“Another financial reporting topic of shared interest and current conversation is the use of non-GAAP financial measures. This area deserves close attention, both to make sure that our current rules are being followed and to ask whether they are sufficiently robust in light of current market practices.” – SEC Chairman Mary Jo White; Keynote address at the 2015 AICPA National Conference on Current SEC and PCAOB Developments

This week’s GAAP Flash includes articles about non-GAAP financial measures, which have been a “hot topic” in the news recently.

Fantasy Math is Helping Companies Spin Losses into Profits (April 22, 2016) – The New York Times (@nytimes)

According to a recent study in the Analyst’s Accounting Observer, 90% of companies in the S&P 500-stock index reported non-GAAP financial measures last year, up from 72% in 2009. Among 380 companies that were in existence both last year and in 2009, the study showed, non-GAAP net income was up 6.6% in 2015 compared with the previous year. However, under generally accepted accounting principles (GAAP), net income at the same 380 companies in 2015 actually declined almost 11% from 2014.

How It’s Relevant: Non-GAAP financial measures are numerical measures that excludes (or includes) amounts that are otherwise included (or excluded) in the comparable measure calculated and presented under GAAP. Section 401 of the Sarbanes-Oxley Act:

• Prohibits material misstatements or omissions making a non-GAAP financial measure misleading, and
• Requires a reconciliation of the non-GAAP financial measure presented with the financial condition and results of operation of the issuer.

Use of non-GAAP financial measures is on the rise and the Securities and Exchange Commission (SEC) is watching!

SEC Cracks Down on Novel Earnings Measures That Boost Profits (April 28, 2016) – The Wall Street Journal (@wsj)

The SEC is stepping up its scrutiny of companies’ use of non-GAAP financial measures, signaling it plans to target firms that inflate their sales results and employ customized metrics that stray too far from accounting rules. Firms that sell their product on a subscription model, for instance, are required to book the revenue as they deliver the goods or services under U.S. GAAP. But, some firms are using non-GAAP financial measures that assume all sales are recorded as soon as customers are billed, which adds revenue to their books earlier than what is allowed under GAAP. “The point is, now the company has created a measure that no longer reflects its business model,” said Mark Kronforst, chief accountant of the SEC’s corporation financial division. “We’re going to take exception to that practice.”

How It’s Relevant: The SEC doesn’t discourage use of non-GAAP financial measures, but, if disclosed, they need to be in compliance with SEC rules and regulations.

When disclosing a non-GAAP financial measure, Regulation G, which covers any public disclosure or release of material information, requires:

• Presentation of the most comparable financial measure calculated and presented in accordance with GAAP; and
• Reconciliation of the differences between the non-GAAP financial measure presented and the comparable measure calculated and presented in accordance with GAAP.

Regulation S-K requires the following disclosures when using non-GAAP financial measures:

• Most directly comparable GAAP financial measure
• Quantitative reconciliation
• Management’s purpose for using the non-GAAP measure

SEC Official Registers Objectives to Non-GAAP Reporting (May 6, 2016) – Accounting Today (@AccountingToday)

During a recent speech, Wesley Bricker, chief accountant with the SEC, said “Recent examples of company practices related to non-GAAP measures have caused concern, including the use of individually-tailored accounting principles to calculate non-GAAP earnings; providing per share data for non-GAAP performance measures that look like liquidity measures; and non-GAAP tax expense.”

How It’s Relevant: Non-GAAP financial measures should help investors understand and analyze core-operating results. Regulation S-K states a registrant should not:

• Present the non-GAAP financial measure in a manner that would give it greater authority or prominence over the comparable GAAP financial measure;
• Exclude charges or liabilities that required, or will require, cash settlement absent an ability to settle in another manner from non-GAAP liquidity measures;
• Adjust a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent, or unusual, when (1) the nature of the change or gain is such that it is reasonably likely to recur within two years, or (2) there was a similar charge or gain within the prior two years;
• Present non-GAAP financial measures on the face of the financial statements prepared in accordance with GAAP or in the accompanying notes;
• Present non-GAAP financial measures on the face of any pro forma financial information required to be disclosed in Article 11 of Regulation S-X; or
• Use titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures.

IASB Chair Rings Alarm Over Use of Non-GAAP Measures (May 11, 2016) – WSJ CFO Journal (@CFOJournal)

Accounting rule setters should play a larger role in reining in the use of non-standard measures, according to Hans Hoogervorst, chairman of the International Accounting Standards Board (IASB). In remarks to the European Accounting Association, Mr. Hoogervorst said the growing use of measures outside GAAP to present a more favorable picture of company performance is a concern for investors and regulators. He believes there is growing evidence “of these measures becoming increasingly misleading.”

How It’s Relevant: It’s uncertain what the IASB or Financial Accounting Standards Board (FASB) can do, given they are responsible for GAAP rules only, but these Boards certainly are jumping on the bandwagon. At the 2015 AICPA National Conference on Current SEC and PCAOB Developments, the following common “issues” were noted with respect to non-GAAP financial measures:

• Not clearly labeling the measures, their underlying components, and how each adjustment is calculated
• Using them to smooth earnings or adjust for “non-recurring” items that regularly occur
• Presenting them more prominently than the corresponding GAAP measures
• Using accounting terms that do not conform to the acceptable definition within GAAP
• Failing to disclose changes in how they are calculated year-over-year
• Describing them using boilerplate disclosures

Technical Line: Spotlight on Non-GAAP Financial Measures (April 28, 2016) – EY (@EYNews)

This publication by EY puts the “spotlight” on non-GAAP financial measures, giving preparers a good summary of the rules and why it is an area of focus for regulators.

How It’s Relevant: Preparers should carefully consider the use and disclosure of non-GAAP financial measures to ensure they are clear and useful to investors and ask themselves:

• Why are we using the non-GAAP financial measure, and how does it give investors useful information?
• Are non-GAAP financial measures no more prominent than the GAAP measures, as required by SEC rules?
• Are the explanations of how we use the non-GAAP financial measures and why they are useful to investors accurate and complete? Have they been drafted without boilerplate language?
• Are there appropriate controls over the calculation of non-GAAP financial measures?

If you decide to disclose non-GAAP financial measures, be sure you are up-to-speed with the relevant rules because the regulators are on the prowl!

Disclaimer  

This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.