Reacting to what it sees as the growing prevalence of non-GAAP measures and suspecting that they’re increasingly misleading, the Securities and Exchange Commission is cracking down on the practice.
Following its issuance of a 2010 guidance restoring some non-GAAP measures that the SEC had effectively barred, the SEC “relaxed” its vigilance of the use of measurements that fall outside the realm of Generally Accepted Reporting Practices, Mark Kronforst, the chief accountant of the commission’s corporate finance division, recalled last week.
“For lack of a better way to say it, we are going to crack down,” he said at the Baruch College annual financial reporting conference in New York. “The pendulum has swung.”
In a related development, Hans Hoogervorst, chairman of the International Accounting Standards Board, said that the use of non-GAAP measures may drive IASB to revise its reporting requirements involving income statements. “There is growing evidence showing increasing use of non-GAAP measures, and of these measures becoming increasingly misleading,” he said in a speech at the annual conference of the European Accounting Association in Maastricht, the Netherlands.
More than 88% of the S&P 500 currently discloses non-GAAP metrics in their earnings releases, he noted. Of those releases, 82% show increased net income “and are clearly designed to present results in a more favorable light,” he said, citing 2015 figures from Audit Analytics.
Expressing concern about companies’ increasing use of non-GAAP measures to make their financials look better, Kronforst said that the SEC is “definitely” on the lookout for companies that are prone to “changing the calculation of a measure depending on what happened for any particular year.”
One particular practice that would be in the SEC’s crosshairs is the so-called “cherry picking” of non-GAAP results to portray a company in the best possible light. “That would be moving the goalposts over time to manage the non-GAAP measure,” Kronforst said.
The commission frowns on the practice of senior executives “changing the calculation of a measure depending on what happened for any particular year [in a way that’s] advantageous to management,” he added, “particularly when there’s no disclosure of it.”
To be sure, the SEC hasn’t seen many such instances, Kronforst said, noting that its rules do not explicitly require a company to report a change in how it calculates a non-GAAP measure. Still, if the commission finds that a company has done that, “we will issue a comment that we know that a company is doing that and not talking about it.”
Another SEC official who spoke at the conference, Wesley Bricker, the deputy chief accountant, said in particular that the commission was concerned about “the use of individually-tailored accounting principles to calculate non-GAAP earnings.”
To illustrate the practice, Bricker provided the example of a subscription-based firm that bills for a full subscription at its outset. Since the company will deliver its services over time, however, it earns and recognizes GAAP revenue over that same period.
At the same time, “the company calculates non-GAAP revenue as though it had a different business. That is, it calculates what revenue it would have had, had it not sold a subscription, but rather had sold a product,” he said.
The result? The firm’s GAAP results “are based on revenues recognized as the service is provided and the non-GAAP results are based on revenues that are merely billed to the customer,” according to Bricker.
Such a use of a non-GAAP measure isn’t likely to help investors dig into a company’s operating results. “Rather, it is a replacement of an important accounting principle with an alternate accounting model that does not match the company’s subscriptions business or earnings process, which is over time,” the SEC official says.
Bricker leveled a broader criticism of company alterations of GAAP revenue. “Revenue adjustments do more than just adjust from GAAP: they change the very starting point from which other performance analyses flow,” he contended.
The SEC is also zeroing in on how companies are making required disclosures of why their use of particular non-GAAP measures are useful. “Probably the most common comment that our division will issue is about the usefulness of the measurement,” said Kronforst. “Usefulness disclosures [are] something we are very concerned about.”
Since the issuance of the usefulness requirement under SEC non-GAAP rules in 2003, corporate disclosures “have become somewhat boilerplate,” he said. “And the commission, when they adopted the rules, [made it] very clear that boilerplate is not acceptable.”
It’s also unacceptable for corporations justifying the use of their non-GAAP measures “to say that analysts are begging for this information and therefore [they’re] providing it. That may be true, but that’s not sufficient disclosure,” Kronforst said.