The use of unofficial accounting metrics that make profits look better than they has been flourishing for years. Recently, though, the Securities and Exchange Commission seems to be getting serious about doing something about it.
On Tuesday, James Schnurr, the SEC’s chief accountant, spoke at the 12th Annual Life Sciences Accounting and Reporting Congress in Philadelphia. Most of his remarks dealt with the new revenue recognition standard—how and when companies report sales—becoming effective in 2018, a standard that will be a complex one for life sciences companies to apply.
Also of interest to life science companies were his closing remarks that dealt with non-GAAP reporting—something many life science firms employ regularly. (Every 90 days!)
He’s noticed the same things that everyone else has noticed:
Non-GAAP measures are intended to supplement the information in the financial statements and not supplant the information in the financial statements. However, when the financial news networks report quarterly earnings, 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. In addition, I am particularly troubled 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.
The problem is, the SEC doesn’t regulate financial news networks. And financial news networks are only going to work with what they’re given. Unfortunately, they’re given the same thing as everyone else, which is what the SEC’s Regulation G has led to. He’s got reasonable views on how non-GAAP measures ought to be prepared, though:
In my view, preparers should carefully consider whether significant adjustments to profitability outside of customary measures such as EBITDA or non-recurring items or other charges to the business, such as the sale of portions of the business in order to provide the user with an understanding of how these events impact trends and future performance, are appropriate. As it relates to cash measures, I believe those measures should be reconciled to cash flow from operations.
He’s right: some non-GAAP measures are helpful. Others are just more muck to assess. Without someone prodding the issuers to do it well, it’s not likely to get better. Mr. Schnurr gave no hints of any regulation of the matter beyond letter-writing campaigns:
Staff in the Division of Corporation Finance continues to monitor non-GAAP disclosures as part of its selective review process and regularly issues comments on this issue. The staff also provides guidance on the application of Commission rules through speeches and other mechanisms — and of course, staff comment letters are publicly available. You can expect that the staff will continue to be vigilant in their review of the use of these measures for compliance with the rules.
The reasons why non-GAAP accounting is growing are many. The SEC’s Regulation G provides a cozy, easily-complied-with safe harbor. A general belief by investors that accounting figures are not telling the right story, aggravated by managers who disdain accounting standards that force them to record equity-based compensation. In addition, managements whose compensation is determined by non-GAAP earnings targets want Wall Street to understand why they’re managing the firm in a particular way. There are probably many more reasons.
We’ve been studying non-GAAP earnings empirically each year since 2013, and each year has always been more amazing than the last. We’re currently working on the 2015 study of the practice in the S&P 500, and it’s far more shocking than last year’s 2014 study, which showed that the S&P 500 companies engaging in the practice had total non-GAAP earnings higher than GAAP net income by over 22%. The 2015 difference, so far, makes that look minor.
At a conference yesterday, SEC Chairman Mary Jo White mentioned that the practice is “something that we are really looking at—whether we need to rein that in a bit even by regulation,” The Wall Street Journal reports. She’s kicked it up a notch from a conference last December in which she declared that “This area deserves close attention, both to make sure that our current rules are being followed and to ask whether they are sufficiently robust in light of current market practices.”
Regulation G was enacted in 2002 and hasn’t been modified since; in that time space, non-GAAP earnings have grown like weeds. For years, the SEC has pursued a low-key path on issuing regulations in the financial reporting area. They’ve pursued a vigorous company-directed letter-writing strategy instead. To hear that they’re considering reining in non-GAAP earnings “a bit, even by regulation” may demonstrate an unusual level of concern.
Jack T. Ciesielski is president of R.G. Associates, Inc., an asset management and research firm in Baltimore that publishes The Analyst’s Accounting Observer, a research service for institutional investors. Another version of these articles were published on accountingobserver.com.