The Securities and Exchange Commission is expected to ask more companies to explain how they calculate performance measures that go beyond U.S. generally accepted accounting principles, a move to gauge whether these metrics could potentially mislead investors.
The U.S. securities regulator for years has monitored companies’ use of so-called non-GAAP earnings measures in their financial statements, such as earnings before interest, taxes, depreciation and amortization, or Ebitda, and adjusted revenue. Such measures are commonly used and typically exclude abnormal, nonrecurring items.
The SEC in 2016 warned companies that non-GAAP measures that replace GAAP-based methods with individually tailored disclosure could violate its rules. These activities include moving the timing of recognition of an expense or revenue from one period to another and depreciating operating leases instead of recording rent expenses.
In December, the regulator expanded the guidance with more details on what constitutes a possible violation. For example, companies that change their accounting for revenue or expenses from an accrual basis under GAAP to a cash basis might mislead investors, as the latter is an unofficial accounting practice, the SEC said.
Companies rely increasingly on these measures, often to present an overly optimistic picture of profitability, accounting researchers said. Executives usually say that focusing on core operating earnings is the most accurate way to depict financial performance to investors, but their approach may vary.
Investors might assume that non-GAAP measures represent a company’s earnings minus abnormal, nonrecurring items and then be fooled when the measures mean something different, said Nick Guest, an assistant professor of accounting at Cornell University. “That’s what the SEC doesn’t want and why they’re not allowing each company to come up with their own definition of a non-GAAP measure,” Mr. Guest said.
The SEC in a series of recent letters to businesses focused on companies’ presentations of non-GAAP metrics that seem tailored to the specific firm. It has asked many of them to make changes for future filings so that investors can adequately assess the business. The agency’s corporate-finance division regularly sends letters to public companies to inquire about their disclosures or accounting practices tied to filings such as quarterly or annual reports.
Sleep Number Corp.
, and media and education business
Graham Holdings Co.
were among the companies the SEC sent such letters to in exchanges the regulator made public in recent weeks.
SEC letters released in January and February showed a total of 20 companies were questioned about their compliance with Question 100.04, a section in its guidance focused on calculations of non-GAAP measures, according to MyLogIQ, a data provider. That is up from 11 companies in letters released in January and February 2022. SEC questions on the topic totaled 161 in 2022, down from 206 a year earlier and up from 124 two years earlier, MyLogIQ said.
That number will likely grow in the coming months due to the SEC’s apparent focus and some companies’ lack of awareness of the new guidance, accountants and academics said. The SEC typically makes correspondences public 20 business days after resolving matters, meaning inquiries following the December guidance could be released starting in early spring, said Olga Usvyatsky, a former vice president of research at research firm Ideagen Audit Analytics and a Ph.D. accounting student at Boston College.
The SEC has long expressed concerns about companies placing too much emphasis on their non-GAAP disclosures compared with GAAP disclosures. But its scrutiny on non-GAAP calculations could push companies to overhaul how they compute measures of financial performance. Changing how certain non-GAAP measures are calculated can be embarrassing and even costly for companies, accountants said. The SEC declined to comment.
In letters released this month, the SEC asked Lyft to explain how it considered agency rules in excluding insurance reserve costs, or funds allocated by a company for future insurance claims, in its adjusted Ebitda. Lyft said it included, as part of non-GAAP treatment, its insurance costs for the current period. The company said the adjustment isn’t misleading or individually tailored, but rather conveys to investors its current performance.
“The company believes that this adjustment…provides investors with additional useful information related to the company’s operating performance during the current period, rather than including the impacts associated with insurance claims which occurred in prior periods,” Lisa Blackwood-Kapral, Lyft’s chief accounting officer, wrote in September.
The SEC, following its new guidance in December, pushed back. It said the adjustment is inconsistent with its guidance on adjusted accounting, and told the company to remove it from its non-GAAP calculations. Lyft in January said it would reflect the change in future filings. The company on Feb. 9 reported adjusted Ebitda of negative $248.3 million for the quarter ended Dec. 31, 2022, compared with a negative $47.6 million in the prior-year period, largely due to the calculation change. It boosted its insurance reserves by $375 million for the quarter, the company said.
In other letters released this month, the SEC sought more details on Graham Holdings’ adjusted net income, which it said appeared to apply a different basis of accounting than that of GAAP. Graham Holdings said it isn’t violating SEC guidance because it didn’t substitute an alternative recognition or measurement method for the related adjustments. The company also said it didn’t shift from an accrual basis of accounting to a cash or modified basis of accounting.
“From a CFO standpoint, their job is to show the company in as good a light as possible, but at the same time, you don’t want to go too far because that really can create suspicion. ”
Despite defending its accounting, Graham Holdings said it would significantly expand its disclosure around the adjustments in future filings, which it began to do on Friday with the filing of its annual report.
The SEC also inquired about Sleep Number’s use of a non-GAAP measure known as return on invested capital, or ROIC, which aims to show how efficiently it invests capital.
To calculate ROIC, the company needs to determine its net operating profit after taxes, or NOPAT, which is companies’ earnings excluding financing costs. In removing the GAAP item of operating lease rent expense and replacing it with depreciation to tally up NOPAT, Sleep Number appeared to make individually tailored disclosures with a non-GAAP method, the SEC said.
Sleep Number will change how it computes ROIC and no longer make these adjustments, instead adding back the interest component of its lease expense, then-Chief Financial Officer
wrote on Jan. 12. Still, the company defended its approach. “We believe our current ROIC calculation best represents how we operate our business and deploy our capital,” wrote Mr. Callen, who stepped down as CFO on Jan. 30. Sleep Number’s revised calculation appeared in its annual report filed Friday.
Mr. Callen’s departure was unrelated to the SEC inquiry, a spokeswoman said.
Graham Holdings and Lyft declined to comment.
The inquiries could prompt more companies’ audit committees to more closely review non-GAAP disclosures to ensure the rationale behind the measures are thoroughly explained before filing with the SEC, said H. David Sherman, an accounting professor at Northeastern University and former SEC academic fellow.
“From a CFO standpoint, their job is to show the company in as good a light as possible, but at the same time, you don’t want to go too far because that really can create suspicion,” he said.
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