Which non-GAAP metrics will catch the SECs eye?

By Francine McKenna, MarkeyWatch.com

The Securities and Exchange Commission and company auditors say scrutiny of companies’ use of financial metrics that don’t comply with generally accepted accounting standards is going to increase, especially if they mislead investors, but knowing when regulators might ask more questions can be tricky.

In recent speeches SEC Chairwoman Mary Jo White, SEC chief accountant James Schnurr and SEC Commissioner Kara Stein have all commented on a recent uptick in the use of non-GAAP metrics.

White says the use of non-GAAP metrics can, in some cases, be confusing. Companies, however, say the use of metrics that adjust numbers reported according to Generally Accepted Accounting Principles, or GAAP, in earnings releases, investor presentations and annual and quarterly reports is necessary to tell a better story for investors.

James Doty, the chairman of the Public Company Accounting Oversight Board, the audit firm regulator, chimed on the issue while requesting a larger budget from the SEC for the PCAOB’s oversight of the auditors who scrutinize company compliance. “Companies’ use of unaudited and non-GAAP metrics proliferates,” he said.

At that same meeting to approve the PCAOB budget on March 16, Commissioner Kara Stein brought up a recent reversal by Herbalife HLF, -0.02% whose stock price declined by 7% when it disclosed a significant error in calculating a previously advertised measure of growth in new customers. “It appears that investors,” said Stein, “in this case, were relying on this metric.” At a meeting in December of the American Institute for CPAs, the accounting industry trade association, White specifically highlighted this issue. White asked the audience of auditing professionals, “Are there appropriate controls over the calculation of non-GAAP measures?”

The SEC’s Schnurr spelled out the problem for investors in a speech on March 16 to accountants and lawyers who serve pharmaceutical and biotech companies. He reminded the professionals, who were there to learn more about the trends in financial reporting in their industry, that non-GAAP measures are supposed to supplement the information in the financial statements and not substitute for it. The media focus on the figures that move markets doesn’t help. Lately, “when the financial news networks report quarterly earnings,” said Schnurr, “they very frequently report the non-GAAP measure of earnings with no reference to the actual GAAP earnings, often not even identifying it as having been adjusted.”

Which non-GAAP metrics will likely catch the eye of SEC staff and potentially the enforcement division, and your auditors? “I am particularly troubled,” said Schnurr, “by the extent and nature of the adjustments to arrive at alternative financial measures of profitability, as compared to net income, and alternative measures of cash generation, as compared to the measures of liquidity or cash generation.”

In its manual for Corporation Finance staff, the SEC team that reviews financial statement filings, the regulator describes some practices related to non-GAAP metric use that are strictly prohibited.

Big no-nos include adding non-GAAP financial metrics to the required financial statements in a 10-Q or 10-K or in the notes to those financial statements, and using titles or descriptions of non-GAAP measures that are the same or confusingly similar to the titles used for GAAP figures.

In 2013 at the AICPA annual meeting for auditors and financial reporting professionals, the SEC staff outlined some areas of focus that were on their list. The high-tech and social gaming industries were identified as high risk users of non-GAAP metrics to report trends such as number of registered users to a company’s website, number of active users, daily and monthly average users, average revenue per user and number of paying players for gaming companies.

In the retail industry, non-GAAP metrics such as comparable store sales, store openings, and store closings were noted as deserving of closer scrutiny during the SEC’s 2013 presentation.

In February, Brixmor Property Group BRX, +0.04% admitted in a filing that it smoothed income items to achieve consistent growth in a non-GAAP metric called “same property net operating income.” While that’s not a number reported according to GAAP, it is one that is paid attention to in the REIT business.

Not the first time
Ken Daly, CEO of the National Association of Corporate Directors, told MarketWatch that questions about non-GAAP metric use have been asked by regulators and answered by corporate executives many times in the past. “Executives often believe that their management accounting information is more representative of the business on a go-forward basis,” said Daly, “than the GAAP numbers.”

In a recent publication for clients on enhancing the usefulness of non-GAAP financial measures, global professional services firm PwC reinforced that rationale. Companies use non-GAAP metrics, the firm wrote, to “supplement their GAAP financial reporting with non-GAAP information that is intended to provide additional insight into the business.”

Telling a misleading story was the problem when the SEC filed its first ever enforcement case against a company for inappropriate use of non-GAAP metrics. In January 2002, the SEC settled with Trump Hotels & Casino Resorts Inc. for making misleading statements in the company’s third-quarter 1999 earnings release when it used a net income figure that differed from net income calculated in conformity with GAAP. Trump Hotels’ chief executive officer said the company’s positive results and improvement from third-quarter 1998 were the result of improvements in the company’s operations. The SEC alleged that the company violated the law for highlighting “purportedly” positive results but failing to disclose that those results were because of an unusual one-time gain rather than ongoing activities.

Stephen M. Cutler, the director of the Commission’s Division of Enforcement at the time, said in the press release that “the case starkly illustrates how pro forma numbers can be used deceptively and the mischief that they can cause.”

Research on the subject agrees. Sarah McVay, a professor of accounting at the University of Washington, in the paper “Non-GAAP earnings and board independence” concluded that, while non-GAAP methods may predict a company’s future income better than GAAP numbers, the unaudited numbers lend themselves to “opportunistic manipulation and even insider trading.”

The SEC adopted new regulations that addressed non-GAAP public company disclosure in 2002, prompted by the Enron and WorldCom frauds in particular, as part of the Sarbanes-Oxley Act changes. However, non-GAAP earnings numbers disclosed in press releases are still not subject to audit. While everyone seems to agree reporting, use of, and reliance on non-GAAP measures has increased, the auditor’s obligation to check comparability, consistency, compliance and accountability by companies has not changed.