Companies haven’t wasted any time in reacting to a series of compliance and disclosure interpretations (C&DI) on the use of non-GAAP financial metrics that the Securities and Exchange Commission issued on May 17.
Law firm Debevoise & Plimpton analyzed 100 earnings releases issued since then by Fortune 500 companies that included presentations of two or more non-GAAP financial measures plus guidance on at least one such measure. Among these earnings releases, 79 contained modified disclosures compared with those made in previous earnings releases.
The usage of non-GAAP metrics, not only in publicly filed financial statements but in other media such as press releases and company websites, has proliferated in recent years. The C&DI’s reflected the SEC’s concern that the way companies are using such metrics may be misleading to investors.
Companies are allowed to use non-GAAP metrics. When they do use one, however, SEC regulations require them to also provide, “with equal or greater prominence,” a presentation of the most directly comparable financial measure calculated in accordance with generally accepted accounting principles. They also must provide a reconciliation between the non-GAAP measure (adjusted EBITDA or free cash flow, for example) and the most comparable GAAP measure (net income or operating cash flow).
“The members of the commission have been focused on this for more than a year,” says Matthew Kaplan, co-head of the capital markets group at Debevoise & Plimpton. “They’re not saying you can’t highlight non-GAAP metrics. They’re saying you can’t give them undue prominence.”
In response to the CD&I’s, companies have taken such steps as reordering the presentation of metrics such that GAAP metrics are presented first, replacing non-GAAP metrics with GAAP metrics, and augmenting or modifying reconciliations between the two types of measures (see chart above, representing the results of the Debevoise & Plimpton analysis).
Since issuing the interpretations in May, the SEC has continued to turn up the heat, sending more than 30 comment letters to companies about their use of non-GAAP metrics. The commission also reportedly conducted a sweep of earnings releases that resulted in letters to many other companies, asking for information on their usage of such metrics.
In addition, on Sept. 8 the SEC charged the former CFO and former chief accounting officer of a real estate investment trust — known when the executives worked there as American Realty Capital Properties and now called VEREIT — with misuse of a non-GAAP measure.
The case is notable because of its extreme rarity. Kaplan says that after a recent client inquiry about the prevalence of enforcement activity related to non-GAAP metrics, he conducted a search and could find only one prior such action. That was a 2009 case against SafeNet, a provider of identity and data-protection solutions, and its former CEO and CFO.
In both cases, the misuse of non-GAAP metrics was “egregious,” according to Kaplan, involving much more than simply the way the metrics were presented.
In the SafeNet action — which also included charges of backdating stock options — the defendants were charged with purposely misclassifying recurring expenses as non-recurring expenses that were backed out of a non-GAAP earnings measure.
In the more recent case, according to the SEC’s civil complaint, the executives manipulated the calculation of “adjusted funds from operations,” a non-GAAP measure the company used when providing earnings guidance, so that it appeared the company had met quarterly estimates when in fact it hadn’t. The executives, former CFO Brian Block and ex-CAO Lisa McAlister, are also facing criminal charges.
But, says Kaplan, companies shouldn’t rest easy in merely falling short of compliance with SEC regulations on presentation of non-GAAP metrics, without any egregiously nefarious intent.
“The proximity of the issuance of the C&DI’s, the announcement of the enforcement action, and the reported sweep of public earnings releases is likely not a coincidence but instead intended to send a message that the SEC is focused on these issues,” says Kaplan. “Whether a number is inflated or the disclosure just fails to comply with SEC guidance, the SEC views either as problematic.”
Indeed. A July blog post by Audit Analytics suggested that if non-GAAP reporting “isn’t topic number one among regulators, it must be close.”