SEC Staff guidance in the form of Q&As – known as Compliance and Disclosure Interpretations, or C&DIs – typically is helpful. However, we believe the SEC Staff's most recent guidance, and some recent comments, on non-GAAP financial measures miss the mark.
As good as Generally Accepted Accounting Principles are, they are at best imperfect. GAAP does not come close to reflecting the "fair value" of a business – or businesses generally would trade at prices near their book value – and it falls far short of revealing to investors all of the information necessary or desirable to make informed investment decisions. This knowledge gap is less significant to sophisticated financial analysts (and private equity firms and activists) who have both the resources and expertise to dig deeper and discern a truer value of a business than it is to investors who do not have that ability, but there will always be some level of gap for all investors.
For the last twenty years or so, businesses have attempted to better bridge this information gap through providing financial metrics that they believe better inform investors of their businesses' prospects, and ultimately their value. Some of these metrics have nothing to do with accounting – e.g., the number of cars produced or revenue seat miles – but others do, and inconveniently some of the accounting-centric metrics that businesses believe are the most helpful in better reflecting value do not reflect GAAP accounting. The misuse of these "non-GAAP financial measures" in turn leads to regulation by the SEC, including the C&DIs released by the Staff last week.
Three things struck us as we read the C&DIs. First, we believe the Staff is emphasizing form over substance. For example, while the rule requires that a GAAP financial measure be given "equal or greater prominence" than the corresponding non-GAAP financial measure, the Staff believes the order of presentation is more relevant than the plain meaning of the words in the actual rule. We are confident that the "equal prominence" requirement of the rule is fully satisfied by saying "Adjusted operating income was $104 million, while GAAP operating income was $96 million." The SEC simply disagrees. This carries over to the implication that providing non-GAAP financial information in bullet points at the beginning of a press release is acceptable only if the comparable GAAP measures immediately accompany (actually, precede) the corresponding non-GAAP financial measures and are not contained in the next paragraph, a mere 30 or 40 words later. If there are substantive issues here that would meaningfully benefit investors, we are missing them, and we are not at all so sure that the Staff's conclusions on form are correct.
Second, the Staff takes the position in the C&DIs that it is per se impermissible to use a non-GAAP financial measure that reflects revenue prior to its recognition under GAAP. We see no support in the underlying rule for taking a position that absolute – and wonder how the Staff can do so given the Administrative Procedures Act – and have seen situations where doing precisely what the Staff purports to prohibit clearly presents a more informed view of a business' performance. As a simple example, when a business for the first time offers extended warranties, it reports the income evenly over the lives of the warranties until it has sufficient data on warranty costs to support a different revenue allocation. Read literally, the C&DI on revenue would prohibit the business from reporting the aggregate sales of warranties during a period because that would suggest a prohibited acceleration of revenue into that period.
Third, the Staff's continued resistance to measures based on cash flows disappoints us. We appreciate that cash flow per share can be misleading in that it does not assure an investor of any ability to receive that amount of cash per share, but earnings per share has the same flaw. We do not understand why, when investors value many types of businesses on their ability to generate cash, the Staff is so doctrinally opposed to businesses providing information that facilitates that analysis. Abusive disclosure should not be permitted, but we believe investors benefit when the SEC gives more freedom to businesses and the marketplace to decide what is important.
We also are puzzled by the recent comment letter to a "serial acquirer," in which the SEC challenges the business' practice of excluding certain acquisition-related expenses. While we do not have a view on the particular exclusions, we believe investors benefit by understanding management's expectations for economic productivity on a go-forward basis, maybe more so for a serial acquirer than almost anyone else. We believe that the SEC should encourage, not discourage, this type of disclosure, but, of course, make sure that it is fair and reasonable.
We worry that the SEC, in response to comments from others, is throwing the baby out with the bath water. If there are non-GAAP financial measure presentations that are misleading, then the SEC should address the substantive disclosure shortcomings. We do not believe, however, that it serves investors to undermine their ability to view a business' financial performance and prospects through the eyes of management – a core principle in MD&A – by overly chilling routine communications conveying non-GAAP financial measures.
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