April 29, 2016

Non-GAAP Disclosures: The Gloves Are Off

Companies have been making non-GAAP disclosures for quite some time now. Perhaps spurred by recent remarks from SEC Chair White, SEC Commissioner Stein (remarks during PCAOB budget meeting) and SEC Chief Accountant Schnurr, it appears that the media is now tackling this topic. For example, the NY Times’ Gretchen Morgenson penned a column entitled “Fantasy Math Is Helping Companies Spin Losses Into Profits.”

In response, Fred Wilson blogged a rebuttal to Gretchen. Here’s an excerpt:

The truth is the the accountants who run the accounting standards have forced companies into reporting their financials in a certain way that neither the companies nor the sophisticated investors who own many of these companies’ shares believe accurately represents the financial condition of the reporting companies. Gretchen quotes this stat in her piece: “According to a recent study in The Analyst’s Accounting Observer, 90 percent of companies in the Standard & Poor’s 500-stock index reported non-GAAP results last year, up from 72 percent in 2009.”

That sure feels like the market speaking. When 90% of your customers order the scrambled eggs differently than you normally serve them that tells you something.

My pet issue is stock based compensation. When a company issues options to an employee, accounting standards require that the option be valued (usually by a formula called Black Scholes) and expensed over the vesting period. That sounds reasonable. But the truth is that that option may end up being worth nothing. Or it may end up being worth 10x the value that it was expensed at. By taking out the stock based comp expenses and reporting an “adjusted EBITDA” number that does not include it, companies are giving investors an idea of what the earnings power of the company is without this theoretical expense. And that stock based compensation expense is a non-cash expense meaning that even though it theoretically costs the company something, it is not paid in cash but in dilution of the total number of shares outstanding.

This is not a cut and dried issue. Different investors will approach it differently depending on whether they care about cash flow, long term dilution, or something else. But the accountants who control the accounting standards board require a certain way of presenting these numbers and that is that.

Check out the resources in our “Non-GAAP Disclosures” Practice Area, including these memos (love the top one with practice tips) and our new “Non-GAAP Financial Measures Handbook”…

SEC Enforcement & Non-GAAP Measures

Here’s a note from Troutman Sanders’ Brink Dickerson:

While the recent SEC’s enforcement settlement with Cabela’s involved several different accounting issues, the most interesting was its miscalculation of a measurement – “merchandising gross margin” – that it held out in its MD&As and elsewhere as an important measurement of performance. The underlying error, a failure to eliminate an intercompany account, resulted in the overstatement of this measurement as well as period-over-period improvement that really did not exist. It appears, however, that the error did not flow through to the company’s GAAP financial statements, where the eliminations were appropriate.

While the performance measurement may – or may not – be a non-GAAP measure, the enforcement action highlights the importance of calculating performance measurements, including non-GAAP measures, with accuracy and providing transparency into their calculation.

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