Adjusted Earnings Go Under the SEC Microscope
Sources close to the U.S. Securities and Exchange Commission (SEC) say the agency’s enforcement division is investigating the use of accounting tricks in companies’ earnings reports.
The move is part of a larger SEC effort to discourage the misuse of adjusted earnings, particularly since those results and the ones calculated using the generally accepted accounting principles (GAAP) have reached their widest gap since 2008. (Source: “SEC Probes Whether Companies Are Misusing Adjusted Earnings Metrics,” The Wall Street Journal, October 27, 2016.)
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Critics argue that the growing disparity between GAAP earnings and adjusted earnings are only possible through shady accounting practices. Their contention is that companies are hiding anything that investors would not like, while highlighting flattering features.
No one yet knows which companies are subject to the SEC investigations, nor when the agency plans to take action. All we know is that the SEC is worried that companies have customized their earnings metrics to the point where it undermines the usefulness of financial reporting.
Many companies who use the non-GAAP metrics disagree, saying that non-cash and nonrecurring items distort a true picture of a company’s financial health. They do not see why a one-time cash outlay should give an impression of lower than usual cash flow, when it is nonrecurring in nature.
However, their objections did not stop the SEC from releasing a set of non-GAAP guidelines in May and encouraging companies to give prominence to their GAAP results. They not-so-subtly implied that these changes should be made in the next few quarters.
The SEC’s warnings are having a clear effect: more than a quarter of companies moved towards the GAAP-centered reporting style for second-quarter earnings in July and August, at least according to consulting firm Audit Analytics.
That being said, the SEC still sent out a hundred letters to companies it thought were in violation of the new rules.
It is possible that the new investigation launched this week could be even more serious, given that the scope extends well before the May guidelines. People with knowledge of the situation said it implies that those companies may have violated older, more established rules of the SEC.
