Bridging the GAAP/Non-GAAP Gap

Another quarterly earnings cycle is just about to start with companies putting the final touches on their Q3 2016 earnings releases, analyst presentations and the messages they will share with investors. There is intense pressure on companies to meet quarterly analyst estimates and there is also extra attention from the Securities & Exchange Commission (SEC) on how companies report and present their financial information.

U.S. public companies are required by the SEC to provide financial statements prepared in accordance with U.S Generally Accepted Accounting Principles (GAAP) and this information is audited annually by external auditors to ensure accurate and consistent reporting. However, it is a valid, common practice for public companies to publish non-GAAP or pro-forma financial adjustments to exclude unusual and/or one-time items such as restructuring charges, the sale of a business, extraordinary legal costs, layoffs, etc. Companies doing an IPO will use pro-forma financials to reflect the use of proceeds being used to write-down debt and reduce interest expense, to reflect investor payouts as a result of changes in ownership, for M&A, etc. Non-GAAP data is not audited, but the idea is to give investors and analysts a consistent picture of the business excluding out of the ordinary and/or unusual income or expense so financial results can be tracked and compared over time to determine earnings success (or lack thereof).

The potential over-emphasis and/or over-use of non-GAAP measures has gotten the attention of the SEC. In May, the SEC published updated Compliance & Disclosure Interpretations (CD&I’s) related to the use of Non-GAAP Financial Measures. The updated CDIs called out concerns with certain potentially misleading adjustments companies may be taking, the reconciliations between GAAP and non-GAAP measures, inconsistent reporting between periods, adjustments made for normal, recurring expenses, not adjusting for unusual or non-recurring gains as non-GAAP, the equal or greater prominence of GAAP versus non-GAAP data in financial statements and press releases, etc. In order to focus more attention on this, the SEC also sent comment letters to companies requesting information about their use of non-GAAP measures and there have been several recent enforcement actions as well.

 “In too many cases, the non-GAAP information, which is meant to supplement the GAAP information, has become the key message to investors, crowding out and effectively supplanting the GAAP presentation,”
—SEC Chair Mary Jo White at the June International Corporate Governance Network (ICGN) Annual Conference.

During White’s speech, she urged audit committees to ensure they are carefully overseeing the use of non-GAAP measures and reporting. New York Stock Exchange (NYSE) rules also place responsibility for probing the use of non-GAAP measures on the Audit Committee. NYSE rules 303A.07 Audit Committee Additional Requirements (b) (iii) (H) General Commentary to Section 303A.07(b), says “… the audit committee must review:

1. major issues regarding accounting principles and financial statement presentations, including any significant changes in the listed company’s selection or application of accounting principles, and major issues as to the adequacy of the listed company’s internal controls and any special audit steps adopted in light of material control deficiencies;
2. analyses prepared by management and/or the independent auditor setting forth significant financial reporting issues and judgments made in connection with the preparation of the financial statements, including analyses of the effects of alternative GAAP methods on the financial statements;
3. the effect of regulatory and accounting initiatives, as well as off-balance sheet structures, on the financial statements of the listed company; and
4. the type and presentation of information to be included in earnings press releases (paying particular attention to any use of “pro forma,” or “adjusted” non-GAAP, information), as well as review any financial information and earnings guidance provided to analysts and rating agencies.

The non-GAAP measures issue has also concerned a group of top executives and institutional investors. In July, this group of business leaders including JPMorgan’s Jamie Dimon, Berkshire Hathaway’s Warren Buffett, and BlackRock’s Larry Fink published a set of Commonsense Corporate Governance Principles (discussed on the Forum here). Principle number IV, which relates solely to public company reporting, emphasized the need for transparent financial results and clear communication around the company’s goals and long-term strategy. The use of non-GAAP measures was highlighted as follows:

“Companies are required to report their results in accordance with Generally Accepted Accounting Principles (‘GAAP‘). While it is acceptable in certain instances to use non-GAAP measures to explain and clarify results for shareholders, such measures should be sensible and should not be used to obscure GAAP results.”

Responsibility for a company’s financial statements and disclosures falls on management, but audit committees, in particular, and the full board need to seriously consider non-GAAP measures. Reports indicate that the SEC saw some signs of improvement in Q2 2016 earnings releases, especially with GAAP measures getting equal or greater prominence to non-GAAP measures. However, the SEC will use the comment letter process to drive further changes to which non-GAAP measures are acceptable or not and how companies disclose these measures and why they differ from GAAP. In the meantime:

•  The audit committee should confirm the company’s earnings are being fairly and accurately presented and in accordance with the SEC’s rules and recent CDI’s.
• Directors should be asking questions about why a particular non-GAAP measure is being used, how is it is calculated and whether it is being used for one quarter or multiple periods, is reporting consistently presented and reconciled clearly to GAAP. When the differential between the GAAP and non-GAAP measure is significant, directors should make sure they understand why and that the reasons are clearly disclosed.
• A particular area of focus for the SEC is making sure companies do not factor out any of their regular costs of doing business (e.g. those related to compensation, legal costs, restructurings, etc.).
• Companies and boards need to stay tuned to changing practices and really dig into their non-GAAP measures and disclosures. Looking at what is deemed material may not be enough, because small, individual items can collectively become a major issue.
• Beyond the audit committee, boards and the C-suite can take action here by ensuring there is a proper tone at the top and a strong compliance program in place at the company.

It will be interesting to see if further changes are made to Q3 2016 earnings. In the meantime, audit committees get busy!