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How to Respond to the Scrutiny on Non-GAAP Metrics

The SEC is increasingly concerned about the use of non-GAAP measures to explain company performance; six guidelines will help firms use non-GAAP numbers to enlighten rather than confuse investors

From 2009 to 2015, the number of companies using non-GAAP measures in the S&P 500 increased from 232 to 380 and, as this number has risen, so has the Securities and Exchange Commission’s criticism of these measures. Now the SEC has clarified its intentions to rein in companies’ use of non-GAAP measures by updating its interpretive guidance.

Using different measures obviously have a big effect on investors’ and other corporate observers’ understanding of company performance, and their ability to compare one firm with another.

It also changes the way that corporate accounting teams work and, based on questions from those in CEB’s network of accounting and reporting professionals, the two most important factors for them in this update are clarification about what the SEC will consider misleading (e.g. a non-GAAP measure presented inconsistently between accounting periods), and the requirement that companies present the most directly comparable GAAP measure with equal or greater prominence – like using a bold or larger font – alongside any non-GAAP measure.

Why the SEC has Updated its Guidance

“The SEC announced that it felt that some non-GAAP metrics’ articulation is inconsistent with the commission’s view of how it should be presented,” said Neri Bukspan, a partner in EY Financial Accounting Advisory Services, in a recent CEB webinar on financial reporting. “They [the SEC] actually have been announcing that in some cases they are actually doing the opposite. They are not helping investors understand the company better, but they are detracting from investors’ ability to understand the company.”

For instance, the SEC suspected Valeant of stripping some non-GAAP measures of acquisition-related costs when the company’s business strategy is heavily dependent on acquisitions, according to the Wall Street Journal.

Meanwhile, according to Fortune, the SEC also questioned whether or not the e-commerce company Alibaba overstated its gross merchandise volume using a non-GAAP measure that reflects the volume in dollars of products sold on the company’s e-commerce platforms.

What it Means for A&R Teams

The increased scrutiny surrounding the use of non-GAAP in financial reporting shouldn’t deter companies from using such measures. Rather, companies should rethink their current approach to non-GAAP metrics and put in place a clear process to help determine what is most relevant for investors, as well as consider how prominently they are displaying non-GAAP measures in their financial releases.

Accounting teams shouldn’t overlook one important area when it comes to non-GAAP measures, according to Bukspan: clearly explaining the rationale behind its use of specific measures.

“Companies need to articulate in the market why this is relevant,” said Bukspan. This is especially critical as a significant number of companies are already using non-GAAP measures. Out of the 259 participants polled during a recent CEB webinar, 56% reported that their companies used non-GAAP measures on a limited basis while 24% said their businesses used non-GAAP measures extensively.

Only 8% said they believed GAAP measures provided a better depiction of performance than non-GAAP measures.

What’s more, recent data suggest that non-GAAP metrics are the fourth-leading source of all SEC staff comments in their review of annual and quarterly reports — and Bukspan predicted that it would soon become the top issue.

Keep in mind that receiving a comment letter from the SEC isn’t the only consequence your company might face. The SEC can also target companies for legal actions as it has already been the case in the past for Trump Hotels & Casino Resorts Inc., when the SEC in 2002 said the business had made “misleading statements in the company’s third-quarter 1999 earnings release.”

Guidelines for Preparers of Financial Statements

If you are already using — or plan on using — non-GAAP metrics, these six guidelines will help you and your team keep earnings presentations and reports in compliance with the SEC’s new guidance.

  1. Managers should review existing non-GAAP financial measures and disclosures in conjunction with the audit committee and legal counsel to make sure your company is in compliance with SEC rules, as well as to provide a clear and comprehensive view of your company’s performance.

  2. Clearly articulate your rationale for using non-GAAP financial measures. Remove any boilerplate language.

  3. Non-GAAP financial measures must receive no greater prominence than GAAP financial measures.

  4. If you provide non-GAAP financial measures on a per-share basis, the information should directly relate to performance measures.

  5. Examine your presentation of non-GAAP financial measures from period to period for inconsistencies, as changes to non-GAAP financial measures will likely garner scrutiny from the SEC. Appropriate changes should include extensive disclosure on the purpose and benefits of the change.

  6. Make sure you’re balanced in the way you’re presenting non-GAAP measures: you shouldn’t, for instance, only discuss positive metrics.

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