According to audit firm PwC, non-GAAP financial measures play an important role in financial reporting, "showing a view of the company's financial or operational results to supplement what is captured in the financial statements," and help to tell the company's financial story, as the SEC has advocated in connection with MD&A, "through the eyes of management." Yet, they also have the potential to open the proverbial can of worms, subjecting the company to serious SEC scrutiny and possible SEC enforcement if misused. Just a couple of weeks ago, the SEC announced settled charges against DXC Technology Company, a multi-national information technology company, for making misleading disclosures about its non-GAAP financial performance. According to the Order, DXC materially increased its reported non-GAAP net income "by negligently misclassifying tens of millions of dollars of expenses " and improperly excluding them from its reported non-GAAP earnings. In addition to misclassification, DXC allegedly provided a misleading description of the scope of the expenses included in the company's non-GAAP adjustment and failed to adopt a non-GAAP policy or to have adequate disclosure controls and procedures in place specific to its non-GAAP financial measures. Consequently, DXC "negligently failed to evaluate the company's non-GAAP disclosures adequately." DXC agreed to pay a civil penalty of $8 million. (See this PubCo post.) So what can a company's audit committee do to help prevent the types of problems that have arisen at DXC and elsewhere? Audit committees may find helpful this recent article from PwC providing guidance for committees tasked with oversight of the use of non-GAAP financial measures.

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As discussed in this article in CFO.com, establishment of controls and procedures for non-GAAP measures is especially important because they are—by definition—not standard, and controls and procedures can help companies ensure appropriate disclosure and regulatory compliance. According to the article, these controls should focus on seven key areas:

  • Measures comply with SEC rules and guidance
  • Non-GAAP adjustments are consistent across periods, appropriate and not cherry-picked (e.g., adjusted not only for nonrecurring expenses, but also for nonrecurring gains) or otherwise misleading
  • Data used for inputs in non-GAAP measures are reliable and subject to appropriate controls
  • Calculations of non-GAAP measures are accurate and tie to the same measures as disclosed
  • Descriptions of non-GAAP measures, adjustments and other required disclosures are transparent and unambiguous
  • Non-GAAP measures and related disclosures are reviewed by management for appropriateness and completeness
  • Disclosure controls for non-GAAP measures are monitored by management with oversight from the audit committee

In addition, non-GAAP policies that provide a set of guidelines for preparing and presenting non-GAAP measures can promote consistency and help guide decisions on issues related to non-GAAP measures and the treatment of new transactions or events in the context of the company's non-GAAP measures. The author also recommends that companies craft a written non-GAAP policy that "(1) clearly describes the nature of allowable adjustments to GAAP measures, (2) defines the non-GAAP measure(s) to be used under the policy, and (3) explains how potential changes in the inputs, calculations, and adjustments will be evaluated and approved. For example, a policy might describe qualitatively the types of adjustments that are non-recurring and unusual, and are thus within the defined policy. It might also outline specific quantitative thresholds for which income and/or expense items would be evaluated to determine whether they should be included in non-GAAP adjustments." (See this PubCo post.)

PwC observes that, while non-GAAP measures have commonly been used for at least twenty years, in the last few years, they have regained the spotlight. Data from the Center for Audit Quality cited in the article showed that, in the first calendar quarter of 2020, 94% of S&P 500 companies included at least one non-GAAP financial measure in their earnings releases. And, as illustrated by the enforcement action described above, as well as the prevalence of comments from the SEC on non-GAAP measures and recent CDIs from Corp Fin (see this PubCo post), the SEC has not exactly lost interest in non-GAAP financial measures and their potential misuse.

GAAP offers the advantages of uniformity—not to mention being subject to internal control over financial reporting and an external audit—and widespread acceptance. Not necessarily so with non-GAAP financial measures. According to the CAQ, based on information gained from a series of roundtables held in 2017, one of the biggest challenges for investors with regard to evaluating non-GAAP financial measures is the lack of consistency among companies, making comparisons tricky, even within the same industry. PwC identifies as among the most common or traditional non-GAAP measures operating income that excludes one or more expense items; adjusted revenue, adjusted earnings, and adjusted earnings per share; EBIT and EBITDA, and adjusted EBIT and EBITDA; core earnings; free cash flow; funds from operations; net debt, which could be calculated as borrowings less cash and cash equivalent or borrowings less derivative assets used to hedge the borrowings; and measures presented on a constant-currency basis, such as revenues and operating expenses. However, PwC observes, newer industries and business models, among other things, have led to the emergence of more "non-traditional" non-GAAP measures. That, together with "the proliferation of non-GAAP measures generally, the majority of which show non-GAAP results exceeding GAAP results," have propelled some to question "whether, in some instances, the alternative measures are painting too rosy a financial picture. These factors could lead to an overall lack of trust of non-GAAP measures."

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A working group of the PCAOB's Investor Advisory Group, commenting on the use of non-GAAP measures, observed that GAAP and non-GAAP measures can together provide a more comprehensive perspective on the business. Nevertheless, it was important that non-GAAP measures be verified: are they actually tied to the company's books and records? Do they really reflect how the company is run? How are they tied to the process for setting risk appetite? Are they used consistently at the company and across the industry? How are they used by outsiders? The group even recommended that non-GAAP measures should be audited. (See this PubCo post.)

Just what is the role of the audit committee when it comes to non-GAAP financial measures? The CAQ has characterized the audit committee's oversight role as an important one that positions the committee to "act as a bridge between management and investors," assessing whether "the measures present a fair and balanced view of the company's performance." But non-GAAP financial measures present challenges for audit committees: why is management using this measure? Is it consistent with the measures used by the company's peers? Is the disclosure adequate? In addition, to the extent that non-GAAP measures may be used in determining incentive compensation, audit committee oversight becomes even more critical.

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In a 2019 op-ed, then-SEC Commissioner Robert Jackson and MIT senior lecturer (and former president of Fidelity) Robert Pozen lambasted the use of non-GAAP targets in determining executive pay, absent more transparent disclosure. The pair argued that, although historically, performance targets were based on GAAP, in more recent years, there had been a shift to using non-GAAP pay targets, sometimes involving significant adjustments that can "be used to justify outsize compensation for disappointing results." What's the bottom line? Where comp committees base comp on a different scorecard than GAAP, they argued, the committee should have to explain its decision by reconciling to GAAP in the CD&A.

The op-ed was premised on research co-authored by Pozen, which showed "that firms in the S&P 500 announced adjusted earnings that were, on average, 23% higher than GAAP earnings. At the same time, those firms reporting the largest differences between their adjusted and GAAP earnings awarded higher pay packages to their CEOs than predicted by the standard academic model of normal CEO compensation. Yet those firms with the largest differences, on average, experienced lower stock returns and subpar operating performance...." And, the difference between GAAP and non-GAAP adjusted measures could be significant: the op-ed pointed to 36 companies in the S&P 500 that, in 2015, announced non-GAAP earnings more than 100% higher than the GAAP equivalent, and 57 more companies that reported non-GAAP earnings that were 50% to 100% higher than GAAP. What's more, the "compensation committees of almost all those companies used a non-GAAP measure as an important criterion for awarding executive pay." (See this PubCo post.)

PwC offers a number of questions for audit committees, in fulfilling their oversight roles, to consider asking management about the use of non-GAAP financial measures:

  • "Why has management chosen to present the non-GAAP measure?
    • What is the purpose of the non-GAAP measure?
    • Which competitors and peer companies use non-GAAP measures and how do they compare to those used by the company?
    • What questions or feedback has management received from investors or analysts on a specific non-GAAP measure(s)?
  • What is management's process to calculate the non-GAAP measure?
    • What procedures are in place to ensure the calculations are accurate and consistent with those of prior periods?
    • Is the process covered by management's internal control over financial reporting or other disclosure controls? If not, why not?
    • Has the company considered having internal audit perform a review of the internal controls over the derivation of non-GAAP measures to determine whether the controls are effective?
  • What are the incentives for possible 'earnings management'?
    • What is the company's policy on what will give rise to a non-GAAP adjustment? How is materiality considered in this policy?
    • What are the areas of judgment?
    • How do non-GAAP measures impact management compensation?
    • How does management's disclosure committee focus on non-GAAP measures and consider their appropriateness?
  • Is the presentation and disclosure fair, balanced, and transparent?
    • Are GAAP measures presented with equal or greater prominence?
    • Is the disclosure descriptive and transparent or 'boilerplate'?
    • Has the company received an SEC comment letter focused on any non-GAAP matters?
  • Do the measures comply with the SEC regulations and the SEC staff's 2018 interpretive guidance [and the most recent CDIs]?
    • Can the measures potentially be considered misleading?
    • Are prohibited measures excluded?
    • Are adjustments to arrive at a non-GAAP measure labeled as non-recurring, infrequent, or unusual expected to recur in the next two years?"

In addition, PwC indicates that, "[a]lthough auditors do not report on these measures, some management and audit committees may use the external auditor as an informal sounding board on whether the company has complied with non-GAAP regulations."

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What is the responsibility of the auditors in connection with non-GAAP measures? According to the CAQ, although non-GAAP measures are not audited and are outside the external auditor's opinion, under professional auditing standards, when they are presented in certain documents containing the financial statements, the auditor is still supposed to read them and consider whether they are presented in a way that is "materially inconsistent with information appearing in the financial statements or a material misstatement of fact." As a result, the CAQ recommends that the audit committee leverage the auditors as a resource to provide the committee with perspective on the measures, including potentially even engaging them to perform non-audit procedures such as testing "controls related to the preparation and disclosure of non-GAAP measures in accordance with the company's policies, and reporting results to the audit committee."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.