Regulators have indicated that they will be focused on preparers’ use of non-GAAP measures, meaning that senior financial executives will need to have a vibrant control structure to support them.
FEI Daily spoke with Dave Sullivan, National Managing Partner of Deloitte’s Quality and Professional Practice, regarding his thoughts about the future of non-GAAP reporting.
FEI Daily: How would you describe where most management and directors are in implementing controls around non-GAAP? Is this the beginning of the process?
Dave Sullivan: There isn’t empirical evidence to say where companies are with respect to non-GAAP. They run the gamut in terms of the sophistication of controls over the development and reporting of non-GAAP measures.
That is, they run the gamut from very sophisticated controls that include a lot of oversight—including audit committee oversight — all the way to companies having very few controls.
That’s probably driven by a lot of things, but maybe driven at least in part by the fact that since they don’t have to be tested by the auditors in the internal control audit, they might not get the same attention.
FEI Daily: Is there a great deal of experience that companies can take away from traditional ICFR that can be translated into non-GAAP internal controls? Or is it two separate issues?
Sullivan: There is absolutely a great deal of overlap. There is as much overlap in the controls as there is overlap in the relationship between GAAP and non-GAAP measures.
Non-GAAP measures all start with the foundation of a GAAP measure; they have to be reconciled back to the GAAP measure. The GAAP measure has to be more prominent in the press release and the disclosure; there, the linkage is very direct. Non-GAAP measures are an extension of GAAP disclosures, and the non-GAAP controls would be an extension of the GAAP controls.
FEI Daily: Out of the controls that you’ve seen documented, which has been the most challenging to implement and why?
Sullivan: The benefit of non-GAAP measures, and also the challenge with respect to non-GAAP measures, is the lack of a framework around non-GAAP measures.
While a company goes through a process of determining what non-GAAP measures they’re planning to present and how to compute those non-GAAP measures, there isn’t a framework that says how to accomplish it. Frankly, there isn’t even a framework that says whether or not a non-GAAP measure that is disclosed is relevant to users of financial statements.
In the area of non-GAAP, disclosure around those non-GAAP measures becomes almost as important as the measure itself, because there needs to be a disclosure as to not only how it was computed but why it’s relevant to users of the financial statements and how it relates back to the GAAP measures. There is a bit more of the qualitative aspect that goes into non-GAAP measures than many GAAP measures.
Obviously, many GAAP measures are very qualitative and involve management estimates and those sorts of things, but they’re also driven by accounting standards.
FEI Daily: What types of companies have the largest amount of work when it comes to adopting non-GAAP controls?
Sullivan: Based on anecdotal evidence and personal experience of some individuals I’ve spoken with, those businesses and those enterprises that tend to have the most effective controls over non-GAAP measures also have an audit committee that’s very engaged. This includes considering how management determines which non-GAAP measures they will disclose and why and how they disclose them.
I think one of the drivers of success with respect to effective controls over non-GAAP measures is having appropriate oversight, including effective audit committee participation.
FEI Daily: Does that oversight include a financial expert who is up to date on non-GAAP and understands, or is it something that is the responsibility of the whole audit committee?
Sullivan: I don’t think the responsibilities of the audit committee are parsed that finely. In general, it would be the financial expert(s) on the audit committee who would have the most familiarity and the most ability to challenge management with respect to the relevance and the transparency of the disclosures.
FEI Daily: How are audit committees dealing with this in terms of getting education, getting up to date on what they need to know and asking the right questions when it comes to this?
Sullivan: The U.S. Securities and Exchange Commission has been very vocal about the quality of non-GAAP measures. Since the compliance and disclosure interpretations that were issued by the SEC’s Division of Corporate Finance in May—and the speeches after that which impressed upon registrants that June was the quarter to make those changes—we’ve seen a dramatic increase in the interest and engagement of audit committees in the review and evaluation of the disclosure of non-GAAP measures.
FEI Daily: How do you attack that issue?
Sullivan: There are certainly some people who think a non-GAAP disclosure equals a bad disclosure. I believe non-GAAP measures are, and should be, used to supplement GAAP information to assist users in evaluating financial and investment decisions that they’re going to make. I think non-GAAP measures can be very useful information. Often, those come out simultaneously with or prior to a lot of the GAAP information that comes out.
If that information is important to management and it’s important to the users of financial information, then the internal controls over that information would be just as important to both management and the users of that financial information—even though, admittedly, there is incrementally some work involved.
Incrementally, how much additional work is involved obviously depends on the disclosure and the complexity. In terms of prioritizing what’s most important, the key controls and what you’re going to have controls over, it would seem to me that these would most often qualify as key controls for management.
FEI Daily: Given the amount of work that needs to be done over controls on non-GAAP measures, how likely is it that people will just starting moving away from them rather than embracing them and writing the controls?
Sullivan: The use of non-GAAP measures is widespread and users of financial information have an expectation to get certain of those non-GAAP measures. I am a believer that effective internal controls improve the quality of financial information and protect investors. Therefore, we can’t discount the importance of internal controls over these types of measures as well. It would be pure speculation to say whether or not any individual company or industry might abandon non-GAAP measures because of the difficulty. I find it hard to believe that would happen.
I think in some sense non-GAAP measures are entrenched in the financial reporting world: making sure that they’re transparent, they’re not misleading, they’re not more prominent, they’re relevant, the appropriate disclosures have been made, and that the SEC has laid out the right framework. It’s just important for preparers to make sure they adhere to that as they consider their disclosures.
FEI Daily: Do you think that regulators are satisfied that the industry is keeping pace with where they want them to go on controls in non-GAAP?
Sullivan: Good question for the regulators. Based on what I’ve read and seen lately, I think they’d acknowledge that much progress has been made in the last couple of months in this area. Based on the comment letters that they’ve issued and that they expect to continue to issue in this area, there is more progress to be made.•