With the spotlight now on non-GAAP financial measures, companies might find this article in CFO.com to be particularly useful. The article provides practical guidance to help companies establish effective disclosure controls and procedures for non-GAAP financial measures.
Recently, the SEC and staff (Chair White, Chief Accountant James Schnurr, Corp Fin Director Keith Higgins, Deputy Chief Accountant Wesley Bricker) have been barnstorming the country, wagging their collective fingers about abuses of non-GAAP measures. Corp Fin has issued guidance in the form of new CDIs (see this PubCo post). In addition, the head of the SEC’s Financial Reporting and Audit Task Force has previously indicated that the SEC was looking at the use of these non-GAAP measures “with an eye toward possible enforcement cases.” (See this PubCo post.) In fact, as noted in thecorporatecounsel.net blog, some companies have recently been contacted by Enforcement concerning their non-GAAP disclosure practices in earnings releases, primarily focused on the requirement in Reg S-K Item 10(e) to disclose the most directly comparable GAAP measure with equal or greater prominence relative to the non-GAAP measure. (See this PubCo post and this PubCo post.)
Moreover, in December 2015, at an AICPA national conference, Chair White emphasized the need to ensure that the current rules on non-GAAP financial measures were being followed and that they are “sufficiently robust in light of current market practices. By some indications, such as analyst coverage and press commentary, non-GAAP measures are used extensively and, in some instances, may be a source of confusion.” Notably, she admonished preparers to take care to ask the right questions when using non-GAAP measures:
“Like every other issue of financial reporting, good practices in the use of non-GAAP measures begin with preparers. While your chief financial officer and investor relations team may be quite enamored of non-GAAP measures as useful market communication devices, your finance and legal teams, along with your audit committees, should carefully attend to the use of these measures and consider questions such as: Why are you using the non-GAAP measure, and how does it provide investors with useful information? Are you giving non-GAAP measures no greater prominence than the GAAP measures, as required under the rules? Are your explanations of how you are using the non-GAAP measures – and why they are useful for your investors – accurate and complete, drafted without boilerplate? Are there appropriate controls over the calculation of non-GAAP measures?” (See this PubCo post.)
The author advises that, “[b]ecause non-GAAP measures are—by definition—not standard, companies should have controls and procedures to help ensure clear and accurate disclosure of those measures, and to help ensure compliance with SEC rules and regulations.” According to the article, these controls should focus on seven key areas:
- Measures comply with SEC rules and guidance
- Non-GAAP adjustments are consistent across periods, appropriate and not cherry-picked (e.g., adjusted not only for nonrecurring expenses, but also for nonrecurring gains) or otherwise misleading
- Data used for inputs in non-GAAP measures are reliable and subject to appropriate controls
- Calculations of non-GAAP measures are accurate and tie to the same measures as disclosed
- Descriptions of non-GAAP measures, adjustments and other required disclosures are transparent and unambiguous
- Non-GAAP measures and related disclosures are reviewed by management for appropriateness and completeness
- Disclosure controls for non-GAAP measures are monitored by management with oversight from the audit committee
The author recommends that companies craft a written non-GAAP policy that “(1) clearly describes the nature of allowable adjustments to GAAP measures, (2) defines the non-GAAP measure(s) to be used under the policy, and (3) explains how potential changes in the inputs, calculations, and adjustments will be evaluated and approved. For example, a policy might describe qualitatively the types of adjustments that are non-recurring and unusual, and are thus within the defined policy. It might also outline specific quantitative thresholds for which income and/or expense items would be evaluated to determine whether they should be included in non-GAAP adjustments.”
In light of the importance of management involvement in disclosure controls and procedures, the author suggests review of the selection and determination of non-GAAP measures, as well as the appropriateness of related disclosures, with a disclosure committee, the audit committee or both. For example, the disclosure committee could review drafts of earnings releases based on the seven criteria outlined above, as well as the accuracy, completeness, timeliness and fairness of the disclosures.
The author then runs through an example of the application of disclosure controls to non-GAAP financial measures and related disclosures, which have been calculated for an earnings release by the manager of external reporting and reviewed by the controller and/or CFO:
- “Re-compute each non-GAAP measure and agree the underlying GAAP measure to the general ledger.
- “Consider the income tax effects of the adjustments made to the GAAP measure. (Note: adjusting revenue or income before tax could affect the tax expense or benefits assumed in the calculation of the tax provision. For measures of performance, a current and deferred income tax expense commensurate with the non-GAAP measure of profitability should be calculated and included in the disclosure.)
- “Consider whether the non-GAAP measures contain misleading adjustments [see this PubCo post].
- “Review a list of prohibited presentations of non-GAAP financial measures to ensure the measures are consistent with SEC guidance.
- “Consider whether each adjustment is appropriate under company policy and is consistent with adjustments made in prior periods.
- “Review each reconciliation of the GAAP measure to the non-GAAP measure, which includes agreeing the adjustments to the trial balance or other support, then considering whether the reconciliation clearly labels and describes the nature of each adjustment.
- “Verify that adjustments for income taxes are presented separately, and that there is disclosure of how the adjustment for income taxes was determined.”
According to the author, the disclosure committee would then review the measures for Reg G compliance (and compliance with any other SEC guidance), including compliance with the prohibitions on misleading and cherry-picked disclosures, and the requirements for reconciliation, cross-period consistency and prominence. The committee could also examine whether the measures are appropriately described and labeled, confirm that they are not presented on the face of the GAAP financial statements, in the notes or on the face of any pro forma financials and not titled the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures. The committee could also review disclosures for transparency, as well as the appropriateness of the company’s statements of purpose and use for each non-GAAP measure. Finally, the audit committee, in its oversight role, could confirm that the non-GAAP measures are appropriately disclosed in accordance with policy and are consistent with SEC rules and guidance.