Non-GAAP Financial Measures

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Increased Use of Non-GAAP Financial Measures has Resulted in Heightened Scrutiny from Regulators

The National Association of Corporate Directors (“NACD”) reported, in their July 2016 Audit Committee Oversight publication, that “heightened attention and scrutiny from regulators and the media have sharpened concerns about the expanding use – in terms of both volume and type – of financial metrics not based on U.S. Generally Accepted Accounting Principles (GAAP).”[1] Just how much has the use of non-GAAP metrics increased? According to the article, there were 334 companies that reported non-GAAP earnings in 2014, representing a 44% increase from 232 in 2009.[2] Furthermore, the NACD indicated that “over 40% of companies that used non-GAAP metrics in their IPO prospectuses in 2014 received an SEC comment letter on the issue, and roughly 25% of those companies received further comments about non-GAAP metrics in their subsequent periodic filings.”[3]

In response, the SEC amended its non-GAAP financial measure guidelines as of May 17th, 2016,[4] and has warned that it will enforce these guidelines, taking action against companies that are not in compliance.[5] So if companies are under increased scrutiny, why do they continue to use non-GAAP metrics? Moreover, what are the specific concerns regulators have regarding these non-GAAP metrics? The NACD, together with KPMG’s Audit Committee and law firm Sidley Austin LLP, held a conference for Fortune 500 audit committee chairs to discuss these questions, among others, in an effort to start a dialogue on the oversight of non-GAAP metrics.

When used properly, non-GAAP metrics can provide useful information to investors regarding a company’s performance. Such financial-related measures can include EBIT (Earnings Before Interest and Taxes), EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), and adjusted earnings.[6] These can allow a corporation to quantitatively demonstrate uncommon or irregular occurrences that may have affected the business outside of its normal course of operations. It can also allow a company to convey industry-specific information that GAAP metrics may not account for.[7]

The NACD reports that of concern, however, is the possibility that companies may be presenting an inflated positive view of their corporation, misleading investors. Likewise, Pricewaterhouse Coopers (“PwC”), in their “Non-GAAP Financial Measures: Enhancing their Usefulness” July 2014 publication, point out that one inherent limitation of such metrics are that they are completely subjective – managers can pick and choose what to present.

So what should companies do to avoid SEC scrutiny? The NACD, as well as other major organizations, including PwC, strongly agree that managers must remain transparent and consistent in their non-GAAP measures. Companies should also maintain strong controls within their audit committees, that are continuously evaluated to ensure there is no management bias.

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For more information on how to best quantify and present environment, health and safety (EH&S) liabilities associated with one time occurring costs; or for information on how to better quantify your EH&S liabilities please contact Andy Patz or Bruce Martin.

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[1] NACD Audit Committee Chair Advisory Council, “Audit Committee Oversight of Non-GAAP Financial Measures,” July 18, 2016.

[2] Jack t. Ciesielski, “Where It Lives in the S&P 500: The Non-GAAP Earnings Epidemic, Part 1,” The Analyst’s Accounting Observer, vol. 24, no.9, August 28, 2015.

[3] Olga Usvyatsky, “Use of Non-GAAP Metrics in IPO Prospectuses: SEC Comment Letters,” Audit Analytics, February 10, 2015.

[4] https://www.pwc.com/us/en/cfodirect/assets/pdf/in-brief/us-2016-22-sec-non-gaap-interpretive-guidance-update.pdf

[5] Wesley R. Bricker, Remarks before the 2016 Baruch College Financial Reporting Conference, New York City, May 5, 2016.

[6] https://www.skadden.com/newsletters/Corporate_Finance_Alert_The_Use_of_Non-GAAP_Financial_Measures_A_Disclosure_Guide.pdf

[7] https://www.pwc.com/us/en/cfodirect/assets/pdf/point-of-view-non-gaap-financial-measures.pdf

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