In Episode #2 of GAAP Chats, hosts Mike Walworth and Chris Brundrett provide listeners with an explanation of the top 5 issues associated with non-GAAP financial measures, as noted by the SEC in their comment letters to registrants.
The following content is a detailed outline of Episode 2 of the GAAP Chats podcast. It does not represent a full transcript of the show. You can listen to the full audio here.
Mike: In a previous episode of GAAP Chats, I sat down with Chris to provide listeners with an overview of non-GAAP financial measures. That episode ended with us listing the top 5 non-GAAP issues noted by the SEC in their comment letters to registrants. In this episode we pick up where we left off providing listeners with a deeper dive into these 5 issues.
Mike: 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.
Mike: Chris, I wanted to pick up where we left off on our last episode and get into the weeds a bit on those top 5 issues associated with non-GAAP measures that you so eloquently came up with off the top of your head.
Chris: Sounds good.
Mike: And to recap, these issues, in no particular order, relate to:
- The prominence with which the non-GAAP measure is being disclosed
- The reconciliation between the GAAP measure and the non-GAAP measure
- The appropriateness of adjustments within that reconciliation
- Individually-tailored accounting principles; and
- Management’s explanation of “why” they are using such measures
Chris: I’m sure there’s other “issues” too, but that’s a pretty good list.
Mike: Let’s start with prominence. What are we talking about?
Chris: Well, SEC rules require that if a registrant is presenting a non-GAAP financial measure, the most directly comparable GAAP measure must be disclosed and the non-GAAP measure must be reconciled to it. Furthermore, the comparable GAAP measure must be presented in the filing with “equal or greater prominence” (those are words right out of the regulations) as compared to the non-GAAP measure.
Mike: So, what is the issue?
Chris: Well, at a high level, the SEC has seen filings where the GAAP measure was not given as much prominence as compared to the non-GAAP measure.
Mike: Can you give us some examples of disclosures that would cause a non-GAAP measure to be more prominent than the GAAP measure and, thus, be in violation of the rules?
Chris: I can, and they come courtesy of the SEC!
Mike: What do you mean?
Chris: The SEC has published Compliance & Disclosure Interpretations (or “C&DIs” as we nerdy accountants call them) which comprise the Division’s interpretations of the rules and regulations on the use of non-GAAP financial measures. These C&DIs were most recently updated on December 13, 2022. So, not very long ago!
Mike: That’s a great resource. Let’s provide a link to the C&DIs in the podcast notes. So Chris, what do the C&DIs say about prominence?
Chris: Question 102.10 within the C&DIs is where we find the SEC’s views on prominence. Here are some of the examples of non-GAAP measures that are more prominent that the comparable GAAP measure:
- Presenting a non-GAAP income statement.
- Presenting a non-GAAP measure before the most directly comparable GAAP measure or omitting the comparable GAAP measure altogether, including in an earnings release headline or caption that includes a non-GAAP measure.
- Presenting a ratio where a non-GAAP financial measure is the numerator and/or denominator without also presenting the ratio calculated using the most directly comparable GAAP measure(s) with equal or greater prominence.
- Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font, etc.) that emphasizes the non-GAAP measure over the comparable GAAP measure.
- Describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure.
- Presenting charts, tables or graphs of a non-GAAP financial measures without presenting charts, tables or graphs of the comparable GAAP measures with equal or greater prominence, or omitting the comparable GAAP measures altogether.
- Providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence.
Mike: Basically, the non-GAAP measure cannot get “special treatment” as compared to the comparable GAAP measure.
Chris: You got it!
Mike: By the way, what is a non-GAAP income statement?
Chris: It is one that is comprised of non-GAAP measures and includes all or most of the line items and subtotals found in a GAAP income statement.
Mike: So, basically, a fake income statement, and, I remember, in our previous podcast, you’re not allowed to use confusing descriptions or titles, right?
Mike: Let’s move into issues associated with the reconciliation. Item 10(e)(1)(i)(B) of Regulation S-K requires that registrants that disclose a non-GAAP measure reconcile it to the comparable GAAP measure. What are some of the issues noted by the SEC related to this reconciliation?
Chris: Well, for starters, some registrants do not include a reconciliation at all!
Mike: Woah! Obviously that’s a big omission. But assume they do include a reconciliation. What else is the SEC noting?
Chris: Another issue is starting the reconciliation with the non-GAAP measure.The SEC has made it pretty clear that you must start the reconciliation with the comparable GAAP measure.
Mike: Got it. So it starts with the GAAP measure and reconciles down to the non-GAAP measure. Anything else?
Chris: Registrants should ensure that both the non-GAAP measures and related adjustments should be clearly and transparently labeled as such. The appropriate conventional accounting terminology should be used, and the context of the presentation of such measures should be clear. For example, when labeling a non-GAAP financial measure, a registrant must not use titles or descriptions used for GAAP financial measures or amounts presented under SEC Regulation S-X, which could be misleading.
Mike: What about the infamous use of the “other” line item in the reconciliation?
Chris: Yep. A registrant should not use a reconciling item labeled “other” that includes numerous significant items without clearly disclosing the nature of the items being used, along with the related amounts for each adjustment. Don’t use “other” unless the number is significant. What we see a lot of times is that the “other” number is small, but if you look inside you see larger, offsetting numbers. That’s bad news. They need to be labeled properly.
Misleading or inappropriate adjustments
Mike: Let’s move into a discussion about misleading or inappropriate adjustments. We're talking about adjustments to the comparable GAAP measure to get to the non-GAAP measure. Can you give us an example of some of the issues noted with these adjustments that the SEC has found?
Chris: Sure! Probably the most common is labeling a measure as nonrecurring, infrequent, or unusual. That is a problem particularly if it excludes amounts resulting from an event that has occurred in the last two years or is expected to occur again in the next two years. Now, to be clear, you can still make the adjustment, but you just can’t label it “nonrecurring, infrequent, or unusual.” That’s a problem. You can still make the adjustment. Just call it what it is.
Mike: Does the SEC say two years, or is that made up?
Chris: Yes, two years is in the guidance. It’s in the C&DI. So take a look at that for more detail on this, but I would just caution you at a high level. Be very careful using that.
Mike: That reminds me of the “extraordinary items” in an income statement, and they took that out.
Mike: Makes sense because that is misleading. Regulation G prohibits the presentation of any non-GAAP financial measure if it contains a material misstatement or omits information that makes the measure misleading. Can a non-GAAP measure be misleading if it, and/or any adjustment made to the GAAP measure, is not appropriately labeled and clearly disclosed?
Chris: Yes. Non-GAAP measures are not always consistent across, or comparable with, non-GAAP measures disclosed by other companies. That is just by their nature that they’re unique to different companies. Without an appropriate label and clear description, a non-GAAP measure and/or any adjustment made to arrive at that measure could be misleading to investors. The following examples would violate Rule 100(b) of Regulation G:
- Failure to identify and describe a measure as non-GAAP.
- Presenting a non-GAAP measure with a label that does not reflect the nature of the non-GAAP measure, for example:
- A contribution margin that is calculated as GAAP revenue less certain expenses, labeled “Net Revenue”;
- Non-GAAP measure labeled the same as a GAAP line item or subtotal even though it is calculated differently than the similarly labeled GAAP measure such as “Gross Profit” or “Sales” (remember, you can’t use a GAAP description for a non-GAAP measure. That is really confusing to readers); and
- A non-GAAP measure labeled “pro forma” that is not calculated in a manner consistent with the pro forma requirements in Article 11 of Regulation S-X.
Mike: Chris, remember that company we were looking at last month that was presenting EBITDA, a non-GAAP measure, and in the adjustment back to net income, they had a current goodwill impairment charge as an adjustment. What do you think about that?
Chris: Well, EBIT is defined as “earning before interest and taxes” and EBITDA is defined as “earnings before interest, taxes, depreciation, and amortization.” The “i” stands for interest, not impairment. Measures calculated differently than those described should not be classified as “EBIT” or “EBITDA” and their titles should be distinguished from “EBIT” or “EBITDA,” such as “Adjusted EBITDA.”
Mike: So what should they have done?
Chris: You can have an adjusted EBITDA. So I’ve worked down to my EBITDA calculation, and then make further adjustments after that.
Mike: What else does the SEC say about misleading adjustments?
Chris: They have indicated that non-GAAP measures could mislead investors if:
- They exclude normal, recurring cash operating expenses necessary for business operations;
- They are presented inconsistently between periods, such as by adjusting an item in the current reporting period, but not a similar item in the prior period, without appropriate disclosure about the change and explanation of the reasons for it;
- They exclude certain nonrecurring charges, but do not exclude non-recurring gains, in other words “cherry picking” non-GAAP adjustments to achieve the most positive measure; or
- They are based on individually tailored accounting principles, including certain adjusted revenue measures.
Mike: That’s a nice segue into individually tailored accounting principles. What are we talking about here?
Chris: Probably the best way to answer that question is to give you an example. Say a company was implementing ASC 606 Revenue from Contracts with Customers and realized that they, under 606, now had to recognize revenue from certain contracts at a point in time, basically waiting until control of the performance obligations has transferred to the customer, instead of over time as they had been doing prior to adopting ASC 606. They’ll obviously show less revenue under GAAP, so they decide to present a non-GAAP measure showing what revenue would have been had they recognized it over time.
Mike: That’s a bunch of BS!
Chris: Exactly! A company is not allowed to make up its own GAAP! Non-GAAP adjustments that have the effect of changing the recognition and measurement principles required to be applied in accordance with GAAP would be considered individually tailored and may cause the presentation of a non-GAAP measure to be misleading. Examples the staff may consider misleading include, but are not limited to:
- Changing the pattern of recognition, such as including an adjustment in a non-GAAP performance measure to accelerate revenue recognized ratably over time in accordance with GAAP as though revenue was earned when customers were billed;
- Presenting a non-GAAP measure of revenue that deducts transaction costs as if the company acted as an agent in the transaction, when gross presentation as a principal is required by GAAP, or the inverse, presentation a measure of revenue on a gross basis when net presentation is required by GAAP; and
- Changing the basis of accounting for revenue or expenses in a non-GAAP performance measure from an accrual basis with GAAP to a cash basis.
Mike: Wow! All the examples provided by the SEC are focused on revenue recognition. Makes sense given the importance of that financial statement line item.
Chris: Another example could be presentation of gross or adjusted revenue that adds back sales discounts, return allowances, or other concessions to revenue as an adjusted gross sales measure because this presentation would be a substitute for a GAAP accounting recognition and measurement method.
Mike: I think we mentioned in the last podcast, a lot of times these individually tailored accounting principals kind of come up when a new standard comes. So companies are like, “this is what it would have been.”
Chris: That’s right. And companies may try to argue that it’s important to the users of the financial statements to understand the change. But remember, there are disclosure requirements leading up to the adoption of a new standard where you are disclosing the anticipated effect of that standard. So, that’s a bad argument. As you said, it’s time to move forward, you can’t look back.
Disclosing the “Why”
Mike: And last but not least are the issues surrounding management disclosures of the “why” behind their use of non-GAAP financial measures.
Chris: Registrants should provide transparent disclosure that clearly demonstrates:
- The usefulness of the non-GAAP measure to investors; and
- The additional purposes, if any, for which management uses such measures.
Mike: And, let me guess, management’s explanation was, dare I say, “lacking.”
Chris: Or nonexistent! Furthermore, such disclosures should be specific to the measure used, to the registrant and the nature of its business and industry, and to the manner in which management assesses the non-GAAP measure.
Mike: In other words, the disclosures shouldn’t be boilerplate!
Chris: You got it. The registrant should also ensure that its disclosure of the usefulness and purpose of the measure is consistent with the categorization of the measure as a liquidity or a performance measure.
Mike: Thanks, Chris. That discussion was very helpful and hopefully our listeners thought so as well. Why don’t you take us out?
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 and 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’re the first to know what’s new with GAAP Dynamics.
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