At a meeting yesterday of the PCAOB’s Investor Advisory Group, two working groups reported on topics that might be of particular interest: non-GAAP financial measures and enhanced audit reports.

Non-GAAP Financial Measures

There has been a lot of discussion about non-GAAP abuses, the SEC’s efforts to reel them back and the problems associated with them, including the absence of uniform definitions, comparability and consistency, and the potential to mislead, particularly as a result of the exclusion of critical and recurring investment expenditures. (See, e.g., this Pubco post, this PubCo post, this PubCo post and this PubCo post.) During the meeting, SEC Chair Mary Jo White (who attended the meeting only briefly) asked the participants whether they thought SEC concerns about non-GAAP measures were overstated. In response, some participants said that no, they thought non-GAAP measures were being used to obtain higher valuations and to boost comp. Anecdotally, one participant cited a very big active fund that, in conversation, characterized them as misleading.

Although the working group thought that GAAP and non-GAAP measures can together provide a more comprehensive perspective on the business, it was important that non-GAAP measures be verified: are they actually tied to the company’s books and records? Do they really reflect how the company is run? How are they tied to the process for setting risk appetite? Are they used consistently at the company and across the industry? How are they used by outsiders?

Among the recommendations of the working group discussed were these:

  • Non-GAAP definitions should be prescribed but would need to be dynamic enough to change over time
  • Limit the number and use of non-GAAP financial measures
  • Independently validate non-GAAP financial measures though self-regulation by industry organizations
  • Require inclusion of non-GAAP financial measures in the financial statements to ensure they are consistently calculated and audited
  • Mandate inclusion of non-GAAP measures in supplementary information and make them subject to audit under AS 17

While there is some authority for review of non-GAAP financial measures under AS 2710, which requires that “other information” in annual reports that contain audited financial statements be read and considered (e.g., to identify material inconsistencies), that review may not be adequate. As a result, an audit may make more sense.

SideBar: In 2013, there was an effort to beef up this requirement in a new proposal that would have required the auditor to evaluate the “other information” in the annual report and to state whether the auditor identified a material inconsistency or material misstatement based on the auditor’s procedures. It was noted that that statement was not intended to be an audit opinion, and the procedures were not designed to provide any technical “assurance” about the other information. This component of the proposal was tabled in light of comments received. (See this News Brief.)

However, to conduct an audit of non-GAAP financial measures, auditors would need a framework and prescribed procedures for auditing and reporting. While one exists for GAAP numbers, a framework would have to be created for non-GAAP financial measures. In addition, some meeting participants expressed concern that an audit might create a sense of false assurance, especially given that a fairly hefty percentage of current GAAP audits turn out not to comply with GAAP and require financial restatements. In addition, one participant contended that, while purely factual information could be audited, aspects of these measures that are qualitative or subjective could not be.

With regard to the suggestion of auditing the non-GAAP financial measures as supplementary information, one participant questioned whether the relevant materiality standard would be adequate where it measured accuracy relative to the financial statements as a whole rather than relative to the particular disclosure.

But is an audit in connection with an annual report really the right place to focus? Several participants argued that the real market drivers were the more frequent disclosures that occurred all year in press releases and periodic reports: as one participant put it, press releases are the market-moving engine of the train, and annual financial statements are just the caboose, the numbers that analysts use to validate their models. What should be the responsibility of auditors with regard to non-GAAP financial measures used throughout the year?

And beyond measures that are within the SEC’s definition of non-GAAP financial measures, there are other market-moving performance measures that are also not strictly GAAP, e.g., operating measures such as backlog and same-store sales. These metrics are not necessarily consistent either – how should they be validated?

At the conclusion of this discussion, PCAOB Chair Jim Doty remarked that participants should be careful not to use all of the technical obstacles as a reason not to start to address the need.

Enhanced Audit Reports

As you probably recall, the PCAOB has proposed enhancing the audit report by requiring that auditors discuss “critical audit matters” — matters arising from the audit that required especially challenging, subjective or complex auditor judgment. (See this PubCo post.) The working group reported that the proposed new standard would represent a meaningful improvement from the current standard audit report. In the UK, where similar reports have been required for about three years, investors have found them to be useful and, if they were more “bespoke” — a Brit speaking — they were found to be even more useful. In the UK, over time, the reports included less boilerplate and more specificity. (See this PubCo post, discussing a study of the benefits of the enhanced UK model.)

Although the working group favored the PCAOB proposal, the group advocated one modification that would encourage, as a best practice, the inclusion in the report of a discussion of the auditor’s “findings”: what the auditor found when it addressed the CAM, i.e., the results of the auditor’s procedures in these areas. Although the working group viewed the disclosure of CAMs as useful, it would be incomplete without disclosure of the related findings. Importantly, the findings must be informative and company-specific, particularly with respect to estimates and judgments. That is, the findings should indicate not just that an estimate is reasonable — which is implicit in an unqualified report — but rather generally where in a range the estimate sits. It was noted that some UK audit reports do include findings. Among the concerns raised was whether including findings really added value for investors. Moreover, there was concern that inclusion of findings might expose auditors to incremental legal liability. As a result, the working group supported a safe harbor from liability related only to findings. Some participants, however, opposed that idea as improperly eliminating accountability. (See this PubCo post discussing a new study suggesting that disclosure of CAMs may reduce legal exposure of auditors.)