Tag Archives: Non-GAAP

Year-End Planning – Number Four – Recently Issued Accounting Standards and a Few Example Comments

In recent weeks we have been posting about areas to deal with in advance of year-end. So far we have addressed:

Issues in the Statement of Cash Flows

Evaluating and Auditing ICFR

The New Item 16 Form 10-K Summary

 

The spirit and rationale behind these posts is that it is always a good idea to proactively anticipate problems that may arise and act to keep issues from becoming problems.

As we continue this series our next post is about SAB 74 (Topic 11-M in the SAB Codification), the requirement for disclosures about recently issued accounting standards.

 

With the major changes coming from the new revenue recognition standard, the new lease standard, and for financial companies the new financial instrument impairment standard, these disclosures become increasingly important. Users need to be forewarned about the expected impact of these new standards. This is essentially a known trend disclosure in your MD&A.

 

Here is an excerpt from Topic 11-M. You can read the entire SAB here.

 

Interpretive Response: The staff believes that the registrant should evaluate each new accounting standard to determine the appropriate disclosure and recognizes that the level of information available to the registrant will differ with respect to various standards and from one registrant to another. The objectives of the disclosure should be to (1) notify the reader of the disclosure documents that a standard has been issued which the registrant will be required to adopt in the future and (2) assist the reader in assessing the significance of the impact that the standard will have on the financial statements of the registrant when adopted. The staff understands that the registrant will only be able to disclose information that is known.

 

The following disclosures should generally be considered by the registrant:

 

A brief description of the new standard, the date that adoption is required and the date that the registrant plans to adopt, if earlier.

 

A discussion of the methods of adoption allowed by the standard and the method expected to be utilized by the registrant, if determined.

 

A discussion of the impact that adoption of the standard is expected to have on the financial statements of the registrant, unless not known or reasonably estimable. In that case, a statement to that effect may be made.

 

Disclosure of the potential impact of other significant matters that the registrant believes might result from the adoption of the standard (such as technical violations of debt covenant agreements, planned or intended changes in business practices, etc.) is encouraged.

 

 

As a company gets closer to the adoption date for a new standard these disclosures should evolve. And although “[t]he staff understands that the registrant will only be able to disclose information that is known”, the other side of this disclosure is that when you know something, you should disclose it!

 

One last heads up – when you file your 10-K for the year before adoption, in other words you will adopt the day after that year-end, the staff will likely expect robust disclosure, including quantification of the impact of adoption.

 

When a company has decided which method it will use to adopt, it should disclose that information!

 

As a company researches and builds an understanding of how much a new standard will affect the financial statements, this impact should be disclosed.

 

Frequently we are concerned that there is uncertainty in this process, and that is never comfortable to discuss in an SEC report. Here are two excerpts that are examples of this disclosure from a June 30, 2016 Form 10-K. They deal with this uncertainty (emphasis added):

 

Leases

 

In February 2016, the FASB issued a new standard related to leases to increase transparency and comparability among organizations by requiring the recognition of lease assets and lease liabilities on the balance sheet. Most prominent among the amendments is the recognition of assets and liabilities by lessees for those leases classified as operating leases under previous U.S. GAAP. Under the new standard, disclosures are required to meet the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. We will be required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach.

 

The new standard will be effective for us beginning July 1, 2019, with early adoption permitted. We currently anticipate early adoption of the new standard effective July 1, 2017 in conjunction with our adoption of the new revenue standard. Our ability to early adopt is dependent on system readiness, including software procured from third-party providers, and the completion of our analysis of information necessary to restate prior period financial statements.

 

We anticipate this standard will have a material impact on our consolidated financial statements. While we are continuing to assess all potential impacts of the standard, we currently believe the most significant impact relates to our accounting for office, retail, and datacenter operating leases.

 

Revenue from Contracts with Customers

 

In May 2014, the FASB issued a new standard related to revenue recognition. Under the new standard, revenue is recognized when a customer obtains control of promised goods or services and is recognized in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The FASB has recently issued several amendments to the standard, including clarification on accounting for licenses of intellectual property and identifying performance obligations.

 

The guidance permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (the cumulative catch-up transition method). We currently anticipate adopting the standard using the full retrospective method to restate each prior reporting period presented.

 

The new standard will be effective for us beginning July 1, 2018, and adoption as of the original effective date of July 1, 2017 is permitted. We currently anticipate early adoption of the new standard effective July 1, 2017. Our ability to early adopt using the full retrospective method is dependent on system readiness, including software procured from third-party providers, and the completion of our analysis of information necessary to restate prior period financial statements.

 

We anticipate this standard will have a material impact on our consolidated financial statements. While we are continuing to assess all potential impacts of the standard, we currently believe the most significant impact relates to our accounting for software license revenue. We expect revenue related to hardware, cloud offerings, and professional services to remain substantially unchanged. Specifically, under the new standard we expect to recognize (Product A) revenue predominantly at the time of billing rather than ratably over the life of the related device. We also expect to recognize license revenue at the time of billing rather than over the subscription period from certain multi-year commercial software subscriptions that include both software licenses and Software Assurance. Due to the complexity of certain of our commercial license subscription contracts, the actual revenue recognition treatment required under the standard will be dependent on contract-specific terms, and may vary in some instances from recognition at the time of billing.

 

We currently believe that the net change in (Product A) revenue from period to period is indicative of the net change in revenue we expect from the adoption of the new standard.

 

Lastly, as we always like to do, here are two example comments to reinforce the issues in this disclosure:

 

Please revise your disclosures to fully comply with Question 2 of SAB Topic 11:M for each standard listed. Specifically, if early adoption is permitted, you should state the date that you plan to adopt the standard. You should also discuss the impact that adoption of each standard is expected to have on your financial statements or, if applicable, make a statement to the effect that you are still assessing the impact that adoption of each standard will have on your financial statements and the impact is not known or reasonably estimable at this time.

 

Please revise to include a discussion of the potential effects that recently issued accounting standards will have on your financial statements when adopted in a future period. Refer to SAB Topic 11.M. For example, please revise to disclose the potential effect of ASU No. 2014-09, Revenue from Contracts with Customers.

How Prepared are you for SEC Annual Reporting Season or your next 10-Q?

It has been a very active time at the SEC, FASB and PCAOB. Have you stayed on top of recent developments, activities and proposals? For example, the Leases Standard is final and the FASB is awash in simplification and other projects. Register now for our upcoming live seminar and webcast, 32nd Annual SEC Reporting & FASB Forum being held November 14-15 in Dallas, December 12-13 in New York City and December 19-20 in San Francisco. Prepare for year-end and reporting season by attending this highly anticipated and popular annual seminar and hear a roundtable discussion of current events, including simplification overload, disclosure effectiveness, juggling Rev. Rec., Leases, CECL adoptions and more. Our expert faculty will also discuss the new CDIs on non-GAAP measures, the Regulation S-K Concept Release, frequent accounting and disclosure comments, Revenue Recognition and guidance on lease accounting, MD&A disclosure and much more.

http://www.pli.edu/Content/32nd_Annual_SEC_Reporting_FASB_Forum/_/N-1z11c8sZ4k?ID=262904

Getting the New Revenue Recognition Standard into Perspective

As we all know, the new revenue recognition standard will be effective for public companies for periods beginning after December 15, 2017. This change will have challenges for everyone. Even if the new five-step, contract based model does not dramatically change the timing of your company’s revenue recognition, documenting how the new model applies in your case will require some time, and all of us will have to deal with the significant increase in disclosures, particularly the requirement to disaggregate revenues.

 

One place we see some confusion is about what these challenges will look like. This new standard is a complete departure from our old revenue recognition guidance and the detailed, rule based nature of the old standards. Some writers still talk about the “hundreds of pages” of guidance that must be dealt with. This makes it sound like the new standard is a large collection of detailed rules that simply replaces the large collection of detailed rules in the old revenue recognition GAAP.

 

This is not the case.

 

In the ASU the core of the new revenue model starts on page 14 and ends with the last of the disclosures on page 48.   Seems pretty short!

 

It is very principles base guidance! In our workshops, the broad, principles based nature of the new standard creates some of the biggest challenges for companies.

 

The whole standard is based on this principle, from paragraph 606-10-10-2:

 

“the core principle of the guidance in this Topic is that an entity shall recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”

 

Notice the lack of language about an earnings process being complete or revenue being “realized or realizable”.

 

Each of the five steps and the disclosure requirements also start with a broad principle. Here is an example from step three, determining the transaction price (606-10-32-2):

 

“An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both.”

 

On interesting aspect of this principle is that if there is variable consideration in a contract, it must be estimated! That is a whole new principle and each company will have to assess how to apply it to their circumstances.

 

Because this new revenue recognition model establishes a whole new set of principles, the FASB knew we would all need some help in how to interpret these principles. So, the standard, after the disclosure requirements, includes a number of implementation guidance discussions to explain what the principles are intended to mean. Terms such as “satisfied over time” and “distinct within the context of the contract” are explored. But you won’t find any detailed rules.

 

After the implementation guidance are a number of examples, and here you can find some actual interpretations of the principles which are very helpful. There are not too many of them.

 

As a last source of support for your process of learning about these principles and how to interpret and apply them don’t forget about the TRG. While the TRG does not issue formal guidance, their discussions are rich with examples of how some very experienced professionals are interpreting the standard. And, as you may have heard, the SEC Chief Accountant has said if companies depart from TRG discussions, they should be prepared to support such positions to the SEC staff. (You can read more about that in this speech.)

 

 

So, our tip for today, as you move through your implementation be ready to build an understanding of the principles and how to apply them to your specific circumstances!

 

As always, your thoughts and comments are welcome!

Form S-3 and the New Revenue Recognition Standard

The new revenue recognition standard allows for two transition methods. One is a kind of hybrid “retrospective with a cumulative effect” approach, where in the year of adoption a company records the cumulative effect and goes forward (with some significant “old GAAP” disclosures). The other is full retrospective implementation.

The full retrospective implementation comes with a lot of baggage beyond the amount of work it might require.

One question is what about the five-year summary? In Form 10-K is it necessary to retrospectively adjust the two earliest years in the five year summary along with the three years in S-X audited financial statements? The SEC staff has addressed this question and said this is not necessary. The CorpFin Financial Reporting Manual now states:

11100 REGISTRANT FINANCIAL INFORMATION

 

11100.1 Selected Financial Data

 

Question

A registrant elects to adopt the new revenue standard using the full retrospective approach. Must it apply the new revenue standard when reporting selected financial data (S-K Item 301)) for periods prior to those presented in its retroactively-adjusted financial statements?

 

Answer

No, but registrants must provide the information required by Instruction 2 to S-K Item 301 regarding comparability of the data presented.

This second question is a lot more intricate. What if a company does an S-3 after the first quarter of implementation? To set this issue up, here is a fact set:

Company year-end: December 31

Revenue Recognition Standard adoption date: January 1, 2018

Full retrospective method of adoption is used. In this method, for the 2018 Form 10-K the years 2016, 2017 and 2018 would be presented using the new revenue recognition standard.

Now assume that in 2018 (thus before the December 2018 Form 10-K is filed), the company reports for the first quarter of 2018 and files Form 10-Q on April 30, 2018. If the company then files an S-3 to raise capital on May 31, 2018, the previous Form 10-K for the year ended December 31, 2017, would be incorporated into the Form S-3. That Form 10-K would have financial statements for 2017, 2016 and 2015. The financial statements for 2015 are the key issue here, as they would not be required in the December 31, 2018 Form 10-K. But, since they are incorporated into the S-3 and the company has adopted the new revenue recognition standard, Item 11(b) in Form S-3 will apply (emphasis added):

 

Item 11. Material Changes.

 

(a) Describe any and all material changes in the registrant’s affairs which have occurred since the end of the latest fiscal year for which certified financial statements were included in the latest annual report to security holders and which have not been described in a report on Form 10-Q (§249.308a of this chapter) or Form 8-K (§249.308 of this chapter) filed under the Exchange Act.

 

(b) Include in the prospectus, if not incorporated by reference therein from the reports filed under the Exchange Act specified in Item 12(a), a proxy or information statement filed pursuant to Section 14 of the Exchange Act, a prospectus previously filed pursuant to Rule 424(b) or (c) under the Securities Act (§230.424(b) or (c) of this chapter) or, where no prospectus is required to be filed pursuant to Rule 424(b), the prospectus included in the registration statement at effectiveness, or a Form 8-K filed during either of the two preceding years:

 

(i) information required by Rule 3-05 and Article 11 of Regulation S-X (17 CFR Part 210);

 

(ii) restated financial statements prepared in accordance with Regulation S-X if there has been a change in accounting principles or a correction in an error where such change or correction requires a material retroactive restatement of financial statements;

 

(iii) restated financial statements prepared in accordance with Regulation S-X where one or more business combinations accounted for by the pooling of interest method of accounting have been consummated subsequent to the most recent fiscal year and the acquired businesses, considered in the aggregate, are significant pursuant to Rule 11-01(b), or

 

(iv) any financial information required because of a material disposition of assets outside the normal course of business.

 

This would seem to require that the new revenue recognition standard be applied to the year ended December 31, 2015.

Not a happy outcome!

This question has come up in earlier accounting standard transitions, and the SEC Staff is clearly aware of this issue. Wes Bricker, Deputy Chief Accountant, said this in a recent speech:

“I am also aware that registrants have expressed concern about the requirement to provide restated financial statements when a Form S-3 registration statement is filed after the registrant has filed its first Form 10-Q reflecting adoption of the revenue standard. This requirement to restate the financial statements means that companies that adopt the revenue standard under a full-retrospective transition approach would be required to restate an additional year in its Form S-3 to show the effect of the new revenue standard on that earlier period.

While this issue is not specific to the new revenue standard, the pervasive impact of the new revenue standard amplifies the issue.

To this, I would observe the transition provisions in the new revenue standard reference existing GAAP, which provides for an impracticability exception to retrospective application if, for example, a company is unable to apply the requirement after making every reasonable effort to do so. OCA is available for consultation if a registrant believes that, based on its facts and circumstances, a retrospective application of the new revenue recognition standard to all periods required to be presented in a Form S-3 is impracticable.”

The actual language he refers to in the excerpt above is from ASC 250:

250 – 10 – 45 – 5

An entity shall report a change in accounting principle through retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so.

And:

Impracticability

250 – 10 – 45 – 9

It shall be deemed impracticable to apply the effects of a change in accounting principle retrospectively only if any of the following conditions exist:

  1. After making every reasonable effort to do so, the entity is unable to apply the requirement.
  2. Retrospective application requires assumptions about management’s intent in a prior period that cannot be independently substantiated.
  3. Retrospective application requires significant estimates of amounts, and it is impossible to distinguish objectively information about those estimates that both:
  4. Provides evidence of circumstances that existed on the date(s) at which those amounts would be recognized, measured, or disclosed under retrospective application
  5. Would have been available when the financial statements for that prior period were issued.

That’s where this issue is for now, and this could well be a problematic issue for any company raising capital in the year of adoption of the new revenue recognition standard!

As always, your thoughts and comments are welcome!

SEC News – The FAST Act Form 10-K Summary

The SEC, on June 1, 2016, adopted an Interim Final Rule and Request for Comment to implement the Form 10-K summary provisions of The FAST Act. Passed earlier this year, the FAST Act contains a number of SEC reporting requirements, many of which the SEC has already implemented.

 

The Interim Final rule provides that a company may, at its option, include a summary in its Form 10-K. Each item in the summary must include a cross-reference by hyperlink to the material contained in the company’s Form 10-K to which the item relates.

 

The summary is a new Item 16 in Form 10-K:

 

Item 16. Form 10-K Summary.

 

Registrants may, at their option, include a summary of information required by this form, but only if each item in the summary is presented fairly and accurately and includes a hyperlink to the material contained in this form to which such item relates, including to materials contained in any exhibits filed with the form.

 

Instruction: The summary shall refer only to Form 10-K disclosure that is included in the form at the time it is filed. A registrant need not update the summary to reflect information required by Part III of Form 10-K that the registrant incorporates by reference from a proxy or information statement filed after the Form 10-K, but must state in the summary that the summary does not include Part III information because that information will be incorporated by reference from a later filed proxy or information statement involving the election of directors.

 

 

While perhaps not particularly dramatic, this is a nice step towards making Form 10-K a better communication tool, which is of course a big part of the disclosure effectiveness activities of the SEC. We could even debate whether such a rule is necessary as some companies, GE in particular, already provides such a summary.

 

You can read the Interim Final Rule and request for comment here.

 

And, if you have not read it recently, Carol and George, your bloggers, suggest taking a look here at the GE Form 10-K. You will find it interesting and the summary is on page 217.

 

As always, your thoughts and comments are welcome!

 

Jeepers, You Say There is More Non-GAAP News?

In the latest step in the SEC’s continuing efforts to, in the words of Corp Fin Chief Accountant Mark Kronforst, “crack down” on the inappropriate use of non-GAAP measures, on May 17, 2016 the SEC updated their Compliance and Disclosure Interpretations about the use of non-GAAP measures.

(At this point we almost want to apologize for how many recent posts we have done about non-GAAP measures, but this new guidance is important.)

You will find them at:

www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm

If you use non-GAAP measures anywhere, earnings releases, MD&A, wherever, read them!

To help you get started, here are a couple of highlights.

This first question is a broad theme in current SEC public remarks, as we have discussed them in recent posts:

Question 100.01

Question: Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?

Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading. [May 17, 2016]

This C&DI clarifies issues about per-share presentations:

 

Question 102.05

Question: While Item 10(e)(1)(ii) of Regulation S-K does not prohibit the use of per share non-GAAP financial measures, the adopting release for Item 10(e), Exchange Act Release No. 47226, states that “per share measures that are prohibited specifically under GAAP or Commission rules continue to be prohibited in materials filed with or furnished to the Commission.” In light of Commission guidance, specifically Accounting Series Release No. 142, Reporting Cash Flow and Other Related Data, and Accounting Standards Codification 230, are non-GAAP earnings per share numbers prohibited in documents filed or furnished with the Commission?

 

Answer: No. Item 10(e) recognizes that certain non-GAAP per share performance measures may be meaningful from an operating standpoint. Non-GAAP per share performance measures should be reconciled to GAAP earnings per share. On the other hand, non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in documents filed or furnished with the Commission, consistent with Accounting Series Release No. 142. Whether per share data is prohibited depends on whether the non-GAAP measure can be used as a liquidity measure, even if management presents it solely as a performance measure.  When analyzing these questions, the staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure. [May 17, 2016]

 

As always, your thoughts and comments are welcome.

Lots Happening at the PCAOB!

Since its inception with the Sarbanes-Oxley Act the PCAOB has faced many challenges in fulfilling its responsibilities to establish GAAS for public company audits, inspect audit firms and enforce when auditors do not fulfill their responsibilities. As the PCAOB has evolved one important lesson we have all learned is that their activities and agenda do not affect just auditors. All public company reporting participants have a stake in what they do. For example, the recent audit standard about related party issues was important not just for auditors, but companies needed to assure they would have the information the new standard required auditors to obtain. Some companies even modified their D and O questionnaires in this process.

To help us be aware of where the PCAOB’s activities could impact us all, here are a few items of note going on at the PCAOB right now.

  1. Auditor’s Involvement in non-GAAP Measures

If you use non-GAAP measures in an earnings release, MD&A or other communication vehicles you will want to follow the events of the May 18-19, 2016 meeting of the PCAOB’s Standing Advisory Group. A significant part of the first day’s agenda is a discussion of “Company Performance Measures and the Role of the Auditor”. The meeting will include breakout discussion sessions and a report of the breakout discussions on day two of the meeting. You can find the agenda and how to access a webcast at:

pcaobus.org/News/Releases/Pages/SAG-meeting-agenda-May-18-19.aspx\

  1. Anticipating and Avoiding Accounting and Auditing Problems

The PCAOB inspections staff has published a “Staff Inspections Brief” which provides a preview of their observations from 2015 inspections. Interestingly the number of audit deficiencies identified for annually inspected firms, those with over 100 public clients, has decreased. For firms with less than 100 public clients, who are inspected every three years, the inspection staff found “an overall high number of audit deficiencies”. Areas with frequent deficiencies were:

Auditing internal control over financial reporting

Assessing and responding to the risk of material misstatement

Auditing accounting estimates, including fair value

Audit areas affected by economic risks, including factors such as oil prices

 

The report also discussed several financial reporting issues including business combination accounting, the statement of cash flows, revenue recognition and income taxes.

 

Auditor independence continued to be a problem area, particularly for triennially inspected firms.

You can read the whole Staff Inspection Brief at:

pcaobus.org/News/Releases/Pages/staff-inspection-brief-2015-issuer-inspections.aspx

 

  1. A Board Member’s Perspective on Inspections, Enforcement and Standard Setting

This speech, delivered by Board Member Jeanette Franzel, is a wide ranging summary of “progress in audit oversite” and has some interesting perspectives on changes that could be in store for the inspection process. She comments that inspections of large firms are showing fewer audit deficiencies but that at smaller firms there are still some that “just don’t get it”. She also provides summaries of the enforcement program and standard setting at the PCAOB.

You can read the speech at:

pcaobus.org/News/Speech/Pages/Franzel-progress-in-audit-oversight-Baruch-5-5-16.aspx

 

  1. A “Darker” Staff Practice Alert

The PCAOB inspectors continue to see enough instances of auditors making changes after audit workpapers are supposed to be “locked down” that they have issued a Staff Practice Alert to remind, or perhaps warn, auditors not to make changes inappropriately in advance of an inspection. You can read the Alert at:

pcaobus.org/News/Releases/Pages/staff-audit-practice-alert-improper-alteration-of-documents-4-21-16.aspx

Interestingly, the last section of the new release has a link to the PCAOB’s tip line……

 

  1. Re-proposed Changes to the Auditor’s Report?

The Board met on May 11, 2016 to consider re-proposing changes to the standard auditor’s report. The current pass/fail model would be retained, but the original proposal and the potentially revised proposal hope to provide additional information to make the report more relevant and informative. Stay tuned for updates on the results of the meeting; in the meantime you can read about the meeting, the revised proposal and related original proposal at:

pcaobus.org/News/Releases/Pages/PCAOB-5-11-16-open-meeting-announcement.aspx

 

  1. Naming the Audit Partner is a Done Deal and the PCAOB’s Standard Setting Agenda

 

Last, as you may have heard, the SEC has approved the PCAOB’s new Auditing Standard requiring disclosure of the names of audit partners and information about other firms involved in an audit beyond the principal auditor. To learn about that change and to see what else is on the horizon, here is a link to the PCAOB’s current rulemaking agenda:

pcaobus.org/Standards/Pages/Current_Activities_Related_to_Standards.aspx

Clearly, the PCAOB is busy!

As always, your thoughts and comments are welcome!

SEC Non-GAAP Concerns Ratchet Up

We discuss non-GAAP measures frequently in our blog. We also did a One-Hour Briefing “Non-GAAP Measures and Metrics: Getting it Right” on April 1 which you can find at:

www.pli.edu/Content/Non_GAAP_Measures_and_Metrics_Getting_it/_/N-1z10vnyZ4n?ID=282910

 

While we try to avoid being “preachy” we do see some real problems in how companies are using non-GAAP measures. Our most recent blog post about these non-GAAP measure problems is at:

seciblog.pli.edu/?p=615

 

To reinforce these issues from the SEC’s perspective Deputy Chief Accountant Wesley Bricker and OCA Chief Accountant Mark Kronforst both addressed the use of non-GAAP measures at a recent conference.

 

You can read Mr. Bricker’s speech at:

www.sec.gov/news/speech/speech-bricker-05-05-16.html

 

In his speech he outlines four major areas where the SEC believes that companies may not be using non-GAAP measures appropriately. He even makes the comment that if a company uses a non-GAAP revenue measure they can expect a comment from the staff.

While Mr. Kronforst’s speech is not on the SEC web page, he reportedly used the words “crack down” when talking about how the SEC will be reviewing the use of non-GAAP measures.

The message is clear, be thoughtful and careful with non-GAAP measures!

 

As always, your thoughts and comments are welcome!

Message From Enforcement: Metrics Matter!

Metrics, measures of performance drivers outside the financial statements, have become a larger part of how companies communicate with investors in recent years. As with all communication tools, a carefully planned, balanced presentation is important. Well-designed metrics can provide greater insight into the fundamentals of a company’s operations.

As with other elements of financial reporting, metrics can be misused. A metric could be poorly designed and not really correlate with financial performance. A metric could also be misstated or manipulated.

Poorly Designed Metrics

Many tech companies have complex and hard to understand revenue models. Measures such as “daily active users” and “monthly active users” can help users understand a company’s performance. That said, the link between the metric and performance needs to be clear. The CorpFin Staff has written many comments about this issue. Here are a couple of examples:

  1. In your various quarterly earnings calls, we note your discussion of the performance of your business in terms of the “add/quit metric” and “uniform wearer losses” (based upon changes in the number of uniform wearers within particular sectors of your customer base). We further note this is your fourth consecutive quarter of negative uniform wearer losses. Please expand your MD&A to include this information as well as a discussion of any trends or uncertainties. Additionally, the add/stop metric appears to have a meaningful impact on operating margins and growth rate. Please expand your disclosure to provide a complete picture of the relationship between the add/quit metric, operating margins, and growth rate for each material sector of your customer base. Please refer to Item 303(a)(3) of Regulation S-K and Section III.B.1. of SEC Release 33-8350.

 

  1. We note your statement that your results are highly dependent on comparable store sales. We further note that your comparable store sales have declined over the last three years and within each year have generally declined each quarter. We also note your statements that your comparable store sales are difficult to predict in the current competitive landscape and may get marginally worse before they get better. Given the importance of this metric to your results and its significant decline over the last three fiscal years, please tell us and disclose in more detail the factors that contributed to this decline, such as any significant declines in prices, including significant increases in your promotional activity, any significant declines in the volume of items sold, any change in the mix of products being sold or any other material factors that had a significant impact on the decline in your comparable store sales. While this decline in comparable store sales may ultimately be driven by your competitive environment, we believe a more detailed discussion of changes in intermediate factors such as price and volume will provide more transparency to your investors as to how you are affected by this competition, any steps management has taken to mitigate the impact of this competition and the success of management’s strategies. Refer to Item 303(a)(3)(iii) of Regulation S-K and SEC Release No. 33-8350.

 

Misstated Metrics and Enforcement

When companies present metrics, they should be very careful to use a balanced approach to the information and use the metric consistently to avoid presenting potentially misleading information. We discussed many of these issues in our One-Hour Briefing about Non-GAAP Measures and Metrics. You can find the briefing at:

 

www.pli.edu/Content/Non_GAAP_Measures_and_Metrics_Getting_it/_/N-1z10vnyZ4n?ID=282910

 

One really “old school” example metric would be the financial ratio gross margin. It is not a non-GAAP measure so long as it is computed using the revenues, cost of sales and gross margin lines on a company’s income statement. For retailers, it is a crucial measure of performance. Gross margin trend over time can have a significant impact on how investors view a retailer.

In a recent enforcement case the SEC fined a large outdoor products retailer and its CFO for manipulating their gross margin and then misstating why gross margin changed. The source of the issue was a fee the company charged to its wholly owned banking subsidiary. In the retailer’s financial statements the fee was used to reduce cost of sales and thus increase gross margin. Such a fee would normally be eliminated in consolidation. Here though, the company failed to eliminate this intercompany transaction. As a result, in the consolidated financial statements the net income of the financing part of the business was understated and the gross margin of the retailing part of the business was overstated. Additionally, the company did not disclose that this intercompany fee had increased their gross margin and actually attributed the increase to other causes.

 

Here is a quote from the enforcement order:

This in turn increased ——– merchandise gross margin percentage, a key company-specific financial metric that signaled the profitability of the company and was referenced by the company in earnings releases and analysts calls.

 

The end result: Enforcement!

And, a clear message, manipulating metrics can get a company into just as much trouble as manipulating the financial statements!

You can read the enforcement release at:

www.sec.gov/litigation/admin/2016/34-77717.pdf

 

As always, your thoughts and comments are welcome!

A non-GAAP Measure Subtle Trap

One of the more complex traps when presenting non-GAAP measures is this question:

Which source of SEC non-GAAP measure guidance applies to your earnings release:

Reg G, or

S-K Item 10(e)?

In case you are not familiar with Reg G and S-K Item 10(e) and when each of them applies:

Reg G applies when you use a non-GAAP measure in a non-filed source, and

S-K Item 10(e) applies when you use a non-GAAP measure in a filed document.

You can learn more about these two non-GAAP rules in some of the earlier posts on our blog. Here is a post with the basics:

 

seciblog.pli.edu/?p=401

 

You can also check out our one-hour briefing about non-GAAP measures from March 2016 at:

www.pli.edu/Content/Non_GAAP_Measures_and_Metrics_Getting_it/_/N-1z10vnyZ4n?ID=282910

 

The trap here is this: You might believe that since an earnings release is not a filed document Reg G is the applicable guidance, and all you have to do is present the most directly comparable GAAP measure and provide a reconciliation.

That is NOT the case. The reason that S-K Item 10(e) applies to your earnings release is actually very subtle. It is in the instructions to Form 8-K. Tucked away in the earnings release 8-K, Item 2.02, is this instruction:

 

  1. The requirements of paragraph (e)(1)(i) of Item 10 of Regulation S-K (17 CFR 229.10(e)(1)(i)) shall apply to disclosures under this Item 2.02.

 

Thus, the first part of S-K Item 10(e) DOES apply to your earnings release, even though it is not “filed” and even though the Item 2.02 8-K is not a filed document!

 

So, to be very detailed, this part of S-K Item 10(e) applies to year earnings release (there are other requirements in S-K Item 10(e) that do not apply, we won’t list them here):

 

(e) Use of non-GAAP financial measures in Commission filings. (1) Whenever one or more non-GAAP financial measures are included in a filing with the Commission:

 

(i) The registrant must include the following in the filing:

(A) A presentation, with equal or greater prominence, of the most directly comparable financial measure or measures calculated and presented in accordance with Generally Accepted Accounting Principles (GAAP);

 

(B) A reconciliation (by schedule or other clearly understandable method), which shall be quantitative for historical non-GAAP measures presented, and quantitative, to the extent available without unreasonable efforts, for forward-looking information, of the differences between the non-GAAP financial measure disclosed or released with the most directly comparable financial measure or measures calculated and presented in accordance with GAAP identified in paragraph (e)(1)(i)(A) of this section;

 

(C) A statement disclosing the reasons why the registrant’s management believes that presentation of the non-GAAP financial measure provides useful information to investors regarding the registrant’s financial condition and results of operations; and

 

(D) To the extent material, a statement disclosing the additional purposes, if any, for which the registrant’s management uses the non-GAAP financial measure that are not disclosed pursuant to paragraph (e)(1)(i)(C) of this section; and

 

One area the staff will comment on is the “equal or greater prominence” requirement in paragraph (A) above. Here is an example comment:

 

  1. We note that in the Financial Highlights section of your press release furnished on Form 8-K, you disclose Total Segment EBITDA, a non-GAAP financial measure, without the disclosure of the most comparable GAAP measure. Please note that under Item 10(e)(1)(i)(A) when a non-GAAP financial measure is presented, the most directly comparable financial measure calculated in accordance with GAAP must be disclosed with equal or greater prominence. Please revise accordingly. See also Instruction 2 to Item 2.02 of Form 8-K.

 

As always, your thoughts and comments are welcome!