Regulator weigh in on use of unsanctioned accounting measure, amid uproar

The fury over the increasing use of non-GAAP accounting measures when companies report earnings is building, and now the Securities and Exchange Commission is weighing in with some guidance on practices that are and aren’t acceptable.

As part of its published Compliance & Disclosures Interpretations guidance, the SEC issued a series of questions and answers that may come up as companies consider releasing non-GAAP measures. The guidance also serves as a warning to companies to use caution when using non-GAAP measures.

Among the questions it addresses are:

  • Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is considered misleading?

  • Can a non-GAAP measure be misleading if it is presented inconsistently between periods?

  • Can a non-GAAP measure be misleading if the measure excludes charges, but does not exclude any gains?

The answers? Yes, yes, and yes. The SEC also provided examples of how measures used in those situations could be considered misleading. "Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant's business could be misleading," the SEC wrote in the guidance.

The Growing Backlash

The guidance comes as the outcry over the use of non-GAAP measures is mounting. According to a recent study in the Analyst's Accounting Observer, 90 percent of companies in the Standard & Poor's 500-stock index reported non-GAAP results last year, up from 72 percent in 2009.

SEC officials have been increasingly raising eyebrows at the practice. During a speech in March, SEC Chief Accountant James Schnurr waned companies, "that the non-GAAP measures must not be misleading." He also addressed the increase in use of non-GAAP figures. "The SEC staff has observed a significant and, in some respects, troubling increase over the past few years in the use of, and nature of adjustments within, non-GAAP measures by companies as well prominence that the analysts and media have accorded such measures when reporting on the results of the companies they cover," he said.

"It's something that we are really looking at—whether we need to rein that in a bit even by regulation," SEC Chairman Mary Jo White said in March at a conference in Washington. "We have a lot of concern in that space."

The SEC is reportedly reviewing use of non-GAAP measures by Valeant Pharmaceuticals, which is already under scrutiny for accounting practices. "We are concerned with your overall format and presentation of the non-GAAP measures and believe revisions to your future earnings releases and investor materials are appropriate," the SEC said in a letter to the company in February.

Sometimes It Has Merit

The use of non-GAAP measures is, of course, nothing new. Companies have been pulling out or adding in numbers that make their results look better for eons. Sometimes it's justified and sometimes it's not. The high instance of non-GAAP usage, however, may indicate that companies are blurring the lines between trying to make an honest representation of reality and gilding the lily.

"There are occasions where investors do value non-GAAP disclosures," says Amy Borrus, deputy director of the Council of Institutional Investors. "Foreign exchange is a good example. For companies that have significant operations outside the United States, for example, foreign currency fluctuations can buffet financial reporting significantly. In such cases, it can be useful for investors to see a reconciliation based on a fixed exchange rate."

Now, issues must tread more carefully when using non-GAAP measures. It's likely the SEC will be examining their use more closely after issuing the guidance.

According to law firm Cozen O'Connor, the C&DIs provide that certain adjustments to a GAAP number, although not explicitly prohibited in the SEC's rules and regulations, can result in a non-GAAP measure that is misleading. Specific examples include:

  • Presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a company's business;

  • A non-GAAP measure that is presented inconsistently between periods, such as one that adjusts a particular charge or gain in the current period and for which other similar charges or gains were not also adjusted in prior periods, unless the change between periods is disclosed and the reasons for it explained;

  • A non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period; and

  • A non-GAAP performance measure that substitutes individually tailored revenue recognition and measurement methods for those of GAAP.

The bottom line is tread lightly when straying from Generally Accepted Accounting Principles.