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Accounting

Nonplussed by Non-GAAP


by Erik Bradbury

Accounting-related confusion and handwringing continue in the daily headlines, with accusations of companies misleading investors emerging in dynamic ways.

©dolgachov/ISTOCK/THINKSTOCK

Although the days of Enron and WorldCom are well behind us, the latest concerns center around the common, and at times creative, use of “non-GAAP” financial reporting. In particular, the pervasive use of non-GAAP measures has led to recent scrutiny by some, including the U.S. Securities and Exchange Commission (SEC).

The majority of publicly-listed companies in the U.S. use some form of non-GAAP financial reporting. Companies often use a financial figure that starts with a “GAAP” number (i.e., one that complies with U.S. Generally Accepted Accounting Principles), and adjust that figure to arrive at a “non-GAAP” measure they use to report their performance to investors. For example, many companies adjust their net income to arrive at EBITDA or Adjusted EBITDA (i.e., Earnings Before Interest, Taxes, Depreciation and Amortization and other items).

The use of non-GAAP measures is not prohibited by SEC rules. In fact, SEC regulations have long allowed management to provide additional insight about a company’s operations and business through the use of non-GAAP measures. Furthermore, many companies believe GAAP measures are limiting and don’t allow management to help investors understand past performance or future earnings potential, particularly in scenarios where one-time nonrecurring events influenced past performance and results.

The SEC’s attention to non-GAAP measures is ramping up with Senior SEC Staff sending out warning signals that began last year and have continued to increase in 2016. In many public meetings, the SEC has warned that comment letters are imminent and that issuers should be prepared to respond to questions.

On May 17, 2016, the SEC updated its guidance on the use of non-GAAP financial measures adding a number of new Compliance and Disclosure Interpretations (C&DIs) to its guidance shedding even more light on where the SEC may focus its attention. We highlighted this issue for you in a recent article titled, Mind the (Non) GAAP: The SEC Elevates Its Attention to Non-GAAP Measures.

SEC Enforcement Actions

The SEC Enforcement attention to non-GAAP dates all the way back to 2002 when the Commission, in its first “pro-forma”1 financial reporting case, charged Trump Hotels with allegedly misleading investors. The SEC asserted that Trump Hotels, through the conduct of its chief executive officer, chief financial officer and treasurer, violated the anti-fraud provisions of the Securities Exchange Act by knowingly or recklessly issuing materially misleading information to investors in a press release.

In a press release on Oct. 25, 1999, Trump Hotels, while announcing its quarterly results, used net income and earnings-per-share (EPS) figures that differed from GAAP reported net income and EPS. The figure used by management excluded a one-time charge, yet failed to correspondingly exclude a one-time gain. According to SEC records, “The misleading impression created by the reference to the exclusion of the one-time charge and the undisclosed inclusion of the one-time gain was reinforced by the comparison in the earnings release of the stated earnings-per-share figure with analysts' earnings estimates and by statements in the release that the Company been successful in improving its operating performance.

As a result of this practice, Trump Hotels was able to beat analyst expectations, which had led to an immediate rise in its stock price of 7.8 percent. The release quoted the company’s CEO as attributing the positive results and improvement from third-quarter 1998 to improvements in the company’s casino operations. Had the one-time gain been excluded from the quarterly pro forma results as well as the one-time charge, those results would have reflected a decline in revenue and net income, and the company would have failed to meet analysts' expectations.

On October 28 of that year, the day on which an analysts' report and a news article revealing the impact of the one-time gain were published, the stock price fell approximately 6 percent.  The SEC stated “the earnings release was fraudulent because it created the false and misleading impression that the Company had exceeded earnings expectations primarily through operational improvements, when in fact it had not.”

Since the first enforcement action against Trump Hotels in 2002, SEC enforcement actions for violations of non-GAAP reporting have been sparse. In 2009, in its first enforcement action under regulation G, the SEC charged SafeNet, Inc. with materially misstating its financial results and disseminating materially false and misleading information concerning its financial condition.

Specifically, the SEC charged that the CEO, CFO and other accountants engaged in a scheme to meet or exceed quarterly earnings per share (EPS) targets through the use of improper accounting adjustments. While management was aware it would be unable to meet its earnings targets through normal business operations, it took actions to ensure SafeNet would meet its earnings targets through accounting adjustments and improper financial reporting.

In particular, management represented to investors that SafeNet's non-GAAP earnings results excluded certain non-recurring expenses, when, in fact, SafeNet had misclassified and excluded a significant amount of recurring, operating expenses from its non-GAAP earnings results to meet or exceed quarterly EPS targets.

Whether the renewed focus of the SEC will lead to future enforcement actions is not clear. What is clear, as expressed by a senior SEC official with the Division of Enforcement at a March 30 Anti-Fraud Collaboration workshop meeting, is that, “any issuer who is using non-GAAP measures inappropriately opens itself up to a myriad of vulnerability in the enforcement space.”

All key participants in companies’ financial reporting process, including the finance team, investor relations, the CFO and the CEO have a shared responsibility to produce accurate and reliable financial information that is free of misleading information. The antifraud statutes of the Securities and Exchange Act require it. Boards and audit committees play a significant oversight role as well, and should be prepared to ask the hard questions that will help steer a company away from a claim of intentionally misleading investors.

As recently suggested by SEC Chairman Mary Jo White, companies that present and use non-GAAP measures may want to ask themselves four key questions:

  • Why are we using the non-GAAP measure, and how does it provide investors with useful information?
  • Are we giving non-GAAP measures no greater prominence than the GAAP measures, as required under the rules?
  • Are our explanations of how we are using the non-GAAP measures – and why they are useful for investors – accurate and complete?
  • Are there appropriate controls over the calculation of non-GAAP measures?
Antifraud Collaboration Task Force Efforts

FEI is an active member of the Anti-Fraud Collaboration task force, along with the Center for Audit Quality (CAQ), The Institute of Internal Auditors (The IIA) and the National Association of Corporate Directors (NACD). As a member organization, we are committed to methods to deter and detect financial reporting fraud through thought leadership, awareness programs, educational opportunities, and other resources targeted to the unique roles and responsibilities of the primary participants in the financial reporting supply chain.

Visit http://www.antifraudcollaboration.org/ for more information.

1The term non-GAAP was not used by the SEC in 2002. “Pro-forma” has a similar meaning to “non-GAAP.”