The Center for Audit Quality has released a new tool, Questions on Non-GAAP Measures: A Tool for Audit Committees, to help audit committees cope with non-GAAP financial measures (NGFMs). Rather than provide a checklist, the CAQ provides examples of sample questions that audit committees should consider asking of management and external auditors regarding transparency, consistency and comparability of NGFMs. The tool is designed to assist audit committees evaluate whether management is complying with the SEC rules and guidance regarding NGFMs — particularly in light of the recent intense scrutiny by regulators of potentially abusive or misleading use of NGFMs — and whether NGFMs are actually assisting analysts and investors in understanding the performance of the business. (See, e.g., this PubCo post and this PubCo post.)
Transparency: In this context, the tool focuses on ways to consider the purpose, prominence and labeling of NGFMs relative to GAAP measures. Reg S-K Item 10(e)(1)(i)(A) requires, both in SEC filings and furnished earnings releases, that the most directly comparable GAAP measure be presented with equal or greater prominence relative to the NGFM. Corp Fin’s recent CDIs regarding the use of NGFMs advise that whether the staff will view a NGFM as more prominent than the comparable GAAP measure generally depends on the facts and circumstances. CAQ’s new tool reminds audit committee members that NGFMs should “supplement, not supplant,” GAAP measures, with a clear purpose and method of calculation. NGFMs in documents that are filed with or furnished to the SEC should be “clearly labeled as non-GAAP and not given any more prominence than their closest GAAP measures.” Below are examples of some of the concepts addressed by the questions (but many more are included in the CAQ tool):
- Would a reasonable investor be misled by the NGFM? Could the title or description of the measure be confused with a GAAP measure?
- Are there too many NGFMs used or are they all necessary and appropriate for investors to understand performance?
- Are any of the per-share NGFMs liquidity measures? (The CDIs reinforce that non-GAAP liquidity measures should not be presented on a per-share basis in documents filed or furnished with the SEC. Moreover, when analyzing whether a measure is a liquidity measure, the staff will focus on the substance of the NGFM and not on management’s characterization of the measure.)
- Why has management selected this particular NGFM to supplement established and well-understood GAAP measures? (Note that the CDIs identify as another impermissible practice the replacement of an important accounting principle with a NGFM that is an alternate accounting model that does not conform to the company’s business.)
- Does the company’s disclosure provide substantive detail on the purpose and usefulness of the NGFM (such as any link to executive comp), as well as a clear and adequate description of the calculation and reconciliation of the NGFM to GAAP?
Consistency: Here, the tool provides ways to assess consistency and balance of the NGFM presentation. The CDIs indicate that NGFMs can be misleading when they are presented inconsistently between periods, such as when the measure adjusts a particular charge or gain in the current period while similar charges or gains were not adjusted in prior periods. In those cases, the staff advises, the change between the periods must be disclosed and the reasons for it explained. If the change is significant, the staff suggests that “it may be necessary to recast prior measures to conform to the current presentation and place the disclosure in the appropriate context.”The CDIs also indicate that a NGFM can also be misleading in violation of Reg G if it “cherry picks” the adjustments, such as making adjustments only for non-recurring charges while there were also non-recurring gains that occurred during the same period. The CAQ cites a 2014 survey conducted by academics showing that 27% of companies excluded one-time losses in their non-GAAP earnings measures but failed to adjust for one-time gains. One of the tasks of audit committees is to determine whether the NGFMs used provide consistent insight or are really aimed at presenting company performance in a favorable light. Some of topics covered include:
- With regard to balance, does the measure eliminate similar items that affect both revenue and expense, or does it eliminate only one or the other?
- With regard to consistency, is it a new measure? Has the company stopped presenting certain measures or changed the method or nature of the inputs to the calculation since the last time the measure was presented? Is the reason for the change appropriate and has it been adequately described?
- Have comparable prior periods been revised for consistency and to avoid a potentially misleading presentation, especially if the prior periods would have been materially different?
- How different are the results using the NGFM compared with GAAP (e.g., positive growth vs. a loss)? If there is little correlation, have those differences been clearly explained?
- Have items characterized as nonrecurring, infrequent or unusual occurred in the past two years? Are these items reasonably likely to recur again in the next two years? If yes, consider if their characterizations should be changed. (Reg S-K Item 10(e) prohibits adjusting a non-GAAP financial performance measure to eliminate or smooth items identified 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. This prohibition is based on the description of the charge or gain that is being adjusted, not the nature of the charge or gain. That is, unless the charge or gain meets the specified criteria, it should not be described as non-recurring, infrequent or unusual.)
Comparability: The tool also provides questions to promote the comparability of non-GAAP measures generally within the industry and across industries. The more that the measure is tailored to the company, the less it will be comparable and the more likely it is to be confusing to investors. To help assess and promote comparability, the CAQ suggests that audit committees inquire regarding:
- Are the company’s NGFMs also used by peers? If not, why are they important to the company?
- Is management aware of differences in the company’s calculation compared to other companies? Is the rationale for differences appropriate and disclosed?
- Are there industry standard calculations that could be followed to promote more comparability?
The CAQ also identifies a number of procedural questions that should be asked regarding oversight, policies, sources of information, controls, legal review, education and internal audit.