In our first episode of GAAP Chats, hosts Chris Walworth and Mike Brundrett provide listeners with an overview of non-GAAP financial measures, the number one issue noted by the SEC in their comment letters to registrants.

The transcript of the episode starts below:

Mike: Let's play a game. All right. On the count of three, name the top issue noted by the SEC in their comment letters to registrants. Don't even think about it. Just name it. Ready? One, two, three.

Mike and Chris: non-GAAP financial measures..

Chris: What?

Mike: Did we just become best friends?

Chris: Yup.

Mike: Do you want to do a podcast episode on it? Yup. 

Welcome to GAAP Chats, the podcast dedicated to all things accounting brought to you by GAAP Dynamics. I'm your host, Mike Walworth, and with me, as always, is my faithful partner, Chris Brundrett. We hope you'll join us on our journey today as we share our passion for accounting and help change the way you train. Today we are talking about non-GAAP financial measures disclosed by public companies in their annual reports and other filings with the SEC. Chris, let me ask you a quick question. Why did we pick this topic?

Chris: Well, as we alluded to in the introduction, disclosure of non-GAAP financial measures has always been a number one area of SEC comment letters over the past several years. And as such, it's always a topic of discussion at the annual AICPA and CIMA Conference on Current SEC and PCAOB Developments.

Mike: And did they mention it this year?

Chris: Absolutely. It was a big, big topic of discussion. And some new interpretive guidance is out, which we'll talk about in a little bit.

Mike: Okay. And obviously companies are using non-GAAP financial measures, but are they using them more lately?

Chris: Non-GAAP financial measures are more popular than ever. And according to PwC the use of non-GAAP measures reported by public companies is increasing exponentially. In 1996, now, I know that was a long time ago, but in 1996, 59% of S&P 500 companies used at least one non-GAAP measure, while in 2020 that number jumped up to 94%. So, almost every public company out there is disclosing at least one non-GAAP financial measure.

Mike: Well, I didn't realize it was that high. What's causing the increase, or why do companies use non-GAAP financial measures?

Chris: Well, it helps companies better tell their story. These measures play an important role in delivering a company's view of its financial or operating results to supplement what's already captured in the GAAP financial statements. Management believes that non-GAAP financial measures provide investors with valuable insight into the information that management considers important when running the business.

Mike: Well, I guess that's certainly one take and you sound very “SEC-esque”. I guess alternatively you could say that it helps companies paint a rosier picture than is otherwise portrayed under GAAP. It's like the Instagram filter for GAAP financial statements. I kind of like what the former SEC accountant Lynn Turner said in 2020. He was describing non-GAAP financial measures, and he said “it's everything but the bad stuff”.

Chris: I will say non-GAAP financial measures present things better than their comparative GAAP measure, but that's why this is such a hot topic. But, we're also kind of jumping ahead a little bit. 

Mike: All right. I'll bring it back. So, let's start from the beginning. What exactly is a non-GAAP financial measure?

Chris: Quite simply, a non-GAAP financial measure is a numerical measure that excludes or includes amounts that are otherwise included or excluded in the comparable measure that's been calculated and presented under GAAP.

Mike: All right. So, can you give us some examples of non-GAAP financial measures used by companies?

Chris: There are lots of them, but one that most people are familiar with, and one of the most common examples, is EBIT, earnings before interest and taxes, and also EBITDA, earnings before interest, taxes, depreciation, and amortization. Companies might also present adjusted earnings, or adjusted EBITDA, which remove various one-time irregular or non-recurring items from either earnings or EBITDA. But, these are very common.

Mike: I've also seen companies use a measure “free cash flows.” What's that?

Chris: That's another really common one. Free cash flows are typically calculated as cash flows from operating activities coming from the cash flow statement prepared under GAAP less capital expenditures. So, that's sort of the “free cash flow”.

Mike: Okay. So, where are non-GAAP financial measures presented? Where do registrants actually include non-GAAP financial measures in the filings?

Chris: Well, they're in SEC filings, forms 10-Q, 10-K, they can be in registration statements like an S-1 or an S-4, earnings releases, really any public disclosures. It could be even measures found on a company's website or in an analyst or investor presentation.

Mike: So, do they actually include these things in the GAAP financial statements?

Chris: Absolutely not. Financial statements are always presented in accordance with U.S. GAAP - always have been, always will be. Where you find non-GAAP financial measures is outside of the financial statements. So, if you think about in a 10-K, you would find these in the MD&A, management's discussion and analysis, very commonplace for non-GAAP measures, but they could be all over the place in other parts of the filing that are outside of the financial statements. They're also in other filings or presentations by a company. You find them in press releases quite commonly. The rules that we're going to talk about even apply to verbal discussions, such as earnings calls.

Mike: And what specifically are the rules that govern these non-GAAP financial measures?

Chris: Well, first, let's clarify that non-GAAP financial measures are only really a public company issue, right? These are SEC rules, and as such it is the SEC that's providing the guidance. It consists of several things. We have Regulation G. Regulation G was sort of born out of the Sarbanes-Oxley Act all those years ago. We have Item 10(e) of Regulation S-K within the SEC's rules, and we have compliance and disclosure interpretations, otherwise known as C&DIs. Backing up a bit, these are a little bit like a layer. There's layers of these Regulations. We'll start off with Regulation G. Now, Regulation G applies to all non-GAAP financial measures. It doesn't matter whether it's in written communications such as a filing like a 10-K in the MD&A, or a press release, or even verbal communications. Reg G always applies. It applies everywhere. When disclosing a non-GAAP financial measure, Regulation G requires presentation of the most comparable financial measure calculated and presented in accordance with GAAP, and a reconciliation of the difference between the non-GAAP financial measure presented, and the comparable measure that's been presented and calculated in accordance with GAAP.

Chris: Moving on, we have item 10(e) of Regulation S-K. Now this Regulation is a bit more restrictive. Now, it applies to written communications to make it a little trickier, and we won't get into the details here today, but certain portions of Regulation S-K will apply to things like earnings releases. Most importantly, the predominance requirement that we'll talk about here in a minute, whereas all of item 10(e) will apply to non-GAAP financial measures that you would find in MD&A in a 10-K, for example. So, understanding those layers and where these different rules or pieces of these rules apply is important. There's lots of good discussion out there on the internet. This is kind of a legal issue. So, you'll see this a lot of times discussed by law firms. With item 10(e) of Regulation S-K again, more restrictive, it requires companies to disclose when using non-GAAP financial measures the most directly comparable GAAP. Financial measure, quantitative reconciliation, and management's purpose for using the non-GAAP measure. 

Mike: Does Regulation S-K say anything else?

Chris: It does. It says quite a few additional things. One, I've already mentioned. It says that 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 measure. You'll hear this prominence sort of discussion quite a bit when we talk about some of the findings that the SEC has had. In addition, a registrant should not exclude charges or liabilities that required, or will require, cash settlement absent an ability to settle in another manner from non-GAAP liquidity measures. So, you've got to be careful with liquidity measures that are set where we have a settlement in cash. In addition, a registrant should not adjust a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual. They continue to state that it applies when: 

1. The nature of the change or gain is such that it is reasonably likely to occur within two years, or 
2. There is a similar change or gain within the prior two years.

Bottom line is be very careful with anything that is referred to as non-recurring, infrequent or unusual, because oftentimes if something happens once it's going to happen again. It's okay to adjust for these things, but call it what it is. Be very careful. That's what this rule is saying. Some of the interpretations we'll talk about later, about using terminology such as non recurring, infrequent or unusual, it darn well better meet that definition.

Chris: All right. Finally, a registrant should not present non-GAAP financial measures on the face of the financial statements. Mike, you already asked that question, and we covered that because those are prepared in accordance with GAAP. Therefore, non-GAAP financial measures do not belong in the financial statements either on the face or in the notes. 

Mike: Then the question is, I know reading some of the SEC comments, this idea of sort of describing a non-GAAP measure “GAAP-like”, like “operating income”.

Chris: That's been a really big issue, and that's one of the rules in S-K; you can't use titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to titles or descriptions used for the GAAP financial measures. That's been a big issue. You really, really have to label these clearly as non-GAAP and avoid any confusion where people might think, “well, I don't know, is it GAAP? Is it non-GAAP?” Right? It's clearly labeled.

Mike: Is the SEC discouraging the use of non-GAAP?

Chris: No they are not. They are not discouraging the use of non-GAAP. What they are very clearly saying, and what they say every year when this issue comes up, is you can use these measures as long as you follow the rules. You have to follow the rules. Understanding the rules, understanding what rules apply to the various disclosures, as I mentioned earlier, sort of the layer of rules is really, really critical.

Mike: Yeah, and you and you mentioned earlier and, you know, you had these layers and we talked about Reg G, you talked about the item 10(e) of Regulation S-K, and then you mentioned something about these C&DIs. What are they? That's the last layer, right?

Chris: Yeah, right. The compliance and disclosure interpretations. These are put out by the SEC's staff. There's many others not just related to non-GAAP, but they're very helpful,sort of interpretive guidance on how to apply the SEC rules. This one in particular is in a question and answer kind of format. It's sort of “Can we do? How do we do?”

Chris: Yeah, right. But, it has grown and changed over the years. It's been updated numerous times, but it really is reflecting some of the issues that the SEC has seen out there. So, it digs a lot deeper.

Mike: Yeah. I think you mentioned it maybe earlier, when we were talking about the AICPA and CIMA Conference, that these C&DIs were most recently updated in December of 2022. Is that right?

Chris: Yeah, that's absolutely right. It was kind of cool for us nerdy accountants that they were announcing the release of these updated C&DIs at the conference. So, just reflecting their current thoughts, you know, and things change, right? Companies change things that are disclosed over the years as new issues emerge. They’re constantly updating these, but these are really, really good resources. They’re very easy to read because it's sort of in a question and answer format. Very helpful if you're dealing with these.

Mike: And I think what we're going to do is we're going to actually put a link to the most recently updated C&DIs in the note or in the description of this podcast. Listeners can actually download that. So, what are these C&DIs?

Chris: Again, lots of different questions and answers, but overall they state that non-GAAP measures can be misleading if they're presented inconsistently between periods, or maybe if they exclude charges but does not exclude gains. They clarify things like individually tailored accounting principles that are not permitted. I mean, I could go on and on. There's a lot of issues that are addressed by this document.

Mike: I've heard a lot about these,” individually tailored accounting principles.” Can you give us an example of what the SEC would consider an individually tailored accounting principle?

Chris: Absolutely. I can see why this has been a struggle for companies, because there's certainly some gray area between a non-GAAP financial measure, which is including or excluding certain things, it wouldn't be in the comparable GAAP measure, and a tailored accounting principles. So, I think it's a good one too, to highlight. A good example of an individually tailored accounting policy, which is not allowed, let's be clear about that, would be when a new pervasive accounting rule is adopted. A great example would be ASC topic 606, Revenue from Contracts with Customers, or ASC 326 which is Credit Losses. Some companies decided to disclose, for example, what their revenue would have been under the old standard ASC topic 605. For example, maybe accelerating revenue recognition to the current period that, under the new rule, would have required them to recognize it over time. That is not allowed. Or what their allowance for loan and lease losses would have been had they not had to implement the new expected credit losses model. Under the old model it was lower, so you're disclosing a lower number. So, the SEC does not like that.

Mike: I can see why because, you know, the FASB issues a new standard and companies are like, screw it, I don't like this new standard. I don't like how it makes me look, so I'm just going to continue to follow the old rules.

Chris: Yeah, that's exactly right and it’s not allowed. 

Mike: As we mentioned before, we just got back from the AICPA CIMA Conference in D.C. GAAP Dynamics sponsored a table or we were one of the underwriters, and then you, Bob, Rachel, and Jenny actually attended the conference. We mentioned they announced the release of these new and updated C&DIs. Can you give us a little bit of insight on these updates?

Chris: Absolutely. It was just adding some additional questions and answers . It's really looking at some examples, highlighting some of the hot topics in this area over the last few years. While non-GAAP financial measures has been a hot topic for many, many years, what the focus from year to year does change. Individually tailored accounting principles has been kind of a hot topic the last few years. They highlighted some others like the prominence of the presentation that we discussed. That's been a big issue and that makes non-GAAP financial measures misleading.

Mike: Are there any other high level takeaways? I mean, like I said, you attended the conference. I did not. I was manning the table representing GAAP Dynamics. What other high level takeaways related to non-GAAP financial measures? FYI, we'll probably do a different podcast on the big high level takeaways from the whole conference. However, regarding non-GAAP financial measures, what other takeaways did you have?

Chris: Well, just one that pops into mind, and this is my opinion, but having watched this issue over the years, and having been in practice when Reg G actually came out, there has been a kind of shift of what we think the SEC's views are on non-GAAP measures. What I mean by that is when Reg came out, non-GAAP financial measures existed long before Reg G, and when that came out, people said, “okay, well, the party's over, right? The SEC's sort of shutting it down. They don't want us to use these non-GAAP financial measures.” It took a number of years. We actually saw a decline, for a little while, in a number of measures, and it took a number of years.The SEC came and released the first version of this CD&Is, and they sort of said, “hey, you know, time out. We're okay with companies using these measures. We believe that sometimes they're very important for the readers of the filing to understand management's view. We aren't discouraging the use of them, but if you use them, you have to follow the rules.” That's always been their take. You know, that's kind of what came out. When they sort of cracked down a little bit more, there was sort of that feeling, again, that maybe they don't want us using these measures. The SEC continues to clarify they’re okay with these measures being used as long as they are used properly. You need to follow the rules. That's kind of the takeaway.

Mike: In your opinion, since you're into giving opinions now, if you had to pick five, what are the top five most common issues that the SEC has noted in its reviews of registrants regarding non-GAAP financial measures? 

Chris: I’ve got to narrow it down to five? 

Mike: Yes. Let's try it. I mean, everyone likes a top five list.

Chris: If we had to narrow it down to five, I would say the prominence issue. So, the GAAP measure not given enough prominence as compared to the non-GAAP measure. The reconciliation surprisingly continues to be an issue between the GAAP and the non-GAAP measure. It's either missing, or it doesn't start with the GAAP measure. They've clarified that numerous times over the years. The reconciliation starts with GAAP, and ends with non-GAAP. It ties into that prominence thing that we just talked about. Another one, adjustments to eliminate or smooth items identified as non recurring, infrequent, or unusual. They're not appropriate if those items are not truly non recurring, infrequent, or unusual. That's been an issue. Non-GAAP measures based on individually tailored accounting principles. We already highlighted that one. Allso management's explanation of why a non-GAAP measure is useful to investors, that is required, and sometimes it's missing, but other times it's there but it's inconclusive. We don't really know why, right? I mean, it's not cool to say, “Oh well, it's important because it's important”, right? You've got to explain. 

Mike: Yeah. So, no boilerplate disclosures, right?

Chris: Right.

Mike: Well, that is a pretty good list off the top of your head. Honestly, I think we could get into each of those in a bit more detail, and we probably should. We're kind of out of time now. But would you agree to maybe do another podcast on these top five issues that you noted?

Chris: I think that sounds like a plan.

Mike: Awesome. Well, why don't you take us out for this episode?

Chris: That's all for this episode of GAAP Chats. Your source for all things accounting. Notes and resources from today's episode are linked in the description. As always, you can find us online at gaapdynamics.com, and @gaapdynamics across social media. It's never too late to become a gaapologist. Head over to our website and subscribe to our blog so that you are the first to know what's new with GAAP dynamics.

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