SEC Begins Crack Down On Non-GAAP Accounting Gimmicks

Having railed for years against the accounting gimmickry known as non-GAAP, with both the WSJ, AP and even Warren Buffett joining the vocal outcry in recent years, things may finally be changing. According to Dow Jones, the SEC is finally stepping up its scrutiny of companies' "homegrown earnings measures, signaling it plans to target firms that inflate their sales results and employ customized metrics that stray too far from accounting rules."

According go DJ, the move to intensify oversight "signals that regulators have grown weary of the widespread use of some adjusted measures, which often result in a rosier view of profits than what is reported under generally accepted accounting principles, or GAAP.

 And in the most actionably news yet, we read that the SEC is launching a campaign to crack down on made-to-order metrics that regulators think are particularly confusing or opportunistic."

This is long overdue because as we showed in February, the spread between GAAP and non-GAAP earnings has grown to gargantuan levels in recent years and the current reporting season may in fact conclude with the widest nominal gap between GAAP and non-GAAP in history.

 

If the SEC actually plans on follow through with its threats - as opposed to its failed attempt to regulate HFT frontrunning - the gaap may very soon be closing and would reveal the true GAAP P/E of the S&P which according to our calculations is currently north of 24x.

Regulators plan to push back on companies that accelerate the recognition of revenue that hasn't yet been earned, said Mark Kronforst, chief accountant of the SEC's corporation finance division. Firms that sell their product on a subscription model, for instance, are required to book the revenue as they deliver the goods or services. But some firms are using non-GAAP measures that assume all sales are recorded as soon as customers are billed, which adds revenue to their books earlier than allowed under GAAP, Mr. Kronforst said.

"The point is, now the company has created a measure that no longer reflects its business model," he said. "We're going to take exception to that practice."
The SEC's rules allow companies to report profit figures that don't comply with GAAP, provided they don't obscure the official numbers and reconcile the non-GAAP numbers to the equivalent GAAP figure.

To be sure companies for whom non-GAAP means the difference between a miss and a beat (as we documented on numerous occasions recently) are pushing back and saying "investors value the adjusted measures because they exclude unusual or noncash costs, resulting in measures that better reflect future operating results. Technology firms such as Facebook Inc. and other Silicon Valley brand names are particularly devoted users of non-GAAP formulas, reporting numbers that strip out hundreds of millions of dollars of stock compensation."

What companies really mean is that both companies and investors would prefer to lie and be lied to in order to perpetuate the illusion that all is well until this is no longer possible. The most egregious example of all is most likely Alcoa, which we showcased several weeks ago, and which has generated a $500 million loss in the LTM period which however courtesy of $1 billion in non-one time, recurring "one-time, non-recurring" addbacks has been transformed into a $500 million profit.

 

The SEC appears to have noticed, and according to Dow Jones it has recently seen companies report adjusted earnings that go further: A company, for instance, applies different accounting assumptions, such as changing the lifespan of equipment that must be expensed over time. Stretching out the useful life of machinery typically results in lower annual costs and boosts profits. Naturally, there are also far more egregious examples.

So what will the SEC do?

The agency plans to issue comment letters in the coming months that critique firms that booked revenue on an accelerated basis. Mr. Kronforst, who plans to speak Thursday at a Northwestern University legal conference about the issue, declined to name them.

 

Mr. Kronforst said regulators also plan to challenge companies that report their adjusted earnings on a per-share basis. The results are often higher than per-share GAAP earnings and look too much like measures of cash flow, which decades-old rules prevent from being presented on a per-share basis, Mr. Kronforst said. That is because investors could confuse cash flow with actual earnings, which truly represent the amounts that could be distributed to investors.

 

"We are going to look harder at the substance of what companies are presenting, rather than what the measures are called," he said.

In other words, the SEC threatens to finally do its job and determine if companies are abusing every accounting loophole known in order to apply countless layers of lipstick on their piggy lips. The SEC often pushes back on non-GAAP figures that it fears could be misleading, typically by issuing public-comment letters on a company's investor filings. SEC Chairman Mary Jo White said in March that regulators could write new rules to restrict the use of non-GAAP financial metrics.

Amusingly, the SEC has previously "objected" to companies' non-GAAP metrics. That clearly led nowhere. In 2011, regulators raised questions with Groupon Inc. before the firm went public, criticizing its use of a non-GAAP profit measure that excluded its marketing costs. Groupon scaled back its use of the metric in response to the SEC's concerns.

That said, we doubt the SEC will push too hard: if it does the companies that make up the S&P may just be force to admit that instead of generating 120 in EPS in 2015, their true earnings were just shy of 90. And that would lead to a massive selloff, something the SEC would never be allowed to unleash.