence” whenever a non-GAAP financial measure was included. To comply, companies should:
Earnings calls. The SEC staff listens to earnings calls and comments on non-GAAP measures referenced on those calls. Make sure that any non-GAAP measures discussed on earnings calls are reconciled in the earnings release or on the company’s website.
Reasons for non-GAAP measures. Another common staff comment asked companies to provide more detail and specificity when explaining why the company believes its non-GAAP measures provide useful information to investors. The SEC staff explained that the reasons should provide detailed information specific to the company’s circumstances regarding the use of each of the company’s non-GAAP measures.
Proper labeling of non-GAAP measures. About a quarter of the letters asked companies to clearly and consistently identify non-GAAP measures as such. This includes not using labels like EBITDA or free cash flow for measures that include adjustments beyond those ordinarily associated with those metrics unless the label includes words such as “adjusted.” Once a non-GAAP measure is given a certain label, the label used for the measure should be consistently applied.
The comment letters also requested that companies clarify how they define the term “core” when they use it to refer to earnings or costs that they report on a non-GAAP basis.
Some companies use the term “core” in a non-GAAP measure, and designate revenues or costs that they eliminate through adjustments as “non-core.” The SEC staff commented on this in several letters, asking companies to clarify how they define “core” for this purpose, or questioning whether the use of the term was appropriate when the relevant adjustments labeled “non-core” seemed inherent to the company’s core business and were applied year after year. Some companies were able to provide satisfactory explanations for its use of “core” and “non-core,” while others decided to change the terminology.
In addition, in some comment letters, the SEC staff noted that the term “pro forma” be reserved for financial measures that have been prepared in accordance with the SEC’s rules for pro forma financial statements in Regulation S-X, instead of as a blanket label for financials that illustrate hypothetical combined results from a significant acquisition recently announced or consummated.
Non-GAAP adjustments presumed to be misleading. While non-GAAP adjustments were generally viewed as permitted if sufficiently transparent, some adjustments have been identified as problematic. Normal, recurring cash operating expenses such as store closing costs, litigation settlements, and rent expense, among others, have been identified as potentially problematic adjustments. While some of the comment letters resulted in additional disclosure, others led to the adjustments being removed from subsequent filings.
Acquisition-related expenses have been a standard adjustment for many non-GAAP measures. However, this adjustment was challenged in several comment letters, particularly when acquisitions were part of the company’s growth strategy. Most companies that have received a comment on this adjustment responded with detailed explanations and expanded disclosure, but some companies discontinued the use of this adjustment or the affected non-GAAP measure.
The SEC staff also scrutinized inconsistencies in the use of adjustments and their rationales. For example, if a company explains that it used a non-GAAP measure because it enhances comparability across periods, the staff may question adjustments that appear in multiple periods. Or if an adjustment is made because the item adjusted for is not representative of a company’s ongoing operating performance, a warning about similar charges occurring in the future could raise concern.
Public companies should take note of the increasing scrutiny and concern over non-GAAP financial measures and take the following steps in light of the SEC staff guidance and comment letters:
Additionally, CFOs should remember that the guidance also applies to proxy statements, as companies prepare for the year-end and upcoming proxy statements.
Richard Alsop and Robert Evans are partners, Harald Halbhuber is counsel, and Yoon-jee Kim is an associate in the capital markets group at Shearman & Sterling LLP.