While the SEC confirms permissibility of non-GAAP financial measures with proper presentation and disclosure, care must be taken to ensure the proper treatment of income taxes.

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January 26, 2017

U.S. stocks experienced substantial growth in 2016, with the Dow Jones Industrial Average reaching numerous historical milestones to close out the final quarter of the calendar year. Bolstered with a pro-business and growth message, post-election optimism is high for investors. Concurrent with a perceived healthy climate for investing is an appetite for additional financial information to guide decision-making. While standardized, audited financial statements have been staples for investors since the Securities Act of 1933, there is increasing demand for non-GAAP financial measures as an additional indicator of a company’s present condition and potential future cash flows.

Non-GAAP financial measures are numerical metrics that deviate from standard GAAP by making adjustments to highlight or supplement characteristics of a company’s performance. Examples of adjustments include reversing certain noncash transactions, adding back income tax expense, or diminishing the effects of a significant but non-routine financial event. Such measures have increased substantially in the past decade; The New York Times reported that the number of large companies utilizing non-GAAP measures rose from 232 in 2009 to 334 in 2015, and adjusted profits as a result of those measures more than doubled in the same period.

While the popularity of non-GAAP financial measures has grown, their usage is not without scrutiny. Critics assert such measures are biased, erode consistency among financial statements, and distort a company’s performance to be more favorable than under GAAP measures. For example, according to data from S&P Dow Jones Indices, 2015 year-over-year earnings of all S&P 500 companies decreased 15.4 percent on a GAAP basis and 0.5 percent on a non-GAAP basis.

The enforcement of non-GAAP financial measures presentation has come to the forefront of the SEC’s agenda. The authority surrounding these metrics is covered under SEC Regulation G and Regulation S-K (Item 10e). These regulations hold that any non-GAAP measure must be adequately disclosed as not being GAAP compliant and must visibly demonstrate any adjustments made to reconcile the non-GAAP figure to its GAAP counterpart.

In response to the uptick in usage of non-GAAP measures, in May 2016 the SEC issued updated guidance to companies incorporating non-GAAP measures. Under this Compliance & Disclosure Interpretation (C&DI), the SEC explains that non-GAAP measures are permissible, but GAAP metrics must be displayed first and more prominently, any altered recurring expense or item of income should likely be adjusted in prior periods being reported, and the utilization of any adjustments of non-GAAP financial measures requires adequate disclosure that the metrics are not GAAP and an explanation of why their inclusion is helpful as supplemental information to the financial statements.

While historically the income tax effects of non-GAAP adjustments were not heavily scrutinized by the SEC, the C&DI indicated a shifting focus in this regard. The letter clarified that companies should account for the income tax effects when adjusting income to a non-GAAP measure. For example, in 2015 Valeant Pharmaceuticals experienced a GAAP loss of $291.7 million and a non-GAAP operational profit of $2.84 billion after reversing acquisitions costs and amortization expenses. The SEC issued a comment letter to Valeant in 2015 that questioned the company’s use of the same income tax rate between the GAAP loss and non-GAAP profit. In March 2016, the company agreed to adjust the measure so as to avoid misleading the public that such profits were attainable without paying an appropriate amount of income taxes. In addition to profitability metrics as shown by Valeant, non-GAAP liquidity measures that incorporate cash taxes paid should be recomputed using applicable rates reflecting the non-GAAP income, as it is possible this effective tax rate could vary from the GAAP rate. Finally, the C&DI clarified that the reconciliation between GAAP and non-GAAP measures should not be presented net of tax. Rather, the tax effect of adjustments should be its own reconciling item to arrive at the GAAP to non-GAAP measure.

Each of the non-GAAP adjustments needs to be analyzed to consider the corresponding impact on the effective tax rate. Certain non-GAAP adjustments may be related to items that are treated as “permanently” nondeductible for GAAP purposes and therefore have no corresponding income tax benefit. A few of these adjustments are highlighted below.

Goodwill Impairment:

A common non-GAAP adjustment is the addback of goodwill impairment. Depending on the tax treatment of the transaction in which the goodwill is established, there may not be a corresponding tax deduction and therefore there would not be a corresponding adjustment to the GAAP income tax provision.

Stock-Based Compensation Expense:

While stock based compensation is a common incentive for employees, businesses are often evaluated from an operations standpoint excluding the effects of stock-based compensation. Depending on the nature of the stock-based compensation, there may not be a corresponding tax deduction. In addition, any windfall tax benefits that have been recorded to the income statement would need to be considered in this adjustment.

In addition to profit & loss adjustments, non-GAAP adjustments may alter the balance sheet from an income tax provision perspective. Examples of these adjustments are highlighted below.

Deferred Tax Assets & Liabilities:

An income or expense item adjusted for non-GAAP measures that created a temporary difference in calculating GAAP taxable income has a corresponding deferred tax asset or liability on the balance sheet. As a result of adjusting tax-sensitive accounts, non-GAAP balance sheets should ideally be recomputed to reflect the change. For example, if amortization expense for tax purposes varies from GAAP amortization, and amortization is ignored for a non-GAAP measure, the DTA or DTL caused by the GAAP book-tax difference must be removed from the non-GAAP balance sheet.

Valuation Allowance:

Adjustments creating new non-GAAP profit figures may necessitate a re-examination of any recorded valuation allowance. As any allowance is highly dependent on the projection of future earnings, frequent and/or recurring adjustments to GAAP profit may result in starkly different non-GAAP income projections. As a result, any difference will result in the adjustment of a non-GAAP valuation allowance, which in turn will result in a non-GAAP income tax adjustment to the income statement.

Uncertain Tax Positions:

Any adjustment relating to an item of income or expense that resulted in the recording of an uncertain tax position reserve will have a direct effect on the reserve on the balance sheet. As previously discussed, transaction and restructuring costs are a common non-GAAP adjustment because they generally are not recurring in nature and may not be indicative of operational profits. If it is more likely than not that the deductibility of these expenses is in question, a GAAP FIN 48 reserve is required and tax is accrued to reflect the amount of potential tax paid. If a non-GAAP adjustment adds back transaction and restructuring expenses, the reserve should in turn be removed from the balance sheet.

Alvarez & Marsal Taxand Says:

The application of and guidance to non-GAAP financial measures is hardly a new concept. The SEC issued warnings about the misleading nature of registrants’ presentation of non-GAAP financial measures as early as 2001. In 2002, the Sarbanes-Oxley Act included provisions that prohibited improper presentation of such non-GAAP measures. The C&DI and comment letters indicate that a more critical stance of these measures is here to stay, and the proper application of them is not only a best practice, but required under the law. Specific attention to the income tax provision is necessary, as adjusting even one item of income or expense can alter current and deferred expense, the effective tax rate, deferred tax assets and liabilities, valuation allowance, etc. Income tax implications should be considered in any non-GAAP measure to provide holistic and compliant supplementary information to the end users.

Related Issues:

New Accounting Rules for Stock-Based Compensation Are Coming. Is Early Adoption Right for You?

The Financial Accounting Standards Board recently released Accounting Standards Update (ASU) No. 2016-09, which finalizes significant changes aimed at simplifying the accounting for share-based payments. The final rules are effective for annual periods beginning after December 15, 2016 for public companies and after December 15, 2017 for all other entities. Early adoption is permitted, but if a company chooses to early adopt, it must do so for all amendments in ASU 2016-09.