United States: SEC Staff Comment Letters Regarding Non-GAAP Financial Measures

Last Updated: October 19 2018
Article by Cydney Posner

You might recall that, in 2016 and early 2017, the SEC made a big push—through a series of staff oral admonitions and written guidance, as well as an enforcement action—to require issuers to be more transparent and more consistent in the use of non-GAAP financial measures and to avoid altogether non-GAAP measures that were misleading. For example, companies were advised that they needed to present GAAP measures with equal or greater prominence relative to the non-GAAP measures. (See, e.g., this PubCo post.) By early 2017, the SEC staff were apparently sufficiently satisfied (see this PubCo post) with the responses to their campaign that the pendulum swung back, and the relentless finger-wagging by the staff about non-GAAP financial measures appeared to have tailed off. (See this PubCo post.) But, according to this analysis from Audit Analytics, it wasn't until this year that the SEC staff's comments regarding non-GAAP financial measures actually began to decline.

The analysis looked at SEC staff comment letters regarding Forms 10-K, 10-K/A 10-Q, 10-Q/A and 8-K from January 2010 through June 2018. The analysis showed that, while the overall number of staff comment letters declined precipitously from 15,646 in 2010 to 4,525 in 2017 and to only 1,409 for the first six months of 2018, the proportion of comment letters referencing a non-GAAP measure increased from 4.5% in 2010 to 23.7% in 2017, but has declined to 17.7% in the first six months of 2018. Similarly, the percentage of comment letters issued to unique companies addressing a non-GAAP measure spiked to 37% in 2017 from 8.9% in 2010 before declining to 25.1% for the first six months of 2018. The implications are that the staff have been focusing on non-GAAP issues in their comment process, but what does the 2018 decline suggest—increased issuer compliance or deflection of staff interest to other topics?

The analysis also looked at the incidence of specific types of comments in the period between July 2016 (after the non-GAAP CDIs underwent a major overhaul) through August 2018. (See this PubCo post and this PubCo post.) The percentage of companies that received staff comments with regard to the issue of the presentation of GAAP measures with equal or greater prominence fell from 37.6% in the last six months of 2016 to 22.1% in the first six months of 2018. From the perspective of ease of compliance, this comment is kind of a "gimme," so it's likely that companies largely fell in line. As this article revealed, according to Audit Analytics, in 2016, over 25% of the companies in the S&P 500 index had shifted their presentations to put GAAP at the top of their quarterly earnings releases and 81% made GAAP numbers most prominent, compared with only 52% for the prior quarterly earnings. (See this PubCo post.)

While the incidence of many non-GAAP comments has been relatively flat, the incidence of comments on individually tailored recognition and measurement methods has nearly doubled from the last six months of 2016 to the first six months of 2018, from 6.5% to 12.3%. Under the relevant CDI, the staff indicated that non-GAAP measures that substitute individually tailored recognition and measurement methods for those of GAAP could violate Rule 100(b) of Reg G. The example given describes a company that improperly used a non-GAAP measure that accelerated revenue—which, under GAAP, would be recognized ratably over time—to make it appear that the company earned revenue when customers were billed. The staff viewed as impermissible the replacement of an important accounting principle with an alternate accounting model that did not conform to the company's business. In that regard the then-Deputy Chief Accountant had observed that, "if you present adjusted revenue, you will likely get a comment; moreover, you can expect the staff to look closely, and skeptically, at the explanation as to why the revenue adjustment is appropriate."

An earlier analysis of comment letters by Audit Analytics described in the WSJ showed that, of the 42 companies that had received comments about substituting "tailored revenue metrics" in lieu of the applicable GAAP measure, 29 had "changed their presentation of results to satisfy the SEC's concerns." Commenting on the staff's guidance in 2016, the then-Corp Fin Chief Accountant indicated that, for companies attempting to challenge the staff's guidance with regard to the use of individually tailored revenue recognition and measurement methods instead of GAAP, "the bar was high." (See this PubCo post.) Nevertheless, compliance with guidance that concerned more than placement on the page—and that involved nuance, judgment and complexity (See this PubCo post)—seems to have presented more of a challenge, and some of the companies that resisted making a change suggested by the guidance have apparently heard from the staff about that decision. (See this PubCo post.)

Another area that has been subject to a significant increase in the incidence of SEC comments is the presentation of free cash flow. Those percentages have jumped from 2.3% in last six months of 2016 to 9.0% in the first six months of 2018. In the CDI, the staff indicated that Item 10(e)(1)(ii) does not prohibit the use in SEC filings of a measure of "free cash flow," which is typically calculated as cash flows from operating activities (as presented in the statement of cash flows under GAAP), less capital expenditures. However, because this measure does not have a uniform definition and its title does not indicate how it is calculated, companies were advised to accompany the measure with a clear description of how it was calculated along with the necessary reconciliation. The staff advised that companies should also avoid inappropriate or potentially misleading inferences about its usefulness, for example, by inappropriately implying that the measure represents the residual cash flow available for discretionary expenditures (because many companies have mandatory debt service requirements or other non-discretionary expenditures that are not deducted from the measure). The analysis from Audit Analytics suggests that the increase in comments appears to reflect the need to provide more complete descriptions as well as the nature of the measure as a "gray area." Another CDI confirms that, when a non-GAAP liquidity measure (such as free cash flow) is presented, the three major categories of the statement of cash flows should also be presented. This topic was likewise one that has been the subject of increased comment by the staff over the same periods, from 1.3% to 4.1%. The increased incidence of comments on both topics, the analysis suggests, "may indicate that companies are receiving both comments related to one item of financial reporting."

Although the proportion of comments related to the exclusion from a performance measure of normal, recurring, cash operating expenses has dropped a bit—from 12.7% to 9.0%—it is still relatively high. The CDIs note that these exclusions can be misleading where they exclude expenses necessary to operate the business. In addition, under Item 10(e), issuers are prohibited from describing an adjustment to eliminate or smooth items as non-recurring, infrequent or unusual when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years. The analysis observed that these issues can be especially complex, for example, where expenses and costs related to acquisitions and restructuring occur over multiple periods, but are not necessarily recurring expenses.

In the earlier analysis from Audit Analytics for the WSJ, one area that seemed to draw attention was non-GAAP exclusions of restructuring costs, which were questioned as potentially misleading—even when they were not characterized as "non-recurring"—on the basis that, in light of the frequency or duration of the companies' restructurings, the costs could reflect regular business expenses that should not be excluded. In many of these cases, the companies were able to successfully argue that the expenses or charges were not adjustments to remove normal recurring cash operating expenses necessary to operate the businesses or otherwise part of routine operations, but rather were unique charges that skewed the comparability of operating results. In some cases, companies contended that the same charges were excluded for internal purposes, such as decision-making and forecasting by management and assessment of trends and operating performance. (See this PubCo post.)

The analysis concludes that companies may be self-correcting on the easy changes, such as undue prominence, resulting in fewer SEC comments in those areas; however, issues that are more complex, "such as tailored accounting and free cash flows, are being addressed more often in SEC comment letters to registrants....Trends to keep an eye on include the non-GAAP measures that are complicated by complex accounting practices and require detailed explanation of unique circumstances be provided. It will be interesting to see if the trend of the SEC nudging companies for better explanations will endure, or if registrants will make an effort to provide more clarification on financial statements."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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