Why is the sec so vehement in their stance that Non-GAAP metrics should not be used?
Non-GAAP financial measures or metrics are numerical measures of a historical and future financial performance, cash flows, or financial positions which also include amounts not part of the directly comparable measure of GAAP or else do not consider the amounts which are the part of the directly comparable measure of GAAP.
From 2001 onwards, the Securities and Exchange Commission of US has shown its concerns over the possibility of the non-GAAP earnings disclosures contributing in misleading investors. Even though the non-GAAP measures are not all credible to all users of the financial statements, evidence has shown that some stakeholders depend majorly on the non-GAAP earnings. The SEC has also identified the non-GAAP measures as a fraud risk factor. The SEC has also formed in 2013 a task force which was responsible for the investigation of the non-GAAP measures that can be misleading for the investors with a focus on the possible enforcement cases.
In response to the fears of SEC that the companies can use disclosures of non-GAAP earnings for misleading investors, the SEC has issued a warning to investors about the possible dangers of depending on the pro forma earnings numbers. By 2002, the Sarbanes-Oxley Act became law and prohibited the companies from using non-GAAP earnings for misleading investors in any possible way. Congress directed the SEC for issuing regulations for the implementation of the rules.
The non-GAAP financial measures can be useful for the management and investors as it provides an in-depth analysis of the financial statements. However, problems emerge when these measures are defined inadequately, presented inconsistently, or are used for obscuring the financial results as aligned with the GAAP standards. Other than this, the non-GAAP measures can lack the standardizing interpretation and therefore are not in any comparable form causing problems in interpretation.
Furthermore, it is criticized that whether the manager-customized earnings give the investors a clear picture for the future forecasting of the operational performance, which is essentially not conveyed by the GAAP earnings, or it is simply showing a very optimistic and non-practical picture of the operational performance. This criticism has stemmed from the fact that the earning disclosures of non-GAAP measures are not audited, and hence it allows the managers for increased discretion in showing non-standardized metrics for performance.
It has been found that many of the investors and financial statement users are capable of distinguishing the manipulative efforts of the management and in fact, these stocks get punished as well regarding their stock returns. However, not all the users of financial statements are capable of determining the benefits of the non-GAAP measures, and more importantly, the smaller less sophisticated investors are facing disadvantages. It is the reason because of which SEC vehemently criticizes the use of non-GAAP measures by the companies (Black).
Is the use of Non-GAAP financial metrics an attempt to mislead investors?
It is important to realize that every firm is different. The Executives of firms need flexibility to discuss their particulars of business. In accounting, communication needs to follow certain rules of syntax, grammar, and spelling. It means that executives who are using the accounting information for communication with the outsiders need to follow the agreed-upon rules similar to the valuation, recognition, and classification of the accounts. Without following this structure, the financial statements of companies lose their value and risk harmful decisions for the statement users. Bad accounting means users of accounting information can get hurt. The unchecked use of the non-GAAP metrics poses risks which are significantly higher to have the ability to harm the US financial reporting. The use of non-GAAP earnings per share and earnings causes a race between the companies to use more aggressive presentations of accounting to get the favor of the analysts and investors. The SEC has taken many measures to stop the use of non-GAAP metrics. The SEC considers the non-GAAP measures to be misleading if the company management reports the measure not consistently across its accounting periods. In September 2016, SEC charged two executives with overstatement of the financial performance of the real estate trust of Realty Capital Properties. The issue was how the firm had reported the adjusted funds of operations which are a non-GAAP measure of the performance approximating the cash flow (King). It was found that the executive used fake numbers to improve its measure and hence consequently misled the investors. Another action taken was reported on January 18, in 2017 when the SEC fined the marketing company for the settlement of its charges in which it was charged for violating the non-GAAP measure’s rules of disclosures. The firm had used the term organic revenue growth without describing it or showing the clear reconciliation of the figure. As per the SEC, it caused the investors and users of the financial statements to be prevented from making meaningful comparisons (Sherman and Young).
Markets and its participants want the companies to report the increasing earnings as the consistent earnings growth shows rising prices of stock and creates wealth. Even though the broader acceptance of the non-GAAP numbers is understandable, however one should consider what would happen if proliferation is not checked. The companies found themselves forced to use non-GAAP measures and expand it to show ever-increasing earnings to get the favorable results. This case is precisely represented in the Enron scandal. A study has found that the aggressive use of the non-GAAP earnings is linked to the high rate of incidence of the restatements of the company (Rapoport). These restatements are the basis on which investors are misled.
Work Cited
Black, Ervin L. “The Ethical Reporting of Non-GAAP Performance Measures.” Revista Contabilidade & Finanças 27.70 (2016): 7-11.
King, Thomas A. “The Problem With Non-Gaap Earnings.” SF Magazine. SF Magazine, 1 April 2017. Web.30 September 2018. http://sfmagazine.com/post-entry/april-2017-the-problem-with-non-gaap-earnings/.
Rapoport, Michael. “One More Reason for Investors to Worry About ‘Earnings Before Bad Stuff’.” Wall Street Journal. Wall Street Journal, 3 August 2016. Web.30 September 2018. https://www.wsj.com/articles/one-more-reason-for-investors-to-worry-about-earnings-before-bad-stuff-1470261290.
Sherman, H. David and S. David Young. “The Pitfalls of Non-GAAP Metrics.” Sloan Review. Sloan Review, 20 November 2017. Web. 30 September 2018. https://sloanreview.mit.edu/article/the-pitfalls-of-non-gaap-metrics/.
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