Regulators increase scrutiny of non-GAAP measures
Prolonged pandemic puts pressure on what’s unusual
Microchip Technology Inc. was trying to convey how widespread stay-at-home orders affected its bottom line.
The Chandler, Ariz. chip maker went beyond the numbers in its official financial statement, touting in its press release adjusted income that stripped out the costs of temporarily shuttering manufacturing operations at the start of the pandemic. This unofficial, or non-GAAP, earnings number was more than three times larger than its official income as tallied under U.S. generally accepted accounting principles.
Microchip’s alternate accounting shows the tricky territory companies can land in when they stray from official measures. The adjusted earnings will draw regulator scrutiny, especially as the prolonged pandemic turns what seemed rare in the spring into the routine by fall.
The main message: If a company can quantify the effects of the pandemic in a reasonable way and make the case that it’s dealing with an unusual situation, it’s OK. But don’t go too far afield, said Robert Rostan, CFO of Training The Street, an accounting education firm.
Because Microchip Technology calculated the number of days of lost production at each shuttered manufacturing site and quantified the costs, like utilities and pay for idled employees, the Securities and Exchange Commission accepted its unofficial number, according to comment lettersreleased in September. Its non-GAAP income also excluded the cost of stock compensation and expenses related to acquiring other businesses. The company declined to comment.
“Microchip nailed it in their response,” Rostan said. “What’s not acceptable is somebody saying ‘2019 was like this, so we’re taking our 2020 numbers and adjusting up to 2019 numbers.’ That’s egregious. I don’t think any accountants or law firms would ever agree to something like that.”
Non-GAAP metrics are supposed to pluck out the effect of one-time, unusual expenses and show performance in a way official accounting rules don’t fully capture. The most common non-GAAP metric is Earnings Before Interest, Taxes, Depreciation, and Amortization, or EBITDA. At the height of the pandemic, some companies further adjusted that figure to show what it would have been had it not been for the effects of the coronavirus.
Pandemic or New Normal?
But as the pandemic wears on and third-quarter earnings season approaches, companies will have less ammunition for the case that disrupted supply chains, stuck-at-home workers, and increased costs to sanitize stores and offices are still unusual. Investors will become increasingly leery of adjusted earnings, said Sandy Peters, head of financial reporting policy at the CFA Institute.
“The nature of unusual items may change and the longer we go on, the more not unusual they are,” Peters said.
It also will become harder for companies to pull out what’s bad news because of the virus and what’s bad news because of fundamental changes in an industry. Retail anchors of traditional shopping malls struggled well before the coronavirus made headlines, for example, said Jonathan Nus, managing partner at Alvarez & Marsal.
“How do you really separate the adjustment that is strictly related to Covid versus the underlying shifts in what has transpired to the business or to the industry?” Nus said.
Depressed earnings because of the pandemic may not just be a “blip,” he said.
The SEC has made clear that it doesn’t want companies to use non-GAAP measures as window dressing for bad results. Bill Hinman, director of the commission’s Division of Corporation Finance, warned Oct. 1 that companies shouldn’t try to calculate lost revenue because of the pandemic, saying it was too subjective to quantify. Highlighting pandemic expenses like hazard pay and cleaning expenses via non-GAAP measures, however, would be acceptable, he said.
Extra details—when properly identified and measurable—help investors understand a business’s operations, said David Gonzales, senior accounting analyst at Moody’s Investors Service.
“The more information I have, the better,” Gonzales said. “If this is management’s assertion that this is or is not part of core operating costs, I’d rather know that than just have a blanket net income number.”
Companies can play it safe and avoid scrutiny of non-GAAP measures by describing such expenses via enhanced disclosure or more details in the Management’s Discussion & Analysis section of the financial statement, said Robert Tockman, KPMG LLP chief accountant.
“You have to be very careful, particularly if it’s expected to be a recurring cost,” Tockman said. “Then of course it won’t qualify for non-GAAP presentation.”
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