The difference between GAAP and non-GAAP earnings has been widening over the past few years, and the Securities and Exchange Commission is stepping in.
To recap, non-GAAP earnings are profits that don’t include one-time negative occurrences. Companies argue that this is a way to present earnings that are more accurate to the underlying business. Critics, however, say that this obfuscates the reality of the company. Basically, you can’t just strip out the bad things and pretend that everything is peachy keen.
In fact, according to John Butters at FactSet, the gap between GAAP and non-GAAP earnings for the companies in the Dow Jones Industrial Average got even wider in the first quarter to a 28.9% difference from 19.7% a year go.
The growing trend has begun to wear on investors and the argument over the correct way to report earnings has been growing louder.
Enter the SEC, on Tuesday the regulatory agency released updated guidelines for companies reporting non-GAAP earnings. The language can be dense, despite the SEC’s use of a Q&A format, so Credit Suisse analysts David Zion and Ravi Gotatam broke it down in a note to clients.
While there are a lot of finer details to the changes that the SEC made Tuesday, the main thrust of the note and the announcement is that the agency is beginning to look a lot closer at GAAP and non-GAAP and companies should be ready for that.
“We expect to hear more from the SEC on non-GAAP, including comment letters to companies that appear to be pushing the envelope and we wouldn’t be surprised to see the SEC make an example out of a few companies by investigating them for providing ‘misleading’ non-GAAP info,” wrote Zion and Gotatam.
“If that doesn’t do the trick the SEC might write some new rules.”
The analysts recommend that investors start looking a lot closer at companies with differences between GAAP and non-GAAP, not only because the SEC may start to crack down on the issue but also because it may be a sign that the company is stretching the truth a bit too far.
Basically, you should always be wary of large non-GAAP adjustments, and especially now considering the SEC has them under the microscope.
For those interested, here are the technical highlights of the SEC’s new guidelines:
- Adjusting only for non-recurring charges, but not non-recurring gains, may be misleading.
- If a company did not adjust for an expense/gain in the past, it should not do so in the current quarter.
- Companies should not bold, emphasis or otherwise highlight non-GAAP earnings more so than GAAP earnings.
- Don’t highlight other metrics such as cash flow per share or EBIT per share.