Insights > Non-GAAP Financial Measures: Clarification on What Constitutes Individually Tailored Accounting Principles

Non-GAAP Financial Measures: Clarification on What Constitutes Individually Tailored Accounting Principles

Comments from the SEC on non-GAAP financial measures continue to lead the way in 2018. At the recent 2018 AICPA Conference on Current SEC and PCAOB Developments the SEC staff (the “staff”) emphasized that investors and creditors expect publicly reported information to be accurate, complete and in compliance with all applicable rules and regulations. Specifically, the staff highlighted two areas of focus: adherence to Compliance and Disclosure Interpretations (“C&DIs”) as well as the importance of controls and processes when disclosing non-GAAP financial measures.

(1) Adherence to C&DIs particularly as it relates to the use of individually tailored accounting principles.

The staff provided insight into what constitutes “individually tailored accounting principles,” initially referenced in Question 100.4 of the SEC C&DIs. The staff highlighted four questions they ask when reviewing registrant’s reported non-GAAP measures to determine whether they represent “individually tailored accounting principles”:

  • Does the adjustment shift GAAP from an accrual basis of accounting to a cash or modified basis of accounting? 

For example, using cash receipts or billings as a proxy for revenue for a subscription-based business that recognizes revenue over time would result in a profitability measure that would be determined on a nonaccrual basis of accounting. The staff considers this an individually tailored accounting principle.

The staff also provided an example of a registrant that previously recognized revenue over time when applying ASC 605 but now recognizes revenue at a point in time subsequent to the adoption of ASC 606. If this registrant presents adjustments to report revenue under legacy ASC 605 guidance outside of the one-year transition period as part of its non-GAAP measures, assuming the modified retrospective approach is elected, this would also represent an individually tailored accounting principle.

  • Does the adjustment include transactions that are also reportable in another company’s financial statements? 

One applicable scenario would be if a company were to make an adjustment resulting from altering its conclusion that it transfers goods to the customer itself (as a principal) rather than arranging goods to be provided by another party (as an agent). Separately, adjustments related to an alternative conclusion on whether the company has significant influence or control of a subsidiary investment could also result in the presentation of transactions that are reportable within another company’s financial statements. In this case, both examples would be considered individually tailored accounting principles.

  • Does the adjustment reflect parts, but not all, of an accounting concept? 

An example of this is adjusting income tax effects to include the impact of cash taxes paid and exclude the impact of temporary or permanent differences.

  • Does the adjustment render the measure inconsistent with the economics of a transaction or an agreement?

For example, in situations where companies earn revenue from operating and sales-type or financing leases, adjusting revenue for sale-type leases as if they were operating leases would ignore some of the underlying economics of the lease agreement.

(2) Importance of controls and procedures related to the disclosure of the non-GAAP financial measures.

Companies should ensure appropriate policies and controls designed to prevent errors and the presentation of misleading information in the non-GAAP financial measures are in place. Such policies should address how changes in non-GAAP numbers are reported and disclosed. For example, if a company includes an adjustment to a non-GAAP measure in one year and elects not to include the same adjustment in the following year, management should provide an explanation of the inconsistency year-over-year. The disclosure should be clear as to why this change was made and why this non-GAAP measure is useful to management.

The SEC also highlighted the importance of the audit committee’s involvement in the review of non-GAAP financial measures. Audit committees must be comfortable with the information included in the company’s filings and how it is presented.

With the SEC’s continued focus on non-GAAP measures, registrants should use the same level of rigor and accuracy in preparing and presenting its non-GAAP measures as they would for GAAP results. Focusing on clear descriptions of the non-GAAP adjustments and having robust controls around non-GAAP disclosures will help registrants avoid presenting potentially misleading information to its investors and creditors.