It is clear that the communication of non-GAAP financial measures will likely continue to be a core part of the fabric of company reporting. Yet the widespread supply of and demand for these metrics should not mask the many lingering concerns associated with them or downplay the need for robust oversight on their reporting.
Before digging into whether the SEC goes too far or not far enough in its guidance around non-GAAP reporting, it is worth remembering that such guidance has been in place for years.
Regulation G, enacted in 2003, addressed management communication of such measures, including regulatory filings and press releases. Additionally, Item 10 (e) of Regulation S-K and Item 12 of Form 8-K address reporting of the measures in SEC filings.
The SEC also issued compliance and disclosure interpretations (C&DIs) in 2010 and 2016 that supersede the Regulation G requirements. The 2010 C&DI relaxed prohibitions on excluding recurring expenses. On the other hand, in 2016 the SEC tightened its guidance to stave off concerns related to increasing episodes of misleading non-GAAP reporting.
All of this considered, has the SEC gone too far in its guidance?
Such an assertion implies that last year’s C&DIs have adversely affected the usefulness of non-GAAP metrics. But it is simply too early to directly gauge the effects of the latest guidance. Several interim and full-cycle reporting periods are necessary to robustly assess how companies’ reporting behavior has changed and the extent to which the quality of information for investors has been either positively or negatively affected.
Regardless of the most recent guidance, there are also lessons that can be gleaned from the observed effects of the earlier guidance. Academic research shows that there was an improvement in the quality of non-GAAP reporting by U.S. filers after the Regulation G requirements were enacted in 2003. Many companies that had low-quality exclusions in their calculations of non-GAAP measures stopped communicating them.
While many investors find these measures to be useful, they also expect sufficient regulatory bite to ensure their reliability. A CFA Institute member survey revealed that investors generally expect tightened regulatory guidance to yield higher quality non-GAAP reporting.
That said, investors also have varied level of agreement with different aspects of the SEC guidance. For example, there is strong investor support for restrictions in upwardly biased non-GAAP calculations as a result of one-off gains, but minimal support for restrictions on reporting non-GAAP revenue and liquidity-per-share metrics.
As a final thought, some companies object that the regulatory guidance limits their ability to tell a performance story through the eyes of management. But there is a paradoxical aspect to such an objection.
The guidance does not restrict companies from providing robust narrative disclosures on why non-GAAP measures are necessary or from adequately explaining why adjustments to GAAP provide better information on the economics of the business. Many companies simply tend not to provide such robust disclosures.
In other words, companies’ storytelling primarily should entail informative, narrative disclosures. Merely conveying or giving prominence to alternative views of performance via inconsistent or flexible non-GAAP calculations does not lead to a better understanding of performance.
Hence, the SEC objective of increasing transparency and pushing for greater comparability is aligned with investor interests and should continue.
Vincent Papa is interim head of financial reporting policy for the CFA Institute, a global association of investment professionals.