The COVID-19 pandemic has added to the uncertainty and confusion faced by stakeholders. As companies incur revenue loss, plan for recovery, and start to adopt new business models, the proper disclosure of financial performance, changes in strategy changes, and the views of management become issues of concern. Information pertaining to uncertainties often cannot be conveyed through the tabular disclosure of GAAP earnings, but is better expressed through the narrative reporting in non-GAAP metrics and management discussion and analysis (MD&A).
Non-GAAP Reporting
Companies have used non-GAAP measures to express management’s interpretation of performance when GAAP earnings are insufficient or even misleading. A report from PricewaterhouseCoopers shows that, even before the pandemic, 76% of S&P 500 firms were reporting non-GAAP measures; by 2020, this percentage reached 94% (PWC, “To GAAP or to non-GAAP COVID-19: What you should know,” https://pwc.to/3n8LEl9, 2021). Many of the changes and responses related to the pandemic are disclosed in press schedules and summarized numerically in non-GAAP metrics.
Several problematic areas need to be addressed. One is that companies have been exploiting the subjective concept of “nonrecurring” and selectively choosing items to exclude from GAAP. Among many examples, Ulta Beauty added back $40 million impairment costs but ignored the employee retention credit of $51 million under CARES Act (Eaglesham, J., and Trentmann, N., 2021, “Companies put the best face on Covid-19’s financial impact,” The Wall Street Journal, February 23, 2021, https://on.wsj.com/42pRXkF, 2021); a German manufacturing company, Schenck Process, achieved a 20% growth in operating profit instead of a 16% decline after adding backing €5.4 million that was deemed a pure loss from the pandemic (Asgari, N., “Pandemic spawns new reporting term ‘ebitdac’ to flatter books,” Financial Times, May 13, 2020, https://on.ft.com/3Tvdqo9, 2020).
Impairment charges are another concern, as any forward-looking estimation on cash flows is subject to great discretion in the current environment. For example, Marriott’s 2020 annual report states that the company “recorded impairment charges of $116 million in 2020” and “may not be able to fully recover the carrying amount of these U.S. & Canada hotel leases after evaluating the assets for recovery due to declines in market performance and future cash flow projections.” The disclosure seems reasonable, considering that the hospitality industry was perhaps the most impacted by international travel restrictions and a potentially permanent decrease in conference activities. Meanwhile, deteriorating market capitalization is a common impairment trigger, yet stock performance has reached an all-time high. How can assets’ fair value be reliably determined? Non-GAAP metrics may be further distorted by adjustments related to impairments.
Although existing regulations provide a framework for non-GAAP measures, they lack clarifications specific to the pandemic. Non-GAAP reporting falls under Regulation S-K item 10(e), which prohibits “adjusting a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent, or unusual, when (1) the nature of the charge or gain is reasonably likely to recur within 2 years or (2) there was a similar charge or gain within the prior 2 years.” It is unrealistic to apply a specific time frame to transactions that are generally unpredictable like COVID-19. In an SEC guidance document (“Non-GAAP financial measures,” April 4, 2018, https://bit.ly/3n9kF9g), question 102.03 states “it would not be appropriate to state that a charge or gain is non-recurring, infrequent or unusual unless it meets the specified criteria … the fact that a registrant cannot describe a charge or gain as non-recurring, infrequent or unusual, however, does not mean that the registrant cannot adjust for that charge or gain.” The interpretation of one-time expenses is rather subjective and unclear.
Based on these observations and concerns, companies and regulators can at least consider the following aspects when preparing non-GAAP reporting:
How can companies establish some general standards for treating items as excludable due to COVID?
First, the adjustments must be directly attributable to the COVID-19 pandemic. Red flags could be raised when companies were already incurring consecutive losses, supply chain disruptions, or fraudulent scandals prior to the pandemic, yet charges are treated as non-recurring and added back.
Second, the length of recovery for the industry should be considered. For example, consumers have generally returned to restaurants and stores, but are still wary of long-distance traveling and close-contact services. Companies that rely on global markets (e.g., hospitality, tourism, manufacturing) will face greater difficulty in predicting recovery time. On the contrary, businesses that provide online services, digital products, and home improvement merchandise are generating unusually high revenues. Whether those revenues will decline or sustain in this “new normal” must also be considered in determining nonrecurring gains.
Third, as companies modify their business models and cost structure, some changes have become permanent and thus recurring. For example, grocery stores have enhanced their online shopping platforms and delivery services. The investment in software and services is unlikely to change, because consumers’ preferences have changed, and the cost of downgrading can be substantial. Almost all industries have implemented sanitizing procedures that will likely remain. Other costs whose permanence is more debatable include pay raises for essential workers, janitorial services, and expenses related to remote working (e.g., cloud computing, meeting software subscriptions, microphones). It is important to analyze the likelihood that changes are permanent and differentiate them from one-time charges and gains.
How can companies interpret and follow the rules in Regulation S-K?
While item 10(e) of Regulation S-K prohibits treating an item as nonrecurring when it is likely to recur within two years, it is not a hard and fast rule and justifications might be easily accepted these days. The interactions between the regulatory framework and management discretion play an important role in creating standard processes. One potential process for companies to follow is presented in the Exhibit.
Exhibit 1
Process for Analyzing Appropriateness of Excluding Items in Non-GAAP Financial Measures
What role can auditors play regarding non-GAAP reporting?
Because standards do not require auditors to issue formal opinions on non-GAAP measures, companies therefore need to rely on audit committees. Audit committees should exercise caution and communicate with management on risky areas when calculating non-GAAP metrics that may incentivize earnings management, including the following:
- Adjustments or disclosures involving the same type of losses/charges as those already incurred before the pandemic
- Items deemed temporary by management due to the pandemic, but that are likely to recur after the pandemic
- One-time nonrecurring gains currently not excluded from GAAP, especially when one-time nonrecurring charges have been excluded
- Possible permanent changes in business models (e.g., physical stores to online sales) and short-term gains/charges due to the change.
MD&As
SEC released amendments to Management’s Discussion and Analysis (MD&A) disclosures on November 19, 2020, with a focus on providing material information to investors and reducing registrants’ burden. In particular, item 303(a) was added to describe the principal objective of MD&A, stating “the discussion and analysis must focus specifically on material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.” Item 303(b) is also new and emphasizes the disclosure of critical accounting estimates involving a significant level of uncertainty by providing qualitative and quantitative information. An SEC release in June 2020 suggested that companies more proactively disclose uncertainties pertaining to the duration and impact of the then-nascent COVID-19 pandemic, as well as operational changes and liquidity concerns in MD&A [SEC, “Coronavirus (COVID-19)—Disclosure Considerations Regarding Operations, Liquidity, and Capital Resources,” https://bit.ly/3FHFaQS, June 23, 2020]. This echoes the theme of disclosing uncertainties to shareholders.
As many companies modify their business models for the post-pandemic environment, the transition can be confusing to stakeholders and require enhanced narrative disclosure. For example, the fitness industry is offering free classes on Instagram Live and promoting at-home equipment (e.g., Peloton bikes and fitness mirrors); movie theatres are incorporating streaming services and drive-through settings; sports leagues are conducting virtual events and considering AI implementation. Management can directly comment on how and when such changes will take place, how much of them is driven by the pandemic, how long the transition may be, and conjecture on future performance.
Another concerning issue is the lack of corporate disclosure on the pandemic’s impact. Data from MyLogIQ shows that only roughly 10% of S&P companies disclosed EBITDA (earnings before interest, taxation, depreciation, and amortization) reported adjustments related to COVID during the three quarters through December 2020 (Eaglesham and Trentmann, 2021). Some companies assume that the market generally understands operations have been affected by COVID; because stock prices held up well, explanations were unnecessary.
A parallel problem is the decline in earnings guidance. During the earnings season that began in July 2020, at the height of the pandemic, 40% of companies did not issue management guidance (Pisani, B., “Investors should brace for a wild earnings season and expect little guidance for what’s ahead,” CNBC, https://cnb.cx/3ne2n6R, July 13, 2020). The reasons are likely twofold: 1) as the economy re-opened, interruptions continued due to new variants and upticks in COVID cases, increasing unpredictability to a greater extent; 2) long before the pandemic, the usefulness of quarterly earnings guidance had been criticized for focusing on short-term profits thus distracting investors away from the true underlying drivers for business value in the long run.
Given the above, it is helpful for companies to remain transparent about disclosing any current challenges and uncertainties related to COVID-19 and the post-pandemic environment, even if they fear misleading the market. An opaque environment can cause further confusion for investors, creditors, and analysts. Management can, however, lessen investors’ emphasis on quantitative explanations of performance and guidance, by providing qualitative narratives to depict long-term–value drivers, recovery plans, and new strategies.
