Earnings season is upon us, which means that once again it’s time to pay careful attention to “Regulation G.” In the wake of a string of high-profile corporate accounting scandals and the subsequent passage of the Sarbanes-Oxley Act, the Securities and Exchange Commission adopted “Reg G” in January. As of March 28, 2003, the regulation requires companies to state when their earnings reports don’t follow national accounting standards.
Specifically, Reg G governs the presentation of pro forma financial information in earnings releases and similar public announcements. Companies are now required to also furnish numbers that comply with generally accepted accounting principles (GAAP). As a result, whenever a company discloses or releases material information that includes pro forma information, it needs to reconcile the difference between the pro forma and GAAP numbers.
Executives need to be able to discuss both sets of numbers with the investing public and to explain why the company is using one set as its standard rather than the other.
According to a survey of National Investor Relations Institute (NIRI) members released in June, 56.1 percent of respondents said that their companies report both GAAP and non-GAAP earnings results; 26.4 percent said they are reporting GAAP only. Another 16.3 percent specified that they are reporting GAAP but that they previously reported non-GAAP results. Nearly 47 percent of respondents from companies that report only GAAP results said they are doing so specifically because of the requirement in Reg G.
Small Changes, Big Issues
For many companies, even seemingly small changes related to Reg G require meticulous attention. That turned out to be the case at El Segundo, California-based Mattel Inc., which uses just one non-GAAP financial metric: gross sales.
“There’s no such thing as gross sales in the GAAP world,” explains Dianne Douglas, Mattel’s vice president for investor relations. However, the toy maker uses that metric to give more information about its business units, since net sales — a GAAP metric — is not available in similar detail.
Mattel handled Reg G requirements by reporting the gross sales detail and reconciling the total to net sales, by adding exhibits to its quarterly earnings releases with in-depth reconciliation information, and by posting similar information on its web site. In addition, says Douglas, “When we do presentations, just as we used to have our Safe Harbor statement, now we also have a Reg G statement at the very beginning.”
Mattel considered converting entirely to GAAP as early as this year, but it set aside the idea for now because the company felt that GAAP-only reporting would misrepresent its numbers. “We are going through a restructuring,” says Douglas. “We had significant charges in 2001; they were going to be less in 2002. We could have just reported GAAP numbers and they would have looked phenomenal, but that’s the reason we didn’t do it, because we didn’t want to be criticized for making the change.”
Barnes Group Inc., located in Bristol, Connecticut, also reported primarily GAAP figures prior to the advent of Reg G, with the exception of two numbers: free cash flow and EBITDA. The EBITDA number presented a particular problem for the diversified manufacturer, since buy-side and sell-side analysts favor the metric “enterprise value to EBITDA” to assess companies in the industry.
“Although all of the components of EBITDA are GAAP numbers, the actual number EBITDA itself is not,” notes Phillip J. Penn, the director of investor relations for Barnes. The company reconciles EBITDA for investors in select cases, such as in a prospectus filed for an equity offering completed earlier in 2003. “But except for that circumstance, we have largely stopped using it as a measurement tool,” says Penn.
Since free cash flow is also a non-GAAP measure, Barnes has moved away from providing related information in its quarterly earnings discussions. Now the company tends to focus more on balance-sheet highlights than on the actual cash flow generated during the quarter.
In a move that other companies may choose to emulate, Barnes Group established a disclosure committee shortly after the enactment of Sarbanes-Oxley, helping it to sidestep some potential Reg G landmines. “It’s absolutely vital that companies have that disclosure committee, and that it represent a fairly broad range of disciplines throughout the company,” advises Penn.
Analysts Shouldn’t Choose Your Numbers
According to 52 percent of the respondents to the NIRI survey, analysts are basing their earnings estimates on both GAAP and non-GAAP information. Although companies seeking to maximize analyst coverage may feel pressured to supply both sets of figures, from a legal perspective this policy seems less advantageous.
“I wouldn’t let analysts decide what number you are going to use,” says Cynthia M. Krus, a partner at the Washington, D.C., office of law firm Sutherland Asbill & Brennan LLP. As long as companies provide reconciliation information, it is acceptable to use non-GAAP numbers in earnings releases, she explains, but using two sets of numbers can create unnecessary confusion.
“I’ve seen analysts report the wrong number,” recalls Krus. “So I’d be very, very clear about what your bottom-line per-share earnings are, regardless of what analysts are doing.”
Sutherland Asbill & Brennan offers a “road map” for companies to help them comply with Reg G during the earnings-release process. “Companies need to be conscious of Reg G at the outset,” says Sutherland’s Krus. “Your whole timetable needs to take Reg G into account.” In brief:
- The company should issue a press release with the date and time that earnings will be announced, as well as the customary information regarding the earnings call, including where on the company web site the audio archive will be posted.
- If the earnings release includes a material non-GAAP financial measure, the company must include in the earnings release a presentation with the most directly comparable GAAP financial measure, as well as reconciliation between the non-GAAP and GAAP measures.
- If the earnings release contains a material non-GAAP financial measure, the company’s Form 8-K earnings-release filing must explain why the non-GAAP measure provides more-useful information to investors. The company is also required to include a statement disclosing any additional purposes for which management uses the non-GAAP measure.
- The company should review the script for the earnings call to determine if any non-GAAP financial measure will be communicated during the call. If so, the company needs to provide a comparable GAAP measure and GAAP reconciliation on the company’s web site before the call begins.
- The company should hold the earnings call within 48 hours of publicly disseminating the earnings release and furnishing Form 8-K to the SEC. The earnings call must be broadly accessible to the public. If, during the earnings call, the company discloses any material non-GAAP financial measure, the company must disclose to participants on the call the specific location on its web site of the most directly comparable GAAP measure as well as GAAP reconciliation information.
- Immediately after the earnings call, the company should post an audio archive of the call on the company web site.
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