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SEC cracking down on fuzzy math in company earnings

The Securities and Exchange Commission in Washington.
Jim Bourg | Reuters
The Securities and Exchange Commission in Washington.

Prompted by federal regulators, Tesla urged its numbers crunchers to do their work a bit differently last year.

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Alarmed by publicly traded companies' increasing ways to be creative with their income statements, the Securities and Exchange Commission updated last May its standards on how earnings and revenue should be reported in quarterly financial statements. The electric automaker, founded by Elon Musk, became one of the most prominent examples companies working to meet the new standards after being sent a letter from the regulatory agency.

The SEC's changes aim to crack down on companies' use of the so-called non-GAAP (Generally Accepted Accounting Principles) in financial results that often look more favorable than the numbers resulting from GAAP, which is the standard guideline for financial accounting in the U.S. The practice is widespread, and the SEC allows some non-GAAP metrics.

"Substantial progress has been made in addressing the problematic practices," Wesley Bricker, the SEC's chief accountant said in a speech at an industry conference in December. "However, there is more progress for companies to make."

Companies typically use non-GAAP earnings — also called pro forma earnings — to remove the negative impact from one-time special events or revenue that are difficult to record within a specific period, say revenue that can't be booked until transactions are fully closed. And, while GAAP rules consider stock options awarded to executives a cost, many companies continue to exclude them in non-GAAP presentations to enhance the bottom line

Companies argue that non-GAAP figures allow them to tell a fuller, more nuanced story about their operating performance, but some industry watchdogs say their use hurts investors, particularly the more unsophisticated segment, and undermines transparency that is accepted as a bedrock principle of capital markets. Most companies in the Standard & Poor's 500 index — 449 out of 500 — presented at least one non-GAAP metric between July and September of 2015, according to a study by research firm Audit Analytics.

"I don't' think you (as an investor), should work that hard," says Paul Zarowin, an accounting professor at New York University. Earnings "should be straightforward. If (a company) had a negative figure and transformed that into positive, you should know that easily."

The SEC's updates in May technically aren't rules but are staff interpretation of the existing rules, but companies and their lawyers accept the changes as new standards, says Ryan Castillo, a securities attorney at Morrison & Foerster.

Companies found to be lacking in compliance are sent a letter by the SEC. If companies object, discussions with SEC regulators typically ensue. The SEC can penalize by withholding clearance for the SEC paperwork needed for companies' capital financing, issue fines or bring civil enforcement actions for violations of federal securities laws, he says.

Since May, there has been an "uptick" in the comment letters issued by the SEC's Division of Corporation Finance — more than 200 — to companies seeking compliance, principally about non-GAAP reporting, he says

Tesla, whose earning statements were notorious for the use of non-GAAP figures, said in October that it would stop issuing non-GAAP revenue and related financial metrics related to a now discontinued program that allowed customers to sell a vehicle back to the company at a predetermined price after a few years. In GAAP accounting, it deferred the revenue as operating leases, but in non-GAAP accounting Tesla added the vehicle sales price to overall revenue, making it appear larger.

Other companies receiving "please-comply" letters regarding their non-GAAP figures include Valeant Pharmaceuticals International, Brookdale Senior Living, Salem Media, Radio One and Lending Club. In 2016, the SEC also charged two former accounting executives of American Realty Capital Properties, now known as Vereit, for overstating the financial performance using a non-GAAP metric.

Among the SEC's recent updates on non-GAAP rules:

  • Recurring events. The SEC now says companies should no longer strip out recurring, cash operating expenses, particularly if an item — say, severance payments for layoffs — is likely to recur or have occurred within two years.
  • *Apples-to-apples comparison. A result comparison must be consistent. The SEC now frowns on a measure that adjusts a charge or gain in the current period when the similar charge or gain was not also adjusted in the prior periods.
  • *Gains and charges. The SEC now considers misleading any income statement that excludes non-recurring charges but doesn't exclude non-recurring gains, say tax benefits in one period versus tax charges in another.
  • *Equal prominence. There are some reporting considerations as well, with an emphasis by the SEC to urge companies to highlight GAAP numbers as prominently in press releases and headlines as they do non-GAAP. Companies are now told to refrain from bolding non-GAAP figures or using larger fonts, labeling them as "record performance," or provide discussions of a non-GAAP figure without a similar discussion of the comparable GAAP figure.

With the changes in place only for a few months, the level of corporate compliance is difficult to gauge. But Audit Analytics found that companies are making strides, at least in headlines. In a report in December, the firm said only 28 of S&P 500 companies — or 6% — displayed a non-GAAP metric before a GAAP equivalent in their press release headlines from July to September. That's down from 40% of the filings dated April to June.

Still, Zarowin of NYU says non-GAAP will continue to be entrenched in companies' filings. "If they want to dress up their earnings — unless the SEC starts fining people in a big way, which I don't really see — the firms will find a way to push the limits," he says.

And there's the Trump factor. President-elect Donald Trump nominated Jay Clayton as the new SEC chair last week, and the agency could roll back a large chunk of its regulations if Trump has his way. Trump, the real estate developer, is familiar with non-GAAP rules.

In 2002, Trump Hotels & Casino Resorts, then majority-owned by Trump, became the first target of the SEC's crackdown on pro forma earnings rules when it received a cease-and-desist order for making "misleading statements" in a earnings release in 1999.

If Trump were to roll back on non-GAAP rules, it "wouldn't surprise me at all," Zarowin says. "Trump is not a fan of SEC regulation."