United States: SEC Charges DXC With Misleading Non-GAAP Disclosures And Absence Of Non-GAAP Disclosure Controls

The SEC has announced settled charges against DXC Technology Company, a multi-national information technology company, for making misleading disclosures about its non-GAAP financial performance in multiple reporting periods from 2018 until early 2020. According to the Order, DXC materially increased its reported non-GAAP net income "by negligently misclassifying tens of millions of dollars of expenses " as non-GAAP adjustments related to strategic transactions and integration and improperly excluding them from its reported non-GAAP earnings. In addition to misclassification, DXC allegedly failed to accurately describe the scope of the expenses included in the company's non-GAAP adjustment, with the result that "its non-GAAP net income and non-GAAP diluted EPS in periodic reports and earnings releases were materially misleading." What's more, the SEC alleged, DXC did not have a non-GAAP policy or 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. According to the SEC's Associate Director of Enforcement, "[i]ssuers that choose to report non-GAAP financial metrics must accurately describe those metrics in their public disclosures....As the order finds, DXC's informal procedures and controls were not up to the task, and, as a result, investors were repeatedly misled about its non-GAAP financial performance."

Background

According to the Order, DXC Technology Company was created in April 2017 through the merger of two other technology companies. Prior to the merger, one of the constituent companies followed a practice of reporting non-GAAP measures that excluded strategic transaction and integration-related costs (referred to as transaction, separation and integration costs, or "TSI"), and that practice was continued post-merger, using similar disclosure language. As the SEC highlighted, "the company recognized that the non-GAAP measures were material because they allowed investors to better understand the core performance of the company."

The SEC alleged that, following the merger that created DXC, DXC's controller group, which was responsible for reviewing and approving TSI costs for public reporting, "recognized the need for a non-GAAP policy that included disclosure controls and procedures specific to non-GAAP reporting." Although drafts were circulated, none was adopted. In addition, the SEC alleged, there was no formal guidance for, and no process for evaluation and review of, the determinations of which costs should be classified as TSI, with the result that costs were included as TSI that "were beyond the scope of costs described in the company's disclosures."

As described by the SEC, costs were initially classified as TSI upon approval of the DXC financial planning and analysis group and forwarded to the controller group. However, the basis for this initial approval was not documented nor was the expected duration indicated. Instead, the TSI costs would be submitted to the controller group for approval on a spreadsheet identifying tens of thousands of items, but, the SEC alleged, without adequate descriptions, making it difficult for the controller to perform an diligent review. Further, the SEC charged, the controller group did not evaluate whether the classifications were consistent with the description of TSI in the company's public disclosures. As a result, according to the Order, there was no reassessment of the TSI cost classifications from year-to-year; the costs were just coded "transaction" or "integration" and simply rolled up into the quarter's TSI costs. As described in the Order, many employees apparently thought the classification was someone else's job: some in financial planning thought it was the controller group's responsibility, and some in the controller group thought that the financial group "had more robust procedures than it actually did for analyzing and vetting the TSI costs before forwarding the aggregated costs to the controllership."

According to the Order, employees in the controller group who questioned the classification of items as TSI "either did not receive supporting documentation or, at times, were provided with inaccurate or incomplete information," and often the questions were "addressed only orally, without adequate written records of how particular issues were resolved." The SEC highlighted in particular the concerns raised by the former assistant controller "about certain TSI cost issues" in his sub-certifications (although he "ultimately certified, with comments, the company's financial reporting in those periods"). For example, during FY 2019, the former assistant controller was alleged to have raised the question to the former controller-"I know I bring this up every quarter"-of the propriety of characterizing as TSI tens of millions of dollars in certain costs, such as branding, and to have requested additional documentation. But he did not receive the requested supplemental documentation and so indicated in a sub-certification. The same inadequate controller group review was repeated for the following quarter, the SEC charged. Once again, the assistant controller raised the issue in a sub-certification: "I have asked again for supporting information to address the non-gaap adjustments and how they meet the CDI to ensure compliance with non-GAAP SEC Regs. I have not received responses and these non-gaap measures are heavily relied upon by investors. We simply require an explanation for the items as outlined in several requests to Management/FPA. I have provided this information to [the controller] for his assessment." According to the SEC, DXC's "review and approval of the classification of TSI costs continued to be untethered from the plain language of the company's description of those costs in its public disclosures."

SideBar

The Corp Fin staff had apparently been scrutinizing the company's non-GAAP reporting relating to the TSI adjustment. In March 2019, the staff issued a comment letter to the company regarding its March 31, 2018 Form 10-K and December 31, 2018 Form 10-Q focused on the company's non-GAAP adjustments (although not congruent with the charges in this case). The staff commented:

In its final response in September (which apparently followed an initial response and phone conversations with staff), the company disagreed, contending that

The company offered to clarify its disclosure for its non-GAAP adjustment, including an explanation that, while it was excluding the amortization of acquired intangible assets from its non-GAAP expenses, those "intangible assets were recorded as part of purchase accounting and support revenue generation." In October, the staff indicated that it had completed its review and reminded the company that it was "responsible for the accuracy and adequacy of their disclosures, notwithstanding any review, comments, action or absence of action by the staff."