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Jul 06, 2016

SEC cracks down on non-GAAP measures in earnings filings and proxies

Recent interpretations of non-GAAP rules likely to make firms rethink how they present business highlights in CD&A sections and how numbers are tied to compensation targets

Get ready for much more strict regulatory oversight of the use of non-GAAP (GenerallyAccepted Accounting Principles) in quarterly earnings releases and annual proxy statements. Publicly listed companies have a lot of work ahead of them in preparing their second-quarter earnings filings to comply with recent interpretations of rules regarding the use of non-GAAP financial measures, issued by the SEC’s Division of Corporate Finance on May 17.

Clarifying when non-GAAP accounting measures are deemed to be misleading is one of the chief services the Commission has provided in issuing the interpretations. Among other things, the SEC cited ‘adjustments only for non-recurring charges when there were non-recurring gains that occurred during the same period,’ which could violate Rule 100(b) of Regulation G. Groupon’s questionable use of non-GAAP measures such as adjusted consolidated segmented operating income in its IPO filing was cited as a prime example of how the use of non-GAAP measures has become excessive in the SEC’s view. 

The main thing companies will be required to provide is GAAP equivalents of any non-GAAP performance measures included in their quarterly financial filings with equal prominence to the non-GAAP measures. The SEC ‘expects companies to get the equal prominence changes right from the second quarter earnings release,’ John White, partner at Cravath Swaine & Moore and a former director of the SEC’s corporate finance division, said during a panel on SEC developments at the Society for Corporate Governance’s annual conference in Colorado Springs on June 22-25.  

‘Make sure you get your [chief financial officer], IR committee and audit committee educated on this and allow time for all of this,’ he urged the roomful of Society members and other attendees.  The board’s disclosure committee in particular needs to pay attention to getting the non-GAAP reporting right, he said.

While the SEC’s rules regarding reporting of non-GAAP performance measures haven’t changed since 2004, the Commission is taking a tougher stance mostly because of how prevalent it has become in recent years, White said. Eighty-eight percent of S&P 500 companies now use non-GAAP financials and 80 percent of the earnings adjustments are favorable, he explained.

The most significant change regarding equal prominence is that the GAAP number of any accounting metric must be included before the non-GAAP number. If a company decides to highlight a non-GAAP number in its headline, it must also include the GAAP number, which needs to come first. The prioritization of GAAP numbers over their non-GAAP counterparts extends to the use of charts and tables, as well as any discussion in the Compensation Discussion & Analysis (CD&A) section of the proxy statement. Companies will also be required to remove a positive financial metric where they have taken out a negative one and be consistent in comparisons between reporting periods.

During a separate panel on Dodd-Frank executive pay rules and disclosure, Mark Borges, a principal at management consulting firm Compensia, said, ‘I’ve noticed the lack of Regulation G reconciliation between non-GAAP and GAAP numbers in SEC filings. So the Compliance & Disclosure Interpretations couldn’t be more timely.’

Borges said he expects the interpretations to prompt many companies to rethink how they present business highlights at the beginning of their discussions of reasons for compensation plan decisions in the CD&A section of heir proxies. They will also spur ‘re-thinking of the use of non-GAAP measures that really aren’t tied to compensation targets,’ which is the most common non-GAAP measure you see in adjusted earnings, he said.   

Some companies have even gone as far as to redefine what GAAP is, White said during the SEC developments panel. ‘You can’t redefine the method for determining what GAAP revenue is,’ he said.

During the Dodd-Frank panel, White said his sense from discussions with the chief accountant in the SEC’s corporate finance division, Mark Kronforst, is that the division will do a comprehensive review of second-quarter earnings releases and send out letters to any companies whose releases aren’t in compliance with the new interpretations.

‘I can assure you the enforcement division would love to have a case to [make an example of],’ he said.

David Bogoslaw

Associate Editor and Online features producer for Corporate Secretary