If there is one financial reporting topic that is consistently commented on by the SEC, it’s the proper use of non-GAAP financial measures. It’s not that the SEC dislikes the use of these measures, rather it’s just that they want public companies to follow the rules. Those rules can be found in Regulation G and Item 10(e) of Regulation S-K. Regulation G establishes rules for any public presentation of non-GAAP financial measures, which can include earnings releases and other public disclosure, in addition to SEC filings such as Forms 10-Q and 10-K. Item 10(e) provides additional requirements for non-GAAP financial measures included in SEC filings.
As a quick reminder before we focus on recent comments, a non-GAAP financial measure is a numerical measure that excludes (includes) amounts that are otherwise included (excluded) in the comparable measure calculated and presented under GAAP. Basically, they are numerical measures that adjust GAAP amounts in some way. Common examples are earnings before interest, taxes, depreciation, and amortization (EBITDA), adjusted EBITDA, and adjusted earnings per share. If you would like a quick reminder of the basic rules for the use of non-GAAP financial measures outlined by Regulation G and Item 10(e) of Regulation S-K, click here.
With the reminder out of the way, let’s take a look at some recent comments by the SEC on the proper use of non-GAAP financial measures starting with a hypothetical example. Consider the following disclosure made by T. Swift National Bank (a fake company) in the MD&A section of their Form 10-Q:
We adopted ASC 326, Financial Instruments – Credit Losses, as of January 1, 2020. Net income, excluding the effects of expected credit losses, was $26.3 million for the three-months ended March 31, 2020 and $25.4 million for the three-months ended March 31, 2019."
Do you see any issues with this non-GAAP financial measure?
Outside of the fact that the measure hasn’t been reconciled to the nearest GAAP measure, potential prominence issues, etc., there are others. Let’s assume for a moment that the basic rules have been met, as described in the reminder above. What other issues exist? Overall, this non-GAAP financial measure is what the SEC refers to as a “tailored accounting policy” and would not be acceptable. The SEC has highlighted the issue of tailored accounting policies in the past, stating that non-GAAP financial measures involve the inclusion or exclusion of GAAP amounts. However, adjustments that change the accounting policy or method of recognition of an accounting measure are considered misleading and are not permitted. This issue is discussed in the SEC’s Compliance and Disclosure Interpretation (C&DI) on non-GAAP financial measures. This is a helpful resource when preparing or reviewing non-GAAP financial measures as it provides the SEC’s interpretation of the basic rules by way of Q&A.
Past comments by the SEC have highlighted items such as tailored accounting policies around revenue recognition (e.g. presenting revenue on a gross basis when the entity is actually an agent). More recently, the SEC has seen the use of non-GAAP financial measures around the adoption of new standards. The SEC recognizes that companies may consider using non-GAAP financial measures to make it easier for investors to compare current results with those of prior periods when a new standard has been adopted without full retrospective application. However, the SEC believes that generally these measures are inappropriate because they are considered to have been prepared using individually tailored accounting policies, which are considered unacceptable. Although MD&A is supposed to provide period to period comparability, the SEC generally considers non-GAAP financial measures that unwind the effect of a newly adopted accounting principle to be misleading, even when presented for the purposes of discussing comparability with prior periods. The only exception to this is when the transition guidance in the standard itself requires such disclosure.
While the use of tailored accounting policies has been a particular issue that has generated numerous comments, the SEC Staff has made other recent comments as well:
- Excluding costs necessary to generate revenues can be misleading and is therefore often an inappropriate non-GAAP financial measure – e.g. presentation of a “contribution margin”. If a measure such as contribution margin is determined not be misleading and is presented, then it generally should be presented with and reconciled to a “fully loaded” GAAP gross margin, regardless of whether that gross margin is presented on the income statement.
- Ensure measures are calculated consistently period to period – if adjustments are made, clearly explain what those adjustments are and why they were made.
- Non-GAAP financial measures are supposed to be measures that are used by management to run the business, not measures that are prepared solely for disclosure to investors. This type of measure has been referred to by SEC Chairman Clayton as “window dressing”.
- Well developed, rigorous disclosure controls and procedures are important for non-GAAP financial measures.
At this point you might be thinking “wow, we’ve almost made it through an entire blog post without mentioning COVID-19!” Not so fast. The SEC has also made recent comments about the use of non-GAAP financial measures to describe the impact of COVID-19. Some of the key provisions of this guidance are:
- Companies that present a non-GAAP financial measure to explain the impact of COVID-19 should describe why management finds the non-GAAP financial measure to be useful, and how it can be helpful to investors in assessing the impact of COVID-19.
- There may be instances when the nearest GAAP financial measure is not available at the time of an earnings release because it has not yet been finalized. The SEC would not object to a reconciliation to a preliminary GAAP measure as long as proper disclosure is made and prominence rules are followed.
- Limit the non-GAAP financial measures in earnings presentations to those measures that are reported to the board of directors (e.g. the purpose is to communicate to investors how management and the board are analyzing the effects of COVID-19 on the company, not to present a more favorable view of the company’s results).
More information on this COVID-19 related guidance as well as other related disclosure topics can be found in the SEC’s Division of Corporation Finance “Disclosure Guidance: Topic No. 9, Coronavirus (COVID-19)” and “Disclosure Guidance: Topic No. 9A, Coronavirus (COVID-19)”.
Overall, the SEC Staff continues to note issues with proper use and presentation of non-GAAP financial measures. The particular issues, and comments made on those issues, evolve as the financial reporting environment changes. In 2020, those changes include the adoption of new accounting standards and the impacts of COVID-19, among others. Regardless of the specific issues, one recent message from the SEC Staff continues to apply and that is for companies to engage in “responsible” non-GAAP reporting.
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