Mind the GAAP! Here are 5 things you need to know about non-GAAP financial measures

Are you using non-GAAP financial measures? Need an update on the SEC’s rules and interpretative guidance around reporting this information? Then listen to this week’s episode. Diane Howell, a partner in PwC’s national office, joins Heather Horn to discuss 5 things companies should know about non-GAAP measures, including:

• 0:53 - A helpful refresher on the definition of a non-GAAP measure and common examples
• 1:47 - The drivers behind why companies report non-GAAP measures and why they believe the measure is useful
• 4:51 - An overview of the SEC’s rules and interpretative guidance around the use of non-GAAP measures
• 9:20 - Insights into how the SEC reviews non-GAAP information included in SEC filings, including how they view prominence, reconciliations, and individually tailored measures. Diane also discusses recent related comment letters and enforcement cases.
• 15:51 - Best practices for reporting high quality non-GAAP measures

Transcripts available upon request for individuals who may need a disability-related accommodation. Please send requests to us_podcast@pwc.com.

Transcript

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Heather Horn 0:00

Hello and welcome to PwC's accounting and reporting podcast series. Our mission is to inform and educate accountants and other stakeholders on today's hottest accounting issues. I'm your host, Heather Horn, a partner in our national office. Back with me today is Diane Howell, a partner in our national office who specializes in SEC reporting. Diane is a prior guest on our series and it's great to have her back. In today's episode, we'll focus on a perennially popular topic, non GAAP financial measures. Diane will start with some background information and then we'll address key issues, best practices and frequently asked questions. So let's jump right into our discussion. So Diane, thanks so much for joining us today. I'm looking forward to this conversation about non GAAP measures. But maybe before we jump into

A helpful refresher on the definition of a non-GAAP measure and common examples

Heather Horn 0:53

it, why don't we start with some background and can you remind our listeners what we mean when we say non GAAP measures?

Diane Howell 1:00

A non GAAP measure is defined as a measure that either excludes or includes amounts that are included or excluded and the most directly comparable measure calculated in accordance with GAAP. And some examples, some more commonly used examples would be Ebitda, adjusted Ebitda free cash flow. But keep in mind that there are measures of operating performance that fall outside the definition of a non GAAP measure so the rules wouldn't apply to them. And some of those in some examples of those would be number of units, you know, sales, number of employees, number of subscribers, the measures of profit or loss for segments that's calculated in accordance with ASC topic 280, disclosure of the amounts of the payments that have been planned but not yet made.

Heather Horn 1:42

So thanks Diane. So that's helpful background then why don't we move into our next topic, which would be

The drivers behind why companies report non-GAAP measures and why they believe the measure is useful

Heather Horn 1:47

why do companies like to use them. I have some theories, but why don't you let us know what we know about that.

Diane Howell 1:53

Sure. Well in some respects the old adage, everybody's doing it kind of applies here. Let me give you some statistics to show you what I mean. For 2018, 97% of the S&P 500 used at least one non GAAP financial measure. To compare that in 2016 it was 76% in 1996 way back then it was 59%. So they have grown significantly over time. The average number of measures used over the last 20 years has increased from approximately two and a half to seven and a half. That's a huge increase. So there's several reasons why I think companies use non GAAP financial measures. I think they do provide investors with useful information which can benefit investors if this leads into a better understanding of the company and investors are demanding these measures. I think it allows the company to tell its story and it kind of gets to core operations. If you're taking out adjustments sort of one time adjustments or unusual adjustments if it gets you to the actual core operations, it may also assist in you know, cross industry or company to company comparisons. These differences between GAAP and non GAAP measures have increased significantly over time which has resulted in additional interpretive guidance from the staff as well as the staff's continued focus on these measures.

Heather Horn 3:15

So, Diane, let's pause before we get into the rules and interpretations. I just have a question. So from two and a half on average to seven and a half, think that's triple in number and that's a lot of non GAAP measures and you gave a few common examples. What other types of measures do people even include?

Diane Howell 3:36

Well some examples would be presenting numbers on a constant currency basis. Some industry specific measures, for example, funds from operations as a real estate specific measure. Also adjusted Ebitda can be adjusted for several different items at several different times. And each time, you know, the title will be changes a little bit.

Heather Horn 3:53

So, you are saying that you have adjusted Ebitda and then you have sort of a further adjusted.

Diane Howell 4:00

Yeah, exactly. It really depends on the company and their facts and circumstances. And again, sort of industry based as well.

Heather Horn 4:07

And then you said, we went from I think you said around 59%, 60% 20 years ago to 97% today. That's also a huge increase. And again, I think you mentioned investor interest and then I guess if I'm a company and I see another company using a measure then I might think, oh that's helpful to me. I mean anything else that we think is really driving?

Diane Howell 4:33

No, I mean as I said before, it's kind of everybody does it. Like nobody wants to be an outlier and if that's what the analysts are looking for for a particular industry, then they want to see it from all the different companies. So I think it's a combination of those two things.

Heather Horn 4:44

Okay, good. That's helpful. So then why don't we move into our third topic, which you know, I'm aware lot

An overview of the SEC’s rules and interpretative guidance around the use of non-GAAP measures

Heather Horn 4:51

of rules around the use of these measures by SEC registrants. So can you just give us some background on the rules and interpretations?

Diane Howell 4:59

Sure. The rules were issued in 2003 as a result of the Sarbanes Oxley Act. They haven't really changed since then. There's been additional guidance issued primarily in the form of what we call CDIs compliance and disclosure interpretations. But these are basically reflection of the evolution of the staffs thinking based upon the practices of registrants. The SEC does not prohibit disclosure of non GAAP measures. You simply must comply with the rules and the interpretive guidance in developing the measure and disclosing it. So there's specific rules which depend upon where the measure is used. There's three levels. So the first one is Reg G which is for any public disclosures. The rules here can't be misleading. You must disclose the directly comparable GAAP number and a reconciliation from GAAP to non GAAP must be made and that must start with the GAAP number and move to to non GAAP. The second level is for Item 202, Form A-K for an earnings release. This would be all the requirements of Reg G, which I just talked about plus the addition of these three items. The first one is that the GAAP number must be of equal or greater prominence. And in fact must be before the non GAAP measure. Disclosure needs to be made of why management believes the non GAAP measure is useful. And third, how management uses that non GAAP measure if it's applicable, if they actually use that measure in running their business. The third level is Item 10-E of Regulation S-K and this is for SEC Filings Forms 10Q, 10K 20 half et cetera. This would be Item 202 Matters plus the addition of other rules. The first one is is that you cannot exclude charges or liabilities that require cash settlement from liquidity measures. The second one was you cannot exclude items identified as either nonrecurring, infrequent or unusual from performance measures if that item or that event happened at least once in the last two years or is expected to happen again in the next few years. It doesn't mean you can't adjust for it. You just can't call it one time event. You can't include the information financial statements or performa information and you can't use misleading titles.

Heather Horn 7:11

So then, I have a couple questions. You mentioned that the sort of second layer, what applied to an earnings release and then this full sort of suite applies if it's going in one of your registration statements. So then does that mean I could, if I'm a company actually have some non GAAP measures that are included in the earnings release but then aren't in the registration statement? Like is that a common occurrence?

Diane Howell 7:37

It is a common occurrence, however, you know, if the information was deemed to be important enough for an earnings release, I mean there's always a question of well why isn't it then in the filing, the subsequent filing, you know, again the staff wants consistency and again, if you thought it was important to disclose in your press release, you probably should put it in your filing as well.

Heather Horn 7:54

Right. And so then to the extent it doesn't comply with that additional set of rules, I guess that would raise a question if it makes sense for it to be in your press releases to begin with.

Diane Howell 8:03

Or modify your press release so that it meets the rules for inclusion in your 10Q or subsequent SEC filing.

Heather Horn 8:10

Okay, that's helpful. And then you made a comment when you're talking about the press release where you mentioned that a company needs to disclose how the management uses the measure and then so do they need to use that measure as part of managing their business or it's only if they do use the measure?

Diane Howell 8:28

It's only if it's applicable.

Heather Horn 8:29

Okay. So in some cases you may decide to disclose something because you know it's helpful for analysts or something else, but it's always the company job. Okay, that's very helpful. And then think, this might be my last question on this, the very first set of rules you talked about, which would apply to any disclosure. So I would assume that would include if it's on your website or analyst reports, et cetera. So then do we have instances where companies could get comments from the staff even on those types of disclosures?

Diane Howell 8:57

Absolutely. Yes, the SEC will look at websites and analyst reports and analyst calls. They'll look at that oftentimes for non GAAP measures they'll look at it to see, you know, that the way you discuss segments is consistent with your financial statements, there's a lot of things that they look for.

Heather Horn 9:15

So Diane, that's helpful. So then why don't, I think that naturally leads us into our next

Insights into how the SEC reviews non-GAAP information included in SEC filings

Heather Horn 9:20

topic, which is comment letters and comment letter trends. And at least from my recollection, non GAAP measures has been sort of at the top of the trends at least for the past few years. So can you give us some sense of the types of comments companies receive and some of the things that they should be thinking about?

Diane Howell 9:36

Sure. You're right, it is still the number one source of comments and the comments user requests registrants to either remove or substantially modify the measures that are presented. They are less than they were last year, but there's still more in number than they were in 2015, which was right before the new guidance. The new CDIs were issued in 2016. Okay. So some of the common comment letters have been around prominence. Again, GAAP number has to be of equal or greater prominence, reconciliation you have to reconcile from the GAAP number to non GAAP number. Also, the disclosures as to why management believes that the non GAAP presentation provides useful information to investors. It's either not conclusive, it's too boiler plate or it's missing. There's also been a couple of recent enforcement cases that are worth mentioning. Coincidentally they both are around prominence. The first one, the staff, the Corp Fin issued a comment, asked the registrant to modify or remove the particular measure. The registrant agreed to do that and then didn't do it so that's when enforcement stepped in. The second one, the enforcement just went after directly. A couple of lessons here to learn is that you say you're going to do something, do it because the staff will follow up and secondly that the commission will hold people up to CDI interpretations. There has been progress made in some of the easy to fix issues, which to me they are the prominence and the reconciliation. So they've kind of moved on and now focusing on individually tailored accounting principles. So this guidance was added to the 2016 CDIs and question number 100.04 and this states that a non GAAP financial measure that substitutes individually tailored revenue recognition in measurement methods from those of GAAP could violate SEC rules. They're not clearly defined, but when we talk about these measures, these usually are things that that go beyond simple adding and subtracting of GAAP numbers from a financial statement line item. The SEC did provide some insights into what they believe. These individually tailored accounting principles are at the AICPA conference in December and they highlighted four questions that they ask when they review registrants non GAAP measures to determine whether or not they are individually tailored accounting principles.

Heather Horn 11:54

Wait, before you go into the rules then an individually tailored accounting principle is not an acceptable non GAAP measure?

Diane Howell 12:06

That's correct.

Heather Horn 12:07

That's what I thought. So let's keep going. So then, so basically they issued new interpretive guidance in 2016 and that which included this, they highlighted this issue. Okay. Because we're seeing increasing trend to these individually tailored accounting measures.

Diane Howell 12:23

That's right.

Heather Horn 12:24

Okay. So then if I'm a registrant now, what should I be looking for for this? What are these four things?

Diane Howell 12:31

The SEC has four questions that they shared with us as some insights as to things they're asking before they issue a comment. The first one is, is does the adjustment shift GAAP from an accrual basis of accounting to a cash or modified basis of accounting? For example, if you recognize revenue over time and then you switched to a point in time for a non GAAP measure, that would be not acceptable. The second one was does the adjustment include transactions that are also reportable in another company's financial statements. In this would result in changing your conclusion as to whether you're a principle or agent and a gross versus net consideration or whether or not you have significant influence or consolidation over company. These could result in the presentation of transactions that are reportable within another company's financial statements.

Heather Horn 13:14

So if you have those, you cannot change?

Diane Howell 13:17

These are all things that you can't do.

Heather Horn 13:18

Okay.

Diane Howell 13:19

The third one is, does the adjustment reflect parts but not all of an accounting change? For example, if you adjust for income tax effects, but you only include the impact of cash taxes paid and you exclude the impact of temporary or permanent differences. And the last one is this, does the adjustment render the measure inconsistent with the economics of a transaction or an agreement? This example is, for example, in a situation where companies earn revenue from operating in sales type financing leases. If you adjust revenue for the sales type leases as if they were operating leases, then it would ignore some of the underlying economics.

Heather Horn 13:55

Okay. So very helpful. So this is a new, I think going to be a new concept for a lot of our listeners. Can you give us some examples of what we mean when we say these individually tailored accounting principles?

Diane Howell 14:07

Sure. I actually brought a couple of sample comments so why don't we just read those.

Heather Horn 14:11

Okay.

Diane Howell 14:11

The first one is, we note your computations of non GAAP measures adjusted operating earnings, adjusted net income and adjusted eps, exclude acquisition related intangible assets, amortization. Please tell us how you determined the adjustments to exclude the amortization of certain acquired intangible assets. Do not substitute individually tailored income or expense recognition methods for those of GAAP. Refer to question 100.04 of the non GAAP financial measures compliance and disclosure interpretations. A second one is you include adjustments to arrive at net operating profit that appear to remove your operating lease rent expense under GAAP and replace it with estimated depreciation as if these assets had met the criteria for capital assets or you had purchased the properties. You also include adjustments to arrive at average invested capital to add an estimated asset base for these operating assets that does not exist on your GAAP balance sheet and remove various lease liabilities. It appears that these adjustments may substitute individually tailored recognition in measurement methods for those of GAAP. Please remove these adjustments from your non GAAP measure or tell us how you considered the guidance in question 100.04 of the non GAAP financial measures compliance and disclosure interpretations updated on April 4th, 2018 and concluded that these adjustments were appropriate.

Heather Horn 15:27

Wow. So basically with this sort of new trend of individually tailored accounting principles is going one step beyond a non GAAP adjustment, which is taking GAAP number and adjusting it for another GAAP number and almost like making up your own GAAP. And that's what the staff say you cannot do.

Diane Howell 15:46

Exactly, yes.

Heather Horn 15:47

Very clear from those comments. That's helpful. Thank you. Okay, good. Maybe

Best practices for reporting high quality non-GAAP measures

Heather Horn 15:51

then if I'm someone who's listening and hopefully thinking, okay, I will not be coming up with my own accounting principles, but I would like to have high quality non GAAP measures, what are some best practices that our listeners to think about?

Diane Howell 16:02

Sure. Well, remember to clearly describe why you're using the measure and what the measure was designed to do. Again, avoid boiler plate disclosures as to why the information is in there. Implement a structure to reduce the subjectivity of the measures. You know, have policies and approval process, you know, controls around these measures. The same rigor that's used for the preparation and presentation of your GAAP numbers should be used for your non GAAP measures as well. Get your audit committee involved. The audit committee should be comfortable with the measures that are presented and how they're calculated. Whenever the disclosure committee or the audit committee gets involved. We always see that there seems to be a positive impact on the quality of the measures. Remember to be consistent and to be transparent for consistency. If you change the way you're calculating a measure from year to year, that should be disclosed and there should be a bridge from one year to the next. Also remember no cherry picking. If you're going to adjust net income to take away some charges you have to do the same thing for gains, unusual gains. For transparency these would include what we talked about before which is that the comparable GAAP number has to have greater or equal prominence also that the title of the non GAAP measure can't be confusing and it can't be too close or can't be exactly the same as a comparable GAAP number. It has to be very clear and this gets particularly challenging if you have a whole bunch of non GAAP measures. If you could start with your 2.5 to 7.5 that we talked about before, if you have a whole bunch of non GAAP measures, you have to make sure that they're all really clear as to what they are. And lastly, just remember that bending the rules to get the result that you're looking for is wrong whether it's a GAAP number or a non GAAP number.

Heather Horn 17:50

Always a good reminder. Yes. Yes. And it's interesting, I mean you've talked about the fact that the rules were originally issued in 2003 and then obviously there's been recent interpretation, but still that there's still so many comments around this. I think this is really a good reminder for people. Be familiar with the roles and make sure you're falling against the spirit of the rules as well because again, of this trend that we're seeing. So very helpful Diana, I think great timing with calendar year end companies. I'm going into first quarter year reporting so really appreciate you being here today.

Diane Howell 18:17

Thank you Heather.

Heather Horn 18:18

To our listeners, I hope that you learned as much as I did from this discussion with Diane. Check out our podcast page on CFOdirect.com for more information on non GAAP financial measures and to find Diane's prior episode on SEC comment letter trends. I hope you'll join me here again next week for a topic that goes beyond the financial statements when I interview PwC economist Chris Benko to discuss five things you need to know about economic trends. To make sure you never miss an episode, subscribe to our podcast series on iTunes, Stitcher, Spotify, or wherever you find your content, and we'd love to hear from you. So please leave us a review. For PwC, I'm Heather Horn. Thanks for tuning in. This podcast is brought to you by PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This podcast is for general information purposes only and should not be used as a substitute for consultation with professional advisors.