Goodbye "Pro Forma" Earnings: The SEC Tightens Non-GAAP Financial Reporting

By Holtzman, Mark P.; Fonfeder, Robert et al. | Strategic Finance, November 2003 | Go to article overview

Goodbye "Pro Forma" Earnings: The SEC Tightens Non-GAAP Financial Reporting


Holtzman, Mark P., Fonfeder, Robert, Yun, J. K., Strategic Finance


REMEMBER the euphemisms for incomparable, non-GAAP reporting of earnings before one-time charges? Operating income. Pro forma earnings. Income before one-time charges. Street earnings. Or, as Lynn E. Turner, former chief accountant of the Securities & Exchange Commission (SEC), called it, "everything but bad stuff." Even while the business press and regulators attacked this financial reporting as biased and misleading, more companies used it.

Computer Associates, for example, said in its 2001 earnings news release that "Operating earnings per share (diluted) increased 27% to $3.28 from last year's $2.59, excluding special charges and acquisition-related amortization costs." Toward the bottom of the earnings release, Diluted Earnings per Share is reported as only $2.74. But even this is "Earnings Before Special Charges" and excludes more than $800 million in charges related to acquisitions, mostly from in-process R&D. The bottom of the last table in the news release reveals that, according to GAAP, the company earned just $1.25 per share.

With blaring headlines, the business media brought public--and regulators'--attention to these abuses that "pump earnings," "fool investors," "confuse," and even cause stock markets to fall. The charge? Pro forma earnings measures often omit expenses like depreciation, goodwill amortization, restructuring charges, unusual gains and losses, and stock option compensation-related expenses, which artificially inflates income and misleads investors.

Now, as mandated by the Sarbanes-Oxley Act of 2002, the SEC has introduced new rules designed to end abuses of non-GAAP earnings disclosures.

NEW RULE

The Sarbanes-Oxley Act of 2002 said the SEC:

   shall issue final rules providing that pro forma financial
   information ... shall be presented in a manner that
   (1) does not contain an untrue statement of a material
   fact or omit to state a material fact necessary in order to
   make the pro forma financial information ... not misleading,
   and (2) reconciles it with the financial condition and
   results of operations ... under GAAP.

In January 2003, the SEC released its final rule, "Conditions for Use of Non-GAAP Financial Measures," which became effective March 28, 2003. The new rule created Regulation G, covering all public disclosures, defining non-GAAP financial measures, and creating standards for their disclosure. It added new requirements for earnings announcements and reporting non-GAAP measures in SEC filings. It also revised Regulation S-K to prohibit disclosing certain non-GAAP measures in filed documents. Furthermore, the rule requires earnings releases to be filed with the SEC on Form 8-K.

Regulation G defines the term "non-GAAP financial measure" as any numerical measure of historical or future financial performance, financial position, or cash flows that excludes amounts that would be included in analogous GAAP measures. Non-GAAP financial measures might also include amounts that would be excluded from analogous GAAP measures. For example, Westwood One, Inc. reported "operating cash flow" in the first quarter of 2001 as operating income plus depreciation and amortization. This "operating cash flow" would be considered a non-GAAP financial measure under Regulation G because it ignores the usual depreciation and amortization that would be subtracted in arriving at GAAP operating income. On the other hand, because commonly used metrics such as "backlog" have no analogous GAAP measures, they aren't classified as non-GAAP financial measures. Projections of future revenues and expenses, as long as they are computed using GAAP amounts and techniques, are also not considered to be non-GAAP financial measures.

REGULATION G REQUIREMENTS

For any public disclosure of a non-GAAP financial measure, companies must present the most directly comparable GAAP-based measure along with a reconciliation between the two figures. …

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