The Gap between GAAP and Non-GAAP

In Brief

Many companies have increasingly turned to the reporting of non-GAAP measures, which fall outside the realm of generally accepted accounting principles and must be reconciled to more familiar GAAP measures. Proponents claim that non-GAAP measures provide better indicators of performance; critics contend that they obscure problems and impede comparability. The authors analyzed a wide array of non-GAAP measures and found that this reporting did provide some useful insights into the companies that used them, but at the expense of clarity and transparency.

A non-GAAP financial measure adjusts the most directly comparable GAAP measure reported on the audited financial statements by excluding items the company believes are not good indicators of its performance. One such measure is non-GAAP earnings. The calculation of this measure is highly subjective and is not comparable across entities or industries. Non-GAAP earnings is not a required disclosure, nor is it audited. Initial SEC regulation surrounding this disclosure was issued in 2003, entitled “Conditions for Use of Non-GAAP Financial Measures.” The original rule was updated in 2010 and 2016 with the SEC’s “Non-GAAP Financial Measures Compliance and Disclosure Interpretations.” This guidance has offered varying degrees of rigor with respect to the way non-GAAP earnings should be reported and presented.

Regulators, practitioners, and investors are faced with a dilemma. Should the SEC enforce tighter regulation over non-GAAP financial measures, or should companies be permitted to report these performance measures as they deem appropriate? If the latter, how does a corporate preparer fairly present non-GAAP earnings? Does the reporting of non-GAAP financial measures enhance or detract from investors’ database of information used to make portfolio decisions? In a world free of GAAP rules, the liberties associated with corporate reporting are fraught with a lack of consistency and comparability.

Background

In December 2018, SEC Chairman Jay Clayton addressed the AICPA Conference on Current SEC and PCAOB Developments. His remarks included the following counsel: “There has to be a similar consistency in the reporting of non-GAAP numbers and key performance indicators [KPI] as we expect in GAAP numbers. A point of investor frustration that we can be cognizant of is when non-GAAP numbers and KPIs move around in terms of how they are calculated.” Issues surrounding the reporting of non-GAAP financial measures, particularly non-GAAP earnings, have garnered attention as companies are increasingly disclosing them. This increase was most notable following a relaxation of SEC regulation regarding non-GAAP earnings disclosures in 2010. The SEC followed up in 2016 with an updated interpretation that strengthened restrictions on non-GAAP reporting.

To gain a better understanding of non-GAAP earnings reporting, the authors examined the fourth-quarter earnings releases of the S&P 100 for the years 2010 through 2016, studying the extent and nature of non-GAAP reporting by large public companies and the impact of changing SEC regulation and guidance.

An example of the large variation in the ways companies report non-GAAP earnings is apparent in the 2016 disclosures of IBM and HPE in Exhibit 1. The two disclosures differ greatly both in presentation and in their calculation of non-GAAP earnings. IBM presents the non-GAAP counterpart for each line of the income statement, whereas HPE adjusts only the bottom-line total. IBM reports the same two adjustments each year throughout our period of study; HPE reports many more adjustments, some consistent with prior years and others for the first time. The lack of standards and resultant disparities in reporting severely hamper an investor’s ability to make comparisons from one company to another. The consistency and comparability that should form the basis for financial reporting are therefore compromised as a result.

Regulatory Environment

When the SEC issued its guidance in 2003, it adopted Regulation G, which mandated that whenever a public company discloses a non-GAAP financial measure, it must provide a quantitative reconciliation of the differences between the non-GAAP financial measure presented and the most directly comparable GAAP financial measure. A key provision is that public companies cannot “adjust a non-GAAP 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.” The SEC also amended Item 10 of Regulations S-K, S-B, and Form 20-F to provide additional guidance to public companies that report non-GAAP financial measures in their SEC filings.

In 2010, the SEC’s Division of Corporation Finance moderated its Compliance and Disclosure Interpretations (C&DI) related to non-GAAP financial measures. The SEC was concerned that companies were not providing meaningful information to investors due to the original stricter guidance. In particular, the original rule made it difficult for a company to justify and defend the disclosure of a non-GAAP financial measure that excludes a recurring item. The modified C&DIs specifically stated, “The fact that a regis-trant cannot describe a charge or gain as non-recurring, infrequent, or unusual, however, does not mean the registrant cannot adjust for that charge or gain. Registrants can make adjustments they believe are appropriate, subject to Regulation G and other requirements of Item 10(e) of Regulation S-K.”

Growing concern over the inconsistency, lack of comparability, and possible misleading effects of non-GAAP measures led the SEC to revisit the guidance in subsequent years. Former SEC Chair Mary Jo White discussed the topic in her December 2015 keynote address at the AICPA National Conference, stating, “non-GAAP measures are used extensively and, in some instances, may be a source of confusion.”

In May 2016, the SEC issued new C&DIs and amended others, reflecting the unease with the reporting of non-GAAP financial measures as well as the types of adjustments made to GAAP measures. These provisions reiterated the 2003 regulation and further specified reporting practices that could violate Regulation G—specifically, “a non-GAAP measure that is adjusted only for non-recurring charges when there were non-recurring gains that occurred during the same period could violate Regulation G,” and “A non-GAAP measure that adjusts a particular charge or gain in the current period and for which other, similar charges or gains were not also adjusted in prior periods could violate Regulation G.”

The ongoing concern over the reporting of non-GAAP financial measures was evident in the April 2018 remarks of SEC Chief Accountant Wesley Bricker at the 2018 Baruch College Financial Reporting Conference. SEC “rules require that companies must have disclosure controls and procedures, which typically would include appropriate governance practices regarding the measures and policies and controls that prevent error, manipulation, or mischief with the numbers, including a policy that addresses how any changes in the non-GAAP measure will be reported and how corrections of errors will be evaluated,” Bricker said.

Observations and Results

The authors examined the non-GAAP earnings disclosures from fourth-quarter press releases because they provide relatively less-regulated disclosures compared with those found in the 10-Q or 10-K, due to the additional regulations imposed on SEC filings by Item 10(e) of Regulation S-K.

For this article, non-GAAP reporting companies are defined as those that disclose some measure of non-GAAP earnings. There are several other non-GAAP financial measures disclosed by public companies in their earnings releases; some companies report these measures and do not report non-GAAP earnings, while others report other non-GAAP financial measures in addition to non-GAAP earnings. These other non-GAAP financial measures include free cash flow, net debt, constant currency, tangible common equity, net interest, organic sales growth, and a multitude of financial ratios.

Throughout the study, the authors observed wide variety in the terminology used by companies to describe their non-GAAP earnings measure. (Some of the most common terms are listed in Exhibit 2.) The varying styles, calculations, and terminology further hamper the comparability and consistency of the disclosures and make analysis of non-GAAP earnings across companies and years a challenge.

Exhibit 3 summarizes the reporting behavior of the S&P 100 companies over the period of study. One immediate observation is that the percentage of companies disclosing non-GAAP earnings appears to increase substantially from 2010 to 2011 and again from 2011 to 2012, and then levels off. This pattern appears meaningful in light of the 2010 change in Regulations G and S-K. Also, there is a drop in companies disclosing non-GAAP measures, other than annual earnings, from 2010 to 2011, and then again from 2011 to 2012, at which point the numbers level off until returning to the 2011 level in 2016. This could be due to a shift from reporting non-GAAP financial measures other than earnings to reporting non-GAAP earnings as the primary non-GAAP financial measure.

Exhibit 4 provides the median sales, total assets, and market capitalization for companies that only reported GAAP earnings versus those that reported non-GAAP earnings in one or more years. In almost all cases, GAAP-only reporters had greater median sales, assets, and market caps than non-GAAP reporters. Perhaps larger companies are generally less materially affected by nonrecurring or infrequent items and therefore less inclined to report non-GAAP earnings.

The authors also examined the data by industry classification. Non-GAAP earnings reporting does not seem to be more prevalent in certain industries, with one exception: the finance industry was often the least frequent non-GAAP earnings reporter. Almost all industries saw an increase in non-GAAP earnings reporting over time.

Magnitude and Frequency of Non-GAAP Adjustments

To investigate the magnitude of non-GAAP earnings adjustments, the authors standardized results by dividing each company’s non-GAAP earnings adjustments by the absolute value of GAAP net income. The following results were observed:

• Almost 30% of these standardized adjustments fell in the 0% to 10% range, and approximately 50% of standardized adjustments were in the −10% to 10% range.
• Significant numbers of adjustments were quite large; 11% were greater than or equal to 100%. This supports the notion that non-GAAP adjustments should be infrequent or unusual.
• Positive adjustments (77%) far outnumbered negative adjustments (23%). This is in line with other studies indicating that companies are more likely to make non-GAAP adjustments that improve their results.

The authors more finely analyzed the data by grouping the most prevalently reported non-GAAP earnings adjustments into the following categories:

• Tax-related benefit/charges
• Restructuring charges
• Net gains/losses on tangible assets
• Net gains/losses on financial assets
• Impairment charges
• Litigation settlements
• Mergers and acquisitions
• Amortization of intangible assets
• Other adjustments.

The most widely used category was tax-related benefit/charges and restructuring, which made up 50% of the total non-GAAP earnings adjustments reported. The preponderance of very large adjustments (greater than or equal to 100%) arose from impairment charges.

The authors found that the magnitude and frequency of each of the categories was consistent with the total non-GAAP earnings adjustments, with the exception of tax-related benefit/charges and net gains/losses on tangible assets. Here the greatest number of adjustments were in the −10% to 0% range, with the 0% to 10% range the next strongest. The following results were also observed:

• Many terms were used to describe the non-GAAP earnings measures, as well as the number of different types of specific adjustments used to arrive at the values. As the SEC only provides guidance but not specific rules for this, it is not surprising; however, the lack of consistency hampers the ability to make comparisons across non-GAAP reporting companies. In addition, the differing presentations companies use to report non-GAAP measures impede investors’ ability to make comparisons across companies.
• Most of the adjustments classified as a tax-related benefit/charge are the taxes associated with the adjustments reported at their pretax amounts. Because most of the adjustments made are positive (i.e., losses or expenses that are added back to GAAP earnings), the adjustment for the related tax benefit is largely negative. In the period of study, some companies reported their individual adjustments net of tax; however, the 2016 C&DIs added a specific requirement that companies should present the tax effects of the reported adjustments separately going forward.
• The negative percentages for net gains/losses on tangible assets indicate that more gains than losses were reported within GAAP earnings, which are now being deducted to calculate non-GAAP net earnings. The 2016 C&DIs for Regulations G and S-K emphasized the proper inclusion of such adjustments, mandating that if a company makes a positive adjustment to a non-GAAP measure, and that situation arises again but has a negative impact, the company is required to make the negative adjustment.
• A key change in the SEC 2010 C&DI was a relaxation of rules on the inclusion of recurring adjustments. Companies should not adjust GAAP earnings with items that are “reasonably likely to recur within two years, or there was a similar charge or gain within the prior two years.” The authors observed many companies reporting the same category of adjustments year after year; however, it may be that these adjustments resulted from different transactions and are, therefore, not truly recurring. For example, an adjustment classified as a litigation settlement by the same company over multiple years may not necessarily relate to the same lawsuit or judgment. For a large public company, incurring restructuring and impairment charges is a normal course of business. Arguably, one weakness of the current reporting scheme is that it is not always obvious if a non-GAAP item is recurring or not, depending upon the level of detail provided in the disclosure.
• The authors found an increase in the number of companies reporting non-GAAP earnings, reaching 72% by 2016. It seems likely that management took advantage of the more relaxed SEC regulations issued in 2010 to provide a different view of company performance than that permitted by GAAP reporting.
• Over time, the authors observed an increase in non-GAAP earnings reporting across all categories, but none more than another. The most widely used categories were tax-related benefit/charges and restructuring.

Improve Audit Committee Oversight

Non-GAAP earnings present a challenge to regulators, practitioners, and investors. The SEC has delivered changing guidance over the last decade in an effort to provide companies with the freedom to present their own financial performance while ensuring that investors are not misled by the varying presentation and calculation of non-GAAP earnings. Corporate accountants preparing such disclosures must walk the fine line of putting their companies’ best performance forward without appearing to abuse the freedom this unaudited disclosure allows.

Greater audit committee oversight could increase investor trust in non-GAAP financial measures and thwart apprehensions of opportunistic reporting. This oversight, combined with the heightened 2016 regulation, should assist accountants in presenting a fair account of companies’ non-GAAP earnings, with particular focus on the inclusion of recurring adjustments. The enhanced reporting quality of non-GAAP earnings and other financial measures should provide investors with better insight into a company’s performance.