Analyst - Dispute Consulting
Now that the holiday season has passed, it’s season’s greetings for corporate earnings, and public companies are busy finalizing their financial statements and related disclosures.
As with any earnings season, the Securities and Exchange Commission (SEC) will be scrutinizing corporate earnings-per-share (EPS) calculations and disclosures made in quarterly and annual earnings releases and SEC filings. Traditionally, the SEC has focused its enforcement efforts on financial statement fraud schemes that are directed at the components of net income (e.g., revenue, cost of sales, and operating expenses), the numerator in the EPS computation. But the SEC may be changing its focus to the EPS computation itself, especially when it comes to reporting a version of EPS that is not prepared in conformity with generally accepted accounting principles (GAAP). With this in mind, counselors to public companies need to understand the intricacies of GAAP and non-GAAP methodologies with regard to financial reporting.
To nonaccountants, EPS is likely thought of as the ratio of net income to the number of shares outstanding. While that is fundamentally accurate, the EPS computation can be more complex than that, depending on the capital structure of a company. Items may need to be added to or deducted from the numerator or denominator as required by GAAP.
EPS is one of the most widely recognized and touted financial metrics used by U.S. publicly traded companies. It is a key figure often forecast by investment analysts as “analyst expectations” or “consensus estimates.” Many companies also issue their own EPS estimates to set earnings expectations for investors as well as report on a non-GAAP version of EPS. When the actual amounts of EPS turn out to be lower than what was expected, a company’s share price can be severely punished. Accordingly, pressure and opportunity exist for companies to manipulate EPS by inappropriately adjusting the numerator or the denominator, or obscuring it in a non-GAAP version.
U.S. publicly traded corporations are required to report EPS in accordance with GAAP. GAAP requires public companies to report basic EPS and, for companies that have potentially dilutive securities, a diluted version of EPS.
Basic EPS is determined by dividing income available to common stockholders by the weighted-average number of common shares outstanding during the period. Income available to common stockholders begins with net income and is reduced by dividends paid or payable on preferred stock. The basic EPS computation can be illustrated as follows:
Diluted EPS is reported when a company has outstanding securities that can impact the quantity of common shares outstanding upon the occurrence of a future event (e.g., stock options, stock warrants, convertible securities, contracts that may be settled in stock or cash, and other contingently issuable shares). GAAP requires that the dilutive effects of these features be considered and included in the EPS computation so that investors can understand the impact on EPS assuming convertible securities were converted, options or warrants were exercised, or other shares were issued upon the satisfaction of certain conditions. The diluted EPS computation can be illustrated as follows:
While the computation itself is straightforward, attorneys need to understand the factors and sources of data that go into the equation in order to comprehend the risks involved in misreporting results. Below are some of the more significant factors.
Net income is the bottom-line result of a company’s activities (e.g., revenues and gains minus cost of goods sold, expenses, and taxes) for an accounting period.
What counsel should look for: Make sure that net income reported on the face of the income statement agrees with the net income figure reported in the EPS computation found in the footnotes to the financial statements.
Preferred stock is a security that has preferential rights compared with common stock. Preferred shareholders commonly earn a periodic dividend. While dividends paid or payable to preferred shareholders are accounted for as reductions to retained earnings, GAAP requires that preferred dividends be deducted from net income in computing EPS. Accordingly, dividends on preferred stock have a negative impact on EPS.
What counsel should look for: Be cognizant of whether the company has preferred shares outstanding and whether any associated preferred stock dividends are properly included (or should be included) in the EPS computation.
The weighted-average number of common shares outstanding is the number of shares determined by relating the portion of time within a reporting period in which common shares have been outstanding to the total time in the period. Because this factor is the denominator, declines in the shares outstanding from the previous period will have a positive impact on EPS.
What counsel should look for: To ensure that the computation is consistent from period to period, check the financial statement footnote disclosures concerning how the company quantifies the weighted-average number of shares outstanding. In addition, check to see if the company is engaging in stock repurchases and, if so, the timing and impact of the repurchases on the EPS computation.
Diluted EPS adds to the basic EPS computation the number of additional common shares that would have been outstanding assuming the dilutive potential common shares had been issued within the reporting period. Because these types of securities increase the denominator of the EPS computation, diluted EPS results in a lower EPS than basic EPS. Therefore, pressure exists to omit or undercount the number of potentially dilutive shares.
What counsel should look for: Check financial statements, footnote disclosures, and public sources to determine whether any potentially dilutive securities exist and that they were properly included in the EPS computation.
Given its potential ambiguity, non-GAAP EPS reporting has been on the SEC’s radar screen for at least 15 years. In 2003, the SEC issued Regulation G to ensure that the use of non-GAAP performance measures by issuers would not mislead investors. Since then, the SEC’s Division of Corporation Finance (“Corp Fin") has issued several Compliance & Disclosure Interpretations (CDIs) to provide guidance to SEC registrants in their preparation of disclosures for non-GAAP financial measures, with the most recent occurring on October 17, 2017. Reporting and disclosure issues with respect to non-GAAP reporting persist, and Corp Fin continues to ask questions about non-GAAP computations and disclosures in comment letters to registrants.
Despite the rules and persistence by Corp Fin, non-GAAP reporting of EPS can still be confusing to investors. This is because the various titles used to describe non-GAAP EPS and the types and nature of adjustments made in computing non-GAAP EPS vary widely among companies.
A review of select filings and disclosures reveals that there is no one single title used to describe non-GAAP EPS. For example, non-GAAP EPS has been reported under captions such as “adjusted EPS,” “adjusted diluted EPS,” “core EPS,”and “pro forma adjusted EPS,” just to name a few. In addition, some companies report multiple versions of EPS. For example, General Electric provided multiple iterations of EPS in its third-quarter 2017 earnings release, which included captions such as “operating EPS,” “industrial operating EPS,” verticals EPS,” and “industrial operating plus verticals EPS.”
What is included and excluded from non-GAAP EPS also varies among companies. Examples of GAAP to non-GAAP adjustments include expenses such as restructuring costs, merger-related costs, costs relating to customer contracts, litigation settlements, pension costs, amortization of intangible assets, and a variety of others.
It is important for counsel to be mindful of certain adjustments that may violate Regulation G due to the presentation of potentially misleading non-GAAP measures. According to the SEC, examples of these situations include:
Presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate the business
Adjusting a particular charge or gain in the current period but not including the same or similar charge or gain in the comparative prior period’s measure, when such adjustments exist
Adjusting only for nonrecurring charges when there were nonrecurring gains that occurred in the same period
Companies that do not heed these guidelines could be penalized. For example, in 2009, the SEC settled an enforcement proceeding with SafeNet and certain of its former officers and accountants for allegedly violating Regulation G, among other things. Specifically, the SEC alleged that “SafeNet had misclassified and excluded a significant amount of recurring, operating expenses from its non-GAAP earnings results, in order to meet or exceed quarterly EPS targets.” This was the first enforcement action brought by the SEC pursuant to Regulation G. As a consequence of the settlement, SafeNet agreed to pay a civil penalty of $1 million, and the officers and accountants suffered imposed sanctions such as monetary penalties, disgorgement, and suspensions from practicing as accountants before the SEC.
The SEC’s rules governing non-GAAP reporting require public companies that disclose or release non-GAAP financial measures to, among other things, include a presentation of the most directly comparable GAAP financial measure, and a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure.
In 2017, the SEC settled an enforcement action with MDC Partners (MDC) for allegedly violating these requirements, among other things. In the MDC matter, the SEC found that MDC failed to present a reconciliation of the differences between the non-GAAP financial measure it disclosed with the most comparable financial measure calculated and presented in accordance with GAAP. Following the settlement, MDC agreed to pay a civil money penalty of $1.5 million, among other consequences.
In a CDI released by the SEC on May 17, 2016, the SEC stated that “non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in documents filed or furnished with the Commission.” Thus, if a corporation plans to show cash flow per share in earnings releases, annual reports, or presentation materials to investors this earnings season, that company should also plan to receive a letter from Corp Fin or the SEC’s Enforcement Division.
Former SEC Chair Mary Jo White emphasized in a 2016 speech there are many troublesome practices that can make non-GAAP disclosures misleading. These included “the lack of equal or greater prominence for GAAP measures; exclusion of normal, recurring cash operating expenses; individually tailored non-GAAP revenues; lack of consistency; cherry-picking; and the use of cash per share data.” She went on to say that the SEC is watching “this space very closely and are poised to act through the filing review process, enforcement and further rulemaking if necessary.”
Indeed, there may be a few bad actors out there who will try to take advantage of EPS reporting and non-GAAP derivations thereto. But corporate counsel who remain skeptical and diligent throughout the financial reporting process will likely have a joyful earnings season.