Our friends at Audit Analytics, who do some really great work with audit and accounting firm data, compiled data on SEC comment letters sent to companies on their non-GAAP earnings presentations in recent years. We put our heads together to surmise what might lie ahead when the SEC's Division of Corporation Finance makes good on its stated intentions to tamp down fringe non-GAAP reporting. The blog below is the result, and it is also posted on their blog.
On May 18, the PCAOB held a Standing Advisory Group meeting. One topic was the spread of non-GAAP earnings reporting, naturally: if it isn’t topic number one among regulators, it must be close. That meeting was held the day after the SEC’s Division of Corporation Finance (DCF) released a new Compliance & Disclosure Interpretation intended to rein in some of the sloppier practices observed by the Division’s staff.
Mark Kronforst, Chief Accountant for the DCF, stated that “this next quarter will be a great opportunity for companies to self-correct.” Presumably, that means firms will tidy up their reporting in the June quarter, with the promise of greater SEC engagement if the third quarter reporting isn’t in line with DCF expectations after companies have had time to digest the new interpretation. If the DCF is going to initiate, say, a muscular letter-writing campaign, it might not begin until November at the earliest, the month after 8-K third quarter releases have been filed. With the lag between the time letters are sent and the time they appear in EDGAR, we might not know the extent of the SEC’s intervention until, say, late fall.
While the new guidance isn’t going to outlaw non-GAAP reporting (free speech rights, anyone?), you could still wonder what won’t fly. Audit Analytics combed through the pre-and-post-2005 SEC and registrant correspondence relating to non-GAAP earnings presentations which revealed some unusual trends (more on that later) – but also imparted some lessons about what hasn’t worked out well for registrants in the past. Audit Analytics found that in 2014 and 2015, there were 54 instances where the registrant either removed non-GAAP metrics completely, or at least substantially modified them. Here’s the breakdown:
|Reasons to remove or substantially modify non-GAAP metrics||Count|
|Presentation of full Income Statement or Balance Sheet on a non-GAAP basis||23|
|Presentation of non-GAAP metrics in the footnotes or on the face of financial statements||5|
|Adjustments for disallowed expenses /Other||5|
|Presentation of cash flow per share on a non-GAAP basis||3|
|Exclusion of charges that require cash settlement||3|
|Total non-GAAP metrics removed by order of the SEC||39|
|Non-GAAP metrics removed on a voluntary basis||15|
|Total non-GAAP metrics removed after SEC comments||54|
For this set of companies, 33 of them related to letters issued by the SEC in 2014, while 21 related to letters sent in 2015 – the opposite of what one might expect if non-GAAP reporting has been rising in recent times. Still, it’s a small population, and as discussed above, the SEC is just now really turning its attention to it.
When one considers the reasons for some of the radical actions taken with non-GAAP reporting, some of them really are not surprising: they fly directly in the face of what is permitted by the SEC’s Regulation G. Charges requiring cash settlement are not allowed, nor are cash flow per share measures. Presentation of non-GAAP measures on the face of the GAAP financial statements can create the impression that they’re required by accounting standards, as does a presentation in the footnotes. What may be surprising is that some of the firms – 15 of them – simply took the SEC’s advice and removed their presentation. It’s easier to switch than fight, they seem to be saying.
In some cases, the decision to substantially revise the non-GAAP presentation came following a prolonged, and often painful, review process. The recent case of Ashford Hospitality Prime (AHP) is just such an example. The review focused exclusively on non-GAAP presentation and included six rounds of comments over 200 days, beginning in November 2015 and only getting resolved in June 2016. For comparison, in the past two years a typical SEC review was concluded in fewer than 50 days.
Some elements of this particular conversation are quite unusual and warrant a deeper look.
- The SEC’s review did not focus on Ashford’s technical compliance with specific Compliance & Disclosure Interpretation (CDI) questions. Instead, the SEC raised general concerns about some types of adjustments included in the presentation of “Hotel EBITDA” for the recently acquired Sofitel Chicago Water Tower.
- The follow-up letter, issued on January 12, 2016, included some surprising language: “Although we have not requested that you amend your filing, we intend to review your future earnings releases and investor materials for compliance with Regulation G and Item 10(e) of Regulation S-K”. Audit Analytics was able to identify only one case where similar language was used, namely, a recent letter to Valeant Pharmaceuticals (VRX) questioning its use of non-GAAP.
- By February 2016, the SEC expanded the scope of its review, scrutinizing Ashford’s presentation of management incentive fees in the table reconciling Net Income (Loss) to Adjusted EBITDA. In our experience, while requesting additional information is not uncommon, SEC does not often issue entirely new comments 100 days into the review process.
- The review culminated in April 2016 with a request to clarify whether the incentive fee adjustment changes the way the fee is accounted for under GAAP. This language may hint to Question 100.4 in the recently released CDI that stipulates that metrics that use individually tailored recognition and measurement methods for financial statement line items may violate Regulation G.
- On May 27, 2016 Ashford Hospitality Prime agreed to remove the incentive fees adjustment from Adjusted EBITDA and Adjusted Funds From Operations from future filings. In 2015 the advisory incentive fees contributed $2.5 million to the Adjusted EBITDA of $19.06 million.
Naturally, the question arises – what is going to be the SEC’s focal point in the next quarter? Would this be a relatively small number of in-depth reviews of certain companies, or a broader sweep over all or most of non-GAAP filers? We will have to wait and see, but it would be difficult to imagine that each company will get as much attention as Ashford did.
As mentioned above, Valeant is another company that avidly practiced non-GAAP reporting. (For an analysis of their non-GAAP reporting versus GAAP reporting, see this post at Analyst’s Accounting Observer blog.) The company’s accounting is currently under the SEC’s microscope. If that investigation concludes in the next couple months, it might also yield clues about the extent of the SEC’s campaign to clean up non-GAAP reporting.
At least at the beginning of the campaign, broad review is more likely.