SEC Expected to Raise More Questions About How Firms Calculate Non-GAAP Measures
The Securities and Exchange Commission is expected to ask more companies to explain how they calculate performance measures that go beyond US generally accepted accounting principles, a move to assess whether those metrics could potentially mislead investors.
The U.S. securities regulator has for years monitored the use of so-called non-GAAP earnings measures in their financial statements, such as earnings before interest, taxes, depreciation, and amortization, or Ebitda, and adjusted income. Such measures are commonly used and usually exclude abnormal, nonrepetitive items.
The SEC in 2016 warned companies that non-GAAP measures that replace GAAP-based methods with individualized disclosure may violate its rules. These activities include moving the timing of recognition of an expense or revenue from one period to another and amortizing operating leases instead of recording rent expense.
In December, the regulator expanded guidance with more detail on what constitutes a potential breach. For example, companies that change their accounting for revenue or expenses from an accrual basis under GAAP to a cash basis may mislead investors, as the latter is an informal accounting practice, the SEC said.
Companies increasingly rely on these measures, often to present an overly optimistic picture of profitability, accounting researchers said. Executives typically say that focusing on core operating earnings is the most accurate way to portray financial performance to investors, but their approach can vary.
Investors may assume that non-GAAP measures represent a company’s earnings minus abnormal, non-recurring items and then be fooled when the measures mean something different, said Nick Guest, an assistant professor of accounting at Cornell University. “That’s not what the SEC wants, and why they don’t allow each company to come up with its own definition of a non-GAAP measure,” Mr. Guest said.
The Securities and Exchange Commission in a series of recent letters to businesses has focused on companies’ presentations of non-GAAP measures that appear company-specific. He asked many of them to make changes for future deposits so that investors could adequately evaluate the business. The agency’s corporate finance division regularly sends letters to public companies to inquire about their disclosures or accounting practices related to filings, such as quarterly or annual reports.
The ride-hailing company Lyft Inc.,
Mattress maker Sleep Number Corp.
and media and education businesses Graham Holdings Co.
were among the companies to which the SEC sent such letters to exchanges the regulator disclosed in recent weeks.
The SEC’s letters published in January and February showed that a total of 20 companies were questioned about their compliance with Question 100.04, a section in its guidance focused on calculations of non-GAAP measures, according to MyLogIQ, a data provider. That’s up from 11 companies in letters released in January and February 2022. SEC inquiries on the matter totaled 161 in 2022, up from 206 a year earlier and 124 two years earlier, MyLogIQ said.
That number will likely rise in the coming months because of the SEC’s apparent focus and some companies’ lack of awareness of the new guidance, accountants and academics said. The SEC typically releases correspondence 20 business days after matters are resolved, meaning investigations following the December guidance could be released as early as spring, said Olga Usvyatsky, former vice president of research at research firm Ideagen Audit. Analytics and Ph.D. student in accounting at Boston College.
The SEC has long expressed concerns about companies overemphasizing their non-GAAP disclosures compared to GAAP disclosures. However, its scrutiny of non-GAAP calculations could prompt companies to rethink how they calculate measures of financial performance. Changing how some non-GAAP measures are calculated can be disruptive and even costly for companies, accountants said. The SEC refused to comment.
In letters released this month, the SEC asked Lyft to explain how it considered agency rules to exclude the cost of insurance reserves, or funds set aside by a company for future insurance claims, in its adjusted Ebitda. Lyft said it included, as part of its non-GAAP treatment, its insurance costs for the current period. The company said the adjustment is not misleading or personalized, but rather conveys to investors its current performance.
“The company believes this adjustment…provides investors with additional useful information about the company’s operating performance in the current period, rather than including the effects related to insurance claims that occurred in prior periods,” Lisa Blackwood-Kapral, Director Lyft’s accountant, he wrote in September.
The Securities and Exchange Commission, following its new guidance in December, pushed back. It said the adjustment was inconsistent with its guidance on adjusted accounting and told the company to remove it from its non-GAAP calculations. Lyft in January said it would reflect the change in future filings. The company on Feb. 9 reported adjusted Ebitda of negative $248.3 million for the quarter ended Dec. 31, 2022, compared with negative $47.6 million in the prior period, largely due to the calculation change. It increased its insurance reserves by $375 million for the quarter, the company said.
In other letters released this month, the SEC sought more details on Graham Holdings’ adjusted net income, which it said appears to be using a different accounting basis than GAAP. Graham Holdings said it is not in violation of SEC guidance because it did not substitute an alternative method of recognition or measurement for the related adjustments. The company also said it did not switch from accrual accounting to cash or modified accounting.
“From the CFO’s point of view, their job is to show the company in the best light possible, but at the same time, you don’t want to go too far because that can really raise suspicions. “
Despite defending its accounting, Graham Holdings said it would significantly expand its disclosure of adjustments to future filings, which it began doing Friday with its annual report filing.
The SEC also asked about Sleep Number’s use of a non-GAAP measure known as return on invested capital, or ROIC, which aims to show how efficiently it invests capital.
To calculate ROIC, the company must determine net operating profit after taxes, or NOPAT, which is the companies earnings excluding financing costs. In removing the GAAP component of operating lease rental expense and replacing it with depreciation to calculate NOPAT, Sleep Number appeared to be making individualized disclosures under a non-GAAP method, the SEC said.
Sleep Number will change the way it calculates ROIC and will no longer make those adjustments, instead adding the interest component of lease costs, then-Chief Financial Officer David Callen wrote on Jan. 12. However, the company defended its approach. “We believe our current ROIC calculation best represents how our business operates and our capital growth,” wrote Mr. Cullen, who stepped down as CFO on Jan. 30. The revised Sleep Number calculation appeared in its annual report filed on Friday.
Mr. Cullen’s departure was unrelated to the SEC investigation, a spokeswoman said.
Graham Holdings and Lyft declined to comment.
The investigations could prompt more corporate audit committees to more closely review non-GAAP disclosures to ensure the rationale behind measures is thoroughly explained before filing with the SEC, said H. David Sherman, professor of accounting at Northeastern University and former SEC Academic Fellow.
“From the CFO’s point of view, their job is to show the company in the best possible light, but at the same time, you don’t want to go too far because that can really raise suspicions,” he said.
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