Companies Using Non-GAAP Metrics Should Watch Out for the SEC

Companies are permitted to report non-GAAP metrics along with the comparable GAAP measures provided they detail the difference between the two. But the SEC is looking more closely at non-GAPP metrics usage, “as concerns have mounted that these metrics could mislead investors” by “painting two different pictures of” companies’ performance” and making their earnings “look stronger than they really are,” The Wall Street Journal reported. Typically, the Journal said, these measures “strip out” non-cash and non-recurring items from companies’ results to present what the latter contend is a clearer view of their true earnings and performance. However, the SEC and other critics hold that the metrics can be abused, omitting normal operating costs and additional items that should not be so, to give (companies’) finances a rosy glow they don’t deserve,” the newspaper stated.

The SEC has begun to release more comment letters to companies, in which its staff question their use of non-GAAP measures. In late May, the regulator went after embattled pharmaceuticals manufacturer Valeant Pharmaceuticals International based on concern about the manner in which it has been disclosing these measures, according to Reuters, which was siting regulatory filings. Specifically, Reuters observed, the SEC questioned Valeant’s practice of “stripping away acquisition-related expenses from its non-GAAP, or adjusted, metrics,” in light of the fact that the pharma manufacturer “had been fueling growth through frenzied deal-making.” The SEC is also questioning Valeant’s disclosure of the tax effects of the costs it omitted from its non-GAAP measures, calling the strategy “potentially misleading,” Reuters reported.

“We are sending a message, and we are going to continue talking about it,” Mark Kronforst, chief accountant of the SEC’s corporation finance division, told the Journal, adding that companies can expect even more of an “uptick” in the number of SEC comments being issued. In March, SEC Chairman Mary Jo White said the commission is considering implementing new regulations aimed at reining in non-GAAP use, according to Reuters.

Additionally, White, SEC Chief Accountant James Schnurr and SEC Commissioner Kara Stein have all publicly cited problems with the use of non-GAAP metrics, calling them “confusing,” according to MarketWatch. Meanwhile, James Doty, chairman of the Public Company Accounting Oversight Board (PCAOB) weighed in on the issue while requesting a “large budget” from the SEC for the PCAOB’s oversight of “the auditors who scrutinize company compliance.” Doty told the SEC that “companies’ use of unaudited and non-GAAP metrics proliferates,” MarketWatch reported.

In a recent address to accountants and attorneys who serve pharmaceutical and biotechnology manufacturers, Schnurr said that non-GAAP measures are intended to supplement, rather than substitute for information contained in companies’ financial statements. “I am particularly troubled,” Schnurr said in his address, “by the extent and nature of the adjustments to arrive at alternative financial measures of profitability, as compared to net income and alternative measures of cash generation, as compared to the measures of liquidity or cash generation,” MarketWatch said.

The SEC is advocating that companies “self-correct” the way they utilize non-GAAP metrics in the next quarter, according to the Journal. It is also urging companies to review a new guidance that clarifies issues surrounding these metrics. As an example, the newspaper stated, the guidance specifies the conditions under which the SEC believes a given company is affording “too much prominence to non-GAAP metrics at the expense of (its) standard GAAP measurements”—for instance, discussing non-GAAP measures in an earnings release before disclosing the comparable GAAP measure or presenting a full income statement of non-GAAP measures.

In the past, Kronforst told the Journal, the SEC has shown “some deference” to companies that present their own customized metrics in a way they truly believe investors want to see them. “Now, I think we’re going to step back from that,” he added.

With the SEC keeping the heat on non-GAAP metrics, CEOs should ensure that their companies stay away from the flame or risk the consequences down the road.