By Olga Usvyatsky
(Editor’s note: Today we have a guest column from Olga Usvyatsky, a long-time accounting researcher and occasional contributor to the Calcbench blog. Usvyatsky is raising interesting questions about non-GAAP disclosures and how financial analysts might anticipate potential changes in disclosures based on what the SEC says in comments to registrants.)
Non-GAAP disclosures are one of the most common issues in financial reporting. Almost all large publicly traded companies make them, and such disclosures typically paint a more positive picture of corporate performance than comparable GAAP disclosures.
At the same time, however, the Securities and Exchange Commission reviews non-GAAP disclosures with a skeptical eye. Earlier this year an article in the Wall Street Journal raised the possibility that thanks to increased SEC scrutiny, companies might change how they calculate non-GAAP metrics. Altering those calculations could be "embarrassing or even costly" for companies, the article said, because they would need to explain to investors why the previously used metrics were no longer permissible.
SEC rules require companies to reconcile non-GAAP disclosures back to their closest matching GAAP disclosure. Those non-GAAP adjustments can be significant, and changing how non-GAAP metrics are calculated could materially reduce adjusted income. In December 2022 the SEC Division of Corporation Finance updated its guidance on non-GAAP disclosures, expanding the list of non-GAAP metrics that violate SEC rules. This renewed scrutiny made us wonder: what types of non-GAAP adjustments would raise red flags with the SEC?
One way to answer that question is to examine SEC comment letters (letters the SEC sends to registrants, asking them about various issues in their financial statements). We used Calcbench’s Interactive Disclosure tool to identify roughly 1,900 SEC comment letters issued since 2021 that raised at least one non-GAAP comment. Then we looked to see which specific citations from that updated non-GAAP guidance were mentioned in the comment letters.
The issue raised by the SEC most often was Question 102.10, which primarily concerns how companies disclose their metrics. SEC rules prohibit giving undue emphasis to adjusted numbers, such as discussing non-GAAP numbers before GAAP or presenting full non-GAAP income statements. As far as we can tell, presentation-only issues are relatively easy to rectify by updating the disclosure in future filings.
Notably, the updated SEC non-GAAP interpretation states that metrics can be misleading even if properly disclosed. For example, consider removing recurring expenses (Question 100.01) and tailoring non-GAAP metrics to company-specific needs (Question 100.04). Compliance with these provisions following SEC inquiries could be costlier for companies, since it would often require revising the metrics, explaining the changes to investors, and finding alternative ways to communicate results.
One example of this comes from Lyft (Ticker: LYFT). On Aug. 12, 2022, the SEC asked Lyft to clarify how removing insurance reserve liabilities complies with Questions 100.01 and 100.04 of Regulation G. The company responded, stating that the adjustment is useful and not misleading:
Regarding the considerations of Questions 100.01 and 100.04, the company does not believe this adjustment to be potentially misleading nor does it consider it to be a measure that uses an individually tailored recognition and measurement method in violation of Rule 100(b) of Regulation G. The company believes that this adjustment, which is disclosed as a separate line item and explained in the company’s non-GAAP discussions, provides investors with additional useful information related to the company’s operating performance during the current period, rather than including the impacts associated with insurance claims which occurred in prior periods.
After two rounds of back-and-forth comments, however, Lyft agreed to discontinue adjusting for the insurance reserves. The conversation between Lyft and the SEC spanned more than 153 days, much longer than an average 35- to 40-day review.
To understand the impact of the SEC review, let’s look at the materiality of insurance reserves to Lyft’s financial results. In 2021 the adjustment for insurance reserves improved Lyft’s non-GAAP contribution metric by $250.3 million. Removing the adjustment reduced the fiscal 2021 contribution margin from 58.6 percent to 50.8 percent.
When explaining the revision to investors, Lyft noted that the accounting change was made to comply with the new SEC interpretation: In December, the SEC updated its guidance related to non-GAAP financial measures, which applies to all public companies. Subsequent to this change and following consultation with the SEC, we have updated our disclosures for the fourth quarter of 2022 and we have presented past periods on a comparable basis.
Companies are not required to disclose SEC comment letters, and generally managers have little incentive to highlight SEC involvement voluntarily. Still, voluntary disclosure is notable, because managers are likely to aim at providing more transparency to avoid confusion about why the accounting change was necessary.
Another SEC comment letter that led to non-GAAP revisions comes from Microstrategy (Ticker: MSTR). On October 7, 2021, the SEC asked Microstrategy to clarify why removing the impairment of bitcoin in reconciling its non-GAAP income and EPS metrics is useful to investors:
Please tell us and expand your discussion to explain why you believe that adjusting for bitcoin impairment charges provides useful information to investors in light of your strategy and business purpose for purchasing and holding bitcoin. Refer to Item 10(e)(1)(i)(C) of Regulation S-K.
Although the question is fairly neutral and does not imply that the metric is misleading or inappropriate, the SEC noted that the discussion of the usefulness should be tailored to the company’s business strategy. In contrast to companies that hold bitcoins as investments, Microstrategy acquired bitcoins as part of an ordinary business strategy. Under GAAP rules, digital assets are reported on the balance sheet at the lowest price since the acquisition date. Based on the company’s response to the SEC, the adjustment is useful because:
Reflecting cumulative impairment charges …without regard to current market value gains would result in an incomplete assessment” of bitcoin holdings.
In a follow-up letter, the SEC disagreed with the company’s position (emphasis added):
We note your response to prior comment 5 and we object to your adjustment for bitcoin impairment charges in your non-GAAP measures. Please revise to remove this adjustment in future filings. Refer to Rule 100 of Regulation G.
While SEC’s objection to bitcoin impairment adjustments leaves little room for maneuvering (we rarely see strong language such as “we object” in comment letters), the lack of specific guidance in SEC’s response allows for interpretation. For instance, did the SEC object to the adjustment because buying bitcoins is part of the company’s daily operations, so impairment charges are part of recurring expenses? Or is it because impairments create a tailored GAAP modification? (The improvement of GAAP accounting for digital assets is currently on the FASB agenda.) We don’t know the answer, but it’s worth noting the nuance in SEC comment letters.
To summarize, companies often revise their non-GAAP metrics to comply with SEC inquiries. Comment letters provide essential context, helping understand the nature of SEC’s concerns. Analysts can use simple observable metrics, such as duration of the review, tone, and reliance on specific regulatory citations, to help identify more informative comments.