The battle over the use of non-GAAP measures in financial reporting has been simmering for well over a year, but now it may be starting to cool off.
Pressure may be easing on companies that prefer to use unsanctioned measures when reporting earnings
The battle over the use of non-GAAP measures in financial reporting has been simmering for well over a year, but now it may be starting to cool off. New leadership at the SEC may be less inclined to pursue non-GAAP as an issue, and accounting's top rule maker says he's open to rethinking the rules around the use of the unsanctioned metrics.
Companies commonly report financial measures that don't conform to Generally Accepted Accounting Principles (GAAP). A company may think that it's important to include or exclude certain amounts to give what it considers a more accurate picture of performance or to provide greater insight into the business, even when accounting rules require a different computation. The use of non-GAAP metrics isn't necessarily a violation of reporting rules, but using them to mislead investors is. Companies must also reconcile the non-GAAP measures to GAAP and report those figures as well.
Over the last few years, companies have increased their use of non-GAAP metrics when reporting earnings, and some have pushed the envelope on what could be considered an acceptable use of the disclosure tactic. The Securities and Exchange Commission, which enforces securities laws including those related to financial reporting, took notice and embarked on a crackdown of what it considered improper use of non-GAAP measures. Investor groups, financial reporting watchdogs, and other regulators have also voiced concern about non-GAAP measures, sparking a backlash against their use.
Making GAAP More User Friendly
Now, however, that campaign may be starting to recede. Among the most recent developments, the chairman of the Financial Accounting Standards Board, Russell Golden, has signaled that FASB, which sets GAAP, may be willing to explore the idea of making changes to it to better accommodate the situations where companies feel compelled to use non-GAAP measures.
"As we think about identifying new ways in which to improve GAAP, it is important to see how companies today use non-GAAP reporting to communicate their performance to shareholders," Golden wrote in a recent statement. "Another way to learn from non-GAAP measures is to identify cases in which changes to GAAP might reduce the need for non-GAAP reporting. Some non-GAAP reporting develops because investors request and help shape the information provided by companies. Changing GAAP in these situations can help develop a standardized approach that is more consistent with common reporting practices that investors find useful. In other words, it would improve the credibility of financial reporting."
That's not to say that Golden favors opening the floodgates to unencumbered use of non-GAAP measures. In the same statement he expressed concern about how some companies are using them. "While the number of non-GAAP measures garnered significant attention, the nature of some of the non-GAAP measures were particularly troubling. Those measures lacked credibility because they ignored GAAP recognition and measurement principles altogether and inaccurately depicted the underlying transaction or event," he wrote.
A Kinder, Gentler SEC?
While making changes to GAAP to reduce the need to use non-GAAP measures would certainly be a welcome development to companies that use them, they may also find a more sympathetic SEC under its new chairman, Jay Clayton, whom President Donald Trump tapped to take over the reins at the agency. As the Wall Street Journal put it in a recent article, Clayton "is expected to end the streak of aggressive regulators and litigators overseeing the country's top markets cop." Clayton, a former partner in the New York office of law firm Sullivan & Cromwell, has argued in the past for less onerous regulation and has worked on behalf of companies for capital raising efforts. His ties to Wall Street banks and other companies may be in indication that he is unlikely to be a regulatory hawk.
Trump may even have an incentive to push for a less aggressive stance against non-GAAP measures. In 2002, the SEC targeted Trump Hotels and Casino Resorts for using pro forma earnings figures, a version of non-GAAP measures. The company received a "cease and desist letter for making "misleading statements" in a 1999 earnings release.
Last May, the SEC issued new guidance in the form of a Compliance & Disclosures Interpretations document that provided 39 questions and answers on what the SEC would consider acceptable use of non-GAAP measures and what it would take issue with. It also sent several letters to companies, including Valeant Pharmaceuticals and Tesla, warning them that their use of non-GAAP figures could be in violation of securities laws.
It's too soon to tell if the SEC, under a new guard, will back off its fight against the use of non-GAAP measures, or if FASB will change the rules to make GAAP more accommodating of the types of things companies hope to accomplish with non-GAAP, but companies don't seem to be backing away from using them. A recent assessment from research firm Audit Analytics found that 88 percent of the S&P 500 used non-GAAP metrics in a recent earnings report.
In December, Audit Analytics looked at how companies are responding to the guidance in a new report. The firm finds that companies aren't playing it safe by abandoning the use of non-GAAP measures. Indeed, they remain in use by most large companies, even after the warning by the SEC. Of Fortune 500 companies, 475 included at least one non-GAAP metric in financial reports issued in the period from July to September, after the guidance was issued, actually up one from the 474 that used a non-GAAP figure in the second quarter.
Nor are companies shying away from using them to improve how they look to investors. The Audit Analytics report found that Non-GAAP adjustments increase net income 82 percent of the time.