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Widening Use of Non-GAAP Earnings Measures Becomes a Regulatory Concern

Companies have become more aggressive in using non-GAAP measures to make their financial performance look better, and the trend has gained the “close attention” of SEC Chair White. The SEC is investigating whether companies are properly disclosing why they think non-GAAP earnings numbers are useful to investors.

SEC Chair Mary Jo White said the growing use by public companies of non-GAAP earnings measures “certainly” has her “close attention” during a Washington conference on November 17, 2015.

Companies have become more aggressive during recent years in adjusting their earnings numbers to present investors with better-looking financial results. As staffers in the SEC’s Division of Corporation Finance review company filings, they are trying to make sure that their reliance on non-GAAP measures is not misleading investors.

SEC officials are “focusing on whether… disclosure [about the use of non-GAAP] is really adequate,” White said.

“One thing as you go through this, basically these tend to go in one direction, the non-GAAP measures, not both directions,” White said during a question-and-answer session at The Wall Street Journal CEO Council. “So you want to be clear about why it is useful. [It] “causes us some concern… whether some analysts are distinguishing, as they should be, between the GAAP and non-GAAP.”

Under Regulation G, companies that use non-GAAP financial measures must provide a presentation with equal or greater prominence of the most directly comparable financial measure under U.S. GAAP. Companies must also reconcile the differences between the non-GAAP financial measure with the most directly comparable financial measure under U.S. GAAP. The companies must also disclose why they believe that the non-GAAP measures provide useful information to investors about their financial conditions and results of operations.

U.S. public companies have to submit quarterly and annual financial statements to the SEC prepared in U.S. GAAP. For the quarterly earnings releases that come out a few weeks after a fiscal period’s end, companies have some flexibility to highlight unaudited measurements that make them look more attractive to investors and can help boost their stock price.

“If you have a title like ‘core earnings…,’ what you have actually taken out for your non-GAAP measures are expenses that are a core of your operations. That’s problematic,” White said in explaining one concern regulators have. Companies are also “taking out different things in different iterations of non-GAAP measures, but it just multiplies.”

Core earnings exclude goodwill, gains or losses from nonrecurring items, pension gains and losses, costs from settling lawsuits, and the charges associated with employee stock options. But core earnings is not a term that has been standardized, and companies vary in how they define it, which makes it difficult for investors to compare performance.

Jack Ciesielski, president of the Baltimore investment manager R.G. Associates, said investors have trouble properly valuing companies and comparing their financial performance because non-GAAP measurements have become so common.

According to Ciesielski’s research, there was an “explosion” of companies using non-GAAP measures in the past five years. He said companies are removing more cost items from income statements and making it increasingly difficult for analysts to compare companies from the same industry.

White said the expense one company leaves out might be included by another company. Sometimes a company will not provide detailed explanations about expenses that are removed from an income statement.