Disclosure Requirements of Non-GAAP Error Corrections

In a series of posts, we have discussed mounting evidence that, with 90% of U.S. public companies using custom metrics, non-GAAP presentations are becoming a de-facto alternative accounting system. In a May speech, Mark Kronforst, chief accountant of the SEC’s Division of Corporation Finance, stated that SEC requirements to avoid giving undue prominence to non-GAAP results were “not working”.

According to Audit Analytics’ research published in a recent WSJ article, however, there is some evidence of a changing tide; in the most recent quarterly reports, more than 80% of the SP500 companies reported GAAP results first, compared to 52% in the prior quarter.

Nevertheless, only a handful of companies have so far stated their intent to drop non-GAAP numbers completely. The vast majority of companies will still present non-GAAP results, albeit presented after comparable GAAP numbers, with better labeling and clearer descriptions.

But let’s take this line of thought a bit further. If custom metrics are so important to investors, then, analogous to GAAP results, it should be important to investors when non-GAAP metrics turn out to be misstated. What would happen if non-GAAP numbers were to be revised – for example, to correct an error?

We have seen a few instances where this question would be very relevant. In a handful of cases where non-GAAP numbers were intentionally manipulated, we’ve seen an array of related negative events (including management turnover and SEC investigation), which makes these cases hard to overlook. So if errors are found in non-GAAP metrics, how should investors be notified? Non-GAAP numbers are not audited, there is no Item 4.02 requirement for them, and there are rarely any SOX 302 or 404 implications.1

A few recent examples, provided below, provide some insight into how companies may disclose error corrections that affected only the non-GAAP presentation (i.e., comparable GAAP results were not revised). In both cases, the correction was discussed in a footnote to the non-GAAP reconciling tables.

First, from Kraft Heinz’s Fiscal 2015 press release:

The Company revised Q4 2014 Adjusted Pro Forma EPS to $0.56 from the previously published $0.50 to reflect a correction in tax rates applied to certain non-GAAP adjustments”

And another, from Brooks Automation’s Q3 2016 press release:

(a) The tax rate represents the effective tax rate on non-GAAP taxable ordinary income. We expanded our disclosure to correct and clarify the after tax impact of stock-based compensation on Non-GAAP adjusted net income and diluted EPS. For additional information on the impact of this correction on prior periods, please refer to the conference call presentation included in Investor Relations section of the Brooks website at www.brooks.com.

In another example, prior backlog numbers were revised to correct an immaterial error in the Results of Operations section of the MD&A of a 10-Q.

As we stated above, none of these errors had an affect on GAAP numbers. Further, the impact of these errors on the non-GAAP adjusted results appears to be immaterial. Yet, just as with regular GAAP errors, there is a risk that in lieu of a rule similar to the 8-K Item 4.02 requirement, some material errors may possibly fall under the radar.

1. As we discussed in a previous post, SOX 302 requirements “are intended to cover a broader range of information than is covered by an issuer’s internal controls related to financial reporting.” At least in theory, SOX 302 may extend to covering non-GAAP errors. From a practical perspective, however, there are little (if any) implications.