It used to be that some companies pushed the envelope on performance metrics by including measures that are not approved by Generally Accepted Accounting Principles (GAAP). Now, according to a new study, nearly all, large U.S. public companies are using non-GAAP measures, even as regulators question the practice and critics accuse them of earnings manipulation.
Two new separate analyses by research firm Audit Analytics, finds that even as the use of non-GAAP metrics is growing, the topic has dominated SEC enforcement efforts with a high percentage of SEC comment letters referring to potential misuse of non-GAAP metrics.
A sampling of more than 300 S&P 500 companies by Audit Analytics, finds that the use of non-GAAP metrics in 8-K or 10-K regulatory filings jumped from 76 percent in 2006 to a nearly ubiquitous 97 percent in 2017. Meanwhile, companies that have been using non-GAAP figures are using more of them. The number of non-GAAP metrics used per filing increased from 2.3 in 1996 to 7.4 in 2016.
A further analysis by Audit Analytics of all S&P 500 2017 filings finds that 82 percent used operating income or another non-GAAP income metric, 79 percent used non-GAAP metrics related to earnings per share, and 35 percent cited non-GAAP cash flow figures. Not surprisingly, those non-GAAP metrics usually portray the company in a better light. The non-GAAP metrics exceeded the GAAP net income in 69 percent of cases, according to Audit Analytics, and the average per-company disparity between the two figures was more than $1.3 billion.
SEC Watching Closely
While most large companies are choosing to use non-GAAP metrics, the SEC is devoting more of its enforcement energy into pursuing improper use of such measures. According to another Audit Analytics report, while the overall number of SEC comment letters declined drastically from 15, 646 in 2010 to 4,525 in 2017, the percentage of them that relate to non-GAAP reporting metrics has increased from 4.5 percent to 23.7 percent during that period. Although, some evidence suggests the number of non-GAAP SEC letters has declined slightly in the first six months of 2018, the SEC is still showing signs that it is focusing on non-GAAP metrics, says Audit Analytics.
“Overall, the trends that emerged based on the issuance frequency of 16 selected non-GAAP comments indicate that there is a narrowing focus on more specific issues. However, non-linear trending on certain issues is indicative of companies struggling with GAAP compliance on specific measures,” the report’s authors write.
In May 2016, the SEC attempted to influence how companies use non-GAAP figures by issuing new guidance that provided 39 questions and answers on what the SEC would consider acceptable and what it would take issue with. Using metrics in financial statements that aren’t approved by GAAP isn’t necessarily a violation of reporting rules, the guidance points out, but using them to mislead investors is a violation of the rules, the SEC warned.
What the SEC Is Looking for
In the comment letters Audit Analytics examined, it found that the SEC is focused mainly on a handful of issues. The biggest issue for the SEC and the most common trigger for a comment letter is when companies give them too much prominence in their reporting, particularly using them in headlines and section headings. Of the comment letters the SEC issued on non-GAAP topics, 22 percent addressed using non-GAAP metrics while giving the comparable GAAP metric undue prominence.
Another common trigger for an SEC comment letter is when companies present non-GAAP metrics on a “net of tax” basis. To comply with GAAP standards, adjustments that are used to arrive at a non-GAAP measure must show taxes as a separate adjustment and must be explained. Just over 12 percent of SEC comment letters addressed such misuse of non-GAAP.
The SEC is also taking issue with companies when they present performance measures that exclude normal, recurring, cash operating expenses and those that use individually tailored recognition and measurement methods. Such abuses account for 9 percent and 12 percent of comment letters respectively.
“Trends to keep an eye on include the non-GAAP measures that are complicated by complex accounting practices and require detailed explanation of unique circumstances be provided,” audit analytics said in the report. “It will be interesting to see if the trend of the SEC nudging companies for better explanations will endure, or if registrants will make an effort to provide more clarification on financial statements.”
In a speech just before issuing the 2016 guidance, then SEC Chairman Mary Jo White stated that the use of non-GAAP measures “deserves close attention” and “may be a source of confusion” for investors. Now, with the SEC under the direction of Chairman Jay Clayton, it doesn’t appear that the SEC has backed away any from those concerns. But, as the Audit Analytics data shows, those concerns don’t seem to be having any impact on companies’ appetite to use them. 
Joseph McCafferty is editor & publisher of Internal Audit 360°