Reducing Aggressive Non-GAAP Reporting - Essay Example

Introduction

The board responsible for ensuring that the financial reports of companies are standardized-FASB-formulated GAAP (Generally Accepted Accounting Principles) to oversee the standardization. However, there are occasions when GAAP did not accurately represent the operations of a company. In such instances, companies were allowed to use non-GAAP reporting so long as they were disclosed as non-GAAP (Black, 2012). Company managers used this opportunity to make aggressive non-GAAP earnings disclosures. Such reports were misleading to investors as they were adjusted balance sheets and financial statements. Interventions had to be made. Regulations were established to ensure companies did not use the non-GAAP disclosures to mislead the investors (Baumker, 2014). Examples of the major regulations are; Sarbanes Oxley Act (SOX) of July 2002, Regulation G of 2003 and formation of a task force to investigate companies that still used this method to disclose their earnings to the investors (Curtis, 2014). This discussion paper therefore tries to understand what puzzle most people, that is, the extent to which the set regulations have influence managers to use the aggressive earnings reports. Have the regulations worked well to reduce this form of reporting or have they not?

The Issue with non-GAAP Earnings Disclosures

Non-GAAP reporting embraces adjustment of figures by managers to overstate the results of a company. Studies done through the entire field of accounting suggests that adjustment of numbers encourages losses to investors than gain (Baumker, 2014). This means that the managers of firms and companies are more willing to foster investor optimism that maintaining their consistency (Curtis, 2014). This has prompted the need for investors to identify and interpret non-GAAP figures because these figures diverge from GAAP figures and can be misleading to the investors.

Benefits for Non-GAAP Financial Measures

Despite the fact that it has been associated with misleading investors, non-GAAP financial measures also realizes a number of benefits to the investors and the issuers. They provide extra understanding into an issuer’s financial performance (Guillamon, 2014). They are also helpful to the investors in communicating information that could be very useful. Investors sometimes require information that is not available in the GAAP financial measures. Problems arise if the financial measures are not presented in a consistent manner, not adequately defined (IOSC, 2014). Moreover, non-GAAP financial measures cannot be matched with another issuer. This is because they lack a standardized meaning.

Purpose for regulating non-GAAP Reporting

The rise in the number of aggressive non-GAAP reporting prompted the United States Congress and the SEC to make an intervention by developing the SOX and Regulation G for curbing potentially misleading stated disclosures to the investors (Christensen, 2014). SOX was therefore enacted on July 30, 2002 and Regulation G was next the following year. The enactment of the two regulations was not the end. SEC established a taskforce with the purpose of supervising companies that did not adhere to the regulations that were stipulated in the above-mentioned regulations (Black, 2012). Therefore, all the set regulations by collaborative efforts of the Congress and SEC had the purpose of protecting the investors from the misleading firm managers.

Motivations for Non-GAAP Disclosure

Preceding studies suggest a growth in the popularity of non-GAAP reporting and there are still possibilities of investors being misled by these releases (Guillamon, 2014). The same studies purpose to discover the motivations of managers towards adjusting figures. They find out that that it is because of their concerns to meet the analysts’ expectations and earnings unpredictability. Black’s findings are supported by prior studies done by Bhattacharya. However, despite all these, a study done in 2015 by Isidro and Marques suggest that these motivations are determined by the factors that are existence in the business environment of a country (Black, 2012). They further explain that countries that have solid protection grounds for their investors, an efficient law enforcement system, better communication methods and information dissemination strategies and advanced financial markets are likely to experience aggressive non-GAAP reporting (Heflin and Hsu, 2008). This is because the managers are under pressure to keep the investors optimistic. Therefore, managers disclose the non-GAAP numbers.

Christensen and Black note that managers make adjustments to meet strategic earnings targets. It then happens that they fail to meet the targets based on the GAAP earnings (Curtis, 2014). Furthermore, the managers exclude a few one-time items and many recurring items such as research and development, depreciation and stock-based compensation. The purpose is to meet the strategic targets. This is pure indication of aggressive non-GAAP reporting.

Regulation Effectiveness

Studies done in 2006 to scrutinize the influence that the two main regulations- SOX and Regulation G- have on non-GAAP reporting have made similar findings. Three independent studies by Marques, Entwistle and Mbagwu (2006) conclude a decline in non-GAAP reporting. The situation still did not change in 2002; another study established that the two regulations led to a considerable decrease in the same (Heflin and Hsu, 2008). However, a more recent study reveals that even though the non-GAAP reporting decreased for a while, they continued to increase considerably since 2003 (Christensen, 2013). The Securities and Exchange Commission (SEC) expressed concerns due to this increase. The body issued warning to companies that were adjusting its numbers to overstate their results. Krishnan, Chen and Pevzner (2012) supported SEC’s concern by noting that it was still unclear how Regulation G influenced non-GAAP disclosures.

After SOX was enacted and passed to law (also known as Post-SOX period), improvements were observed for a while. For example, managers became more careful. Non-GAAP reporters did not exclude recurring items that they knew analysts would disagree with (Black, 2012). Evidence also suggested that the reporters were less likely to make non-GAAP disclosures. Moreover, it was noted that the reporter’s use of recurring exclusions had changed during this period. For example, they changed from excluding depreciation and amortization expenses to excluding taxes, stock-compensation expenses and interests.

The period that followed was implementation of Regulation G. After its implementation, most investors were able to distinguish aggressive reporting from unaggressive reporting. This helped the investors to discount such firms in the stock market. Further evidence implies that regulation of earnings might have improved the average quality of non-GAAP earnings (Guillamon, 2014). Improvement of quality was achieved through filtering disclosures that were misleading.

Alternatives Managers have to Prevent Aggressive Reporting

Managers do not have to do aggressive reports to affect the perception of the investors or the stakeholders. They have a wide variety of choices from which they can pick. For example, managers could achieve their strategic aims through neutral reporting of operating performance (Black, 2012). Through this, managers will not need to report non-GAAP earnings or to manage the GAAP earning so that they could change the investor or stakeholder’s perception. Nevertheless, it should be noted that the operating performance alone would not be able to achieve the strategic objectives of the company (Christensen, 2013). It is therefore imperative that the managers employ the discretion acceptable within GAAP to influence current performance reporting using their existing choices such as real earnings management. Alternatively, managers have the option of using the conference calls to influence analysts’ street earnings expectations. The conference calls are often used in information sharing on financial performance and its expectations (Heflin and Hsu, 2008). It is a requirement that the managers exercise the influence that they have on performance measures ethically.

Non-GAAP Reporting Recommendations

Black, a professor and the steed school of accounting in his discussion paper “The ethical reporting of Non-GAAP Performance Measures” makes the following recommendations. Since Regulation G cannot be enforced internationally, it is of great importance that international companies that provide disclosure of non-GAAP earnings follow the recommendations that made by Regulation G (Curtis, 2014). Although the task is not easy, this will ensure that non-GAAP reporting generates information that is useful to the stakeholders.

He further recommends that the audit committee should also be involved in overseeing non-GAAP reporting. Full reconciliation and disclosure is not enough. He notes that non-GAAP financial measures needs to be determined in a way that is truthful. This will ensure that that the report is transparent and un-biased. This in turn will be helpful to the users - the investor and other stakeholders- in making their investment decisions. The audit committee can be a very useful in supervising non-GAAP reporting (Black, 2012). Black notes that training the accounting professional managers on the accounting ethics can be helpful. He recommends that the training should be provided to them on a continuous basis. This is because the SEC has received many complaints about non-GAAP reporting.

He summarizes his recommendations for all companies worldwide by noting that all of them should adhere to the guidelines stipulated by SEC and Regulation G (Heflin and Hsu, 2008). He further suggests that the managers should avoid “using recurring items as adjustments for the non-GAAP measures”. He also notes that the companies should include the audit committees in non-GAAP reporting He finally recommends that companies should train the entire accounting professional regularly in order to increase their awareness on the ethics of their profession- especially matters pertaining transparency and biasness of non-GAAP reporting (Black, 2012).

Conclusion

In light of continuous aggressive non-GAAP reporting in the United States companies by managers, the United States Congress and SEC came up with two major regulations that is Sarbanes Oxley Act of 2002 (SOX) and Regulation G. These regulations had the purpose of ensuring companies did not use the non-GAAP disclosures to mislead the investors (Curtis, 2014). Despite the implementation of the two regulations, what puzzled most people was if the regulations worked well to reduce aggressive non-GAAP reporting.

The discussion first examined what was the main issue that raised many questions with the non-GAAP disclosures. Then special attention was also given to the benefits that the disclosure had despite the issues that surround it (Black, 2012). Information on what motivates the managers to make aggressive reports was also brought to light. Most of the attention was given to how effective the established regulations were in ensuring that aggressive non-GAAP reporting was reduced. The effectiveness was built on past studies done after the implementation of the regulations to the present day. The paper also touched on the alternatives that the managers have to prevent aggressive reporting and finally recommendations that were made by a professor in accounting were discussed (Black, 2012). In summary, it was noted that from evidence from the previous studies, Regulation G and the SEC have done tremendous work in regulating the non-GAAP disclosure and reducing the aggressive reporting.