Just in time for fourth-quarter audit committee meetings, everyone’s favorite financial reporting punching bag for 2016 is back: non-GAAP financial metrics!
When we last visited non-GAAP metrics in July, the chatter against this quasi-scourge was rising. The SEC didn’t like it, the PCAOB didn’t like it, governance activists didn’t like it. Then everyone seemed to take early autumn off.
Well, non-GAAP is back on the regulatory agenda now. Corporate compliance and audit executives should brace for the inevitable conversations about it with your audit committees.
Last week the PCAOB heard a presentation from its investor advisory committee on the subject. The group recommended more disclosure about how companies devise their non-GAAP financial metrics, and even suggested that the metrics be subject to external auditor review. At the same time, we saw a Wall Street Journal report that the SEC’s Enforcement Division has begun telling companies that it is reviewing their non-GAAP reporting—a signal that the agency is looking for examples to make.
No wonder that according to Audit Analytics, the S&P 500 saw a remarkable drop in non-GAAP reporting over the summer once regulators made their displeasure known.
Still, that’s all just recap of where non-GAAP has been. Compliance officers need to anticipate where oversight of non-GAAP is likely to go, and right now regulators seem to be meandering toward more regulation, more enforcement, or both. Let’s consider what’s at stake for all parties (companies, regulators, investors), and game out how corporate compliance and audit executives can walk the tightrope unspooling before you.
Issue One: Clarity vs. Clarity
Sensible people can agree that non-GAAP metrics are fine if they help to give investors an accurate sense of the company’s business value and economic activity. Right now, however, our corporate disclosure regime sends conflicting signals about what that accurate sense should be. Those conflicting signals then become a breeding ground for abuse.
A great example of this confusion comes from FASB’s new rules for stock option expensing, which go into effect in December. The rules require companies to start listing the tax benefits of employee stock options on the income statement, rather than on the balance sheet where they reside now.
For a company with a swiftly rising stock price, those tax benefits can be substantial. One estimate from Morgan Stanley pegged the benefit as a 5 to 8 percent boost to net income for “stock compensation intensive” firms. Calcbench did its own ranking of firms likely to feel flush thanks to this rule; to no surprise, they are almost all tech and pharmaceutical businesses.
This new treatment of stock option costs isn’t bad unto itself, but consider what it does. By bringing the tax benefits onto the income statement, net income becomes a more volatile metric—because stock price can change quickly, and the reported tax benefits along with it. So while the investor gains clarity about net income in any specific quarter, he loses clarity about the company’s fundamental income over time.
How do you clarify that confusion for the investor? With a non-GAAP metric.
My point isn’t to beat up on stock option reporting (reporting of pension plan benefits has the same effect). It’s to show that the goals of financial reporting can be interpreted in multiple ways, and our own financial reporting regime reflects that. We have regulators worried about the proliferation of non-GAAP even as they adopt rules that encourage non-GAAP at the same time.
The best rule of thumb for CFOs and audit committees, then, is to think about the clarity you want to give to investors. Sometimes that will take the form of a GAAP metric, other times the form of a non-GAAP metric with appropriate disclosure. That’s what SEC guidance has always required of a non-GAAP metric, really: explain its relevance, and tie it back to a GAAP-permissible counterpart. The audit committee needs to answer: how do these disclosures give the most accurate picture of our business activity?
Issue Two: Defining Harm
The frustrating part, of course, is that so many companies ignore that simple wisdom. Hence we have the SEC’s guidance about non-GAAP disclosures released in early May. Half the message in that guidance telegraphs mundane details like “don’t put non-GAAP in the headline but bury GAAP in the fourth paragraph” or “no fancy adjectives to hype up non-GAAP and glaze over your terrible GAAP numbers.”
When I first read the guidance, I thought: Headlines, fonts, adjectives—didn’t we cover all this in high school composition class? Yet, apparently, companies do it.
That’s why I’m curious to see what an SEC enforcement action over non-GAAP might look like. If the SEC sanctions companies specifically along these lines, over attempts to flimflam your way through an earnings statement with ridiculous descriptives of non-GAAP performance, that’s a clear signal to audit and compliance teams compiling financial statements: don’t do it. Quit applying cosmetics to the nose of the pig, and focus on a substantive defense of non-GAAP numbers’ relevance.
Regulation G (which governs reporting of non-GAAP) only addresses the presentation of these numbers to investors; not the internal uses of the non-GAAP metric itself. So when people complain that, for example, Mylan Labs games its non-GAAP metrics to reward executives for price-gouging EpiPens—they may have a moral high ground. It’s just unlikely to lead to an SEC enforcement over non-GAAP reporting. Much more likely, the SEC will grab attention by sanctioning companies for doing dumb things in their earnings releases.
An astute audit committee should be able to avoid that.
Issue Three: Non-GAAP Reform
That brings us to who should lead on non-GAAP reform. Companies should prefer new guidance or regulation from the SEC (which can raise costs, for some), before new rules from the PCAOB that might bring non-GAAP into the scope of an audit (which will raise costs, for everyone). But we all know the most cost-effective way to avoid non-GAAP trouble in the future is for audit committees and financial reporting executives to do a better job today of preparing all their disclosures.
That better job isn’t easy, but the basics are clear: GAAP numbers equally prominent to non-GAAP numbers. Lucid explanations of why non-GAAP metrics are included. Using non-GAAP to explain performance to investors, not to engineer performance for insiders.
And then we wait for the next wave of non-GAAP attention. Shouldn’t take too long.