As published in MicroCap Review Magazine

Microcaps In SEC Cross Hairs of NON GAAP Measurement Debate

By: Corey Fischer

Managing Partner, Weinberg & Company, P.A.

Microcap companies are once again in the cross hairs of the Securities & Exchange Commission (SEC), as that regulatory body prepares to clamp down on public company use of non-GAAP (Generally Accepted Accounting Principles) metrics in financial reporting.

As the SEC moves to rein in use of non-GAAP metrics by public companies, it may prove to be another example of how financial accounting standards, as well as SEC rules, are written for the big companies, but cause oversized implications for microcap companies.

Non-GAAP financial measures are customized methodologies used by management to reflect earnings. These measures give companies the flexibility to present the results that best reflect their performance. Non-GAAP measures adjust a company’s historical or future performance, financial position or cash flows by excluding or including amounts from the GAAP measure of net income (or loss).

Many large cap companies use non-GAAP measures in an effort to smooth earnings to eliminate such items as restructuring charges, stock compensation costs, impairments and other non-cash or non-recurring charges. Some companies have gone so far as adjusting and accelerating revenue recognition.

Approximately two-thirds of companies that make up the Dow Jones Industrial Average utilized non-GAAP metrics in reporting earnings per share, according to a recent study, and the SEC is wondering if the trend has gone too far. The SEC is seeking to ensure that non-GAAP use is not misleading and that it does not undermine disclosure effectiveness and investors’ ability to assess financial results. It fears that companies may be touting the non-GAAP measures in their press releases to make financial performance appear more favorable than it would be under current accounting guidelines.

Of the listed companies on the DJIA index that reported non-GAAP earnings per share in 2015, the adjusted metric was on average 30% above earnings reported under GAAP, according to data from FactSet. It was even more pronounced for companies in the S&P 500, where fourth quarter pro forma earnings were 59% higher than under GAAP.

While the analyst or sophisticated investor is presumably better equipped to discern the difference between GAAP and non-GAAP, the SEC is concerned that these higher numbers may be most misleading to the less sophisticated investor, who may not be able to distinguish between the adjusted numbers and GAAP results, especially when reported on websites or other venues not covered by SEC rules.

But, any proposed regulations aimed at curtailing large cap companies may be overkill for microcap companies that live in a very different financial and capital raising environment. For microcap companies, non-GAAP reporting may actually provide a clearer picture of a company’s financial situation than GAAP because it allows management of these growth companies to tell their story beyond the basic numbers; providing a broader overview of the company and its future prospects.

Many microcap companies, for example, are burdened with significant non-cash charges that, for practical purposes, are of little use to the readers of their financial statements. Most often, these non-cash charges result from financing transactions or issuance of a company’s equity instruments that are common among microcaps, who frequently go to market for additional capital. The accounting for these rules is overly complicated and creates huge swings in earnings that have nothing to do with the company’s operating performance. Furthermore, these accounting rules can create large non-cash liabilities such as derivatives that often overwhelm cash, payables and the other liabilities on a balance sheet. In these instances the ability to use non-GAAP measurements is the only way to explain the true picture to investors and other financial report readers.

The increased popularity of companies using non-GAAP measures has certainly caught the attention of the SEC. Though there may be an appropriate regulatory path that reels in the more outlandish reporting techniques utilized by Big Board companies, we hope that the SEC appreciates that microcap companies live, and struggle, in a very different world. The same regulation that might necessitate an adjustment in practice for a large cap company, can have serious punitive impact for its microcap brethren and their investors.

For now, non-GAAP earnings are permissible if done correctly. Microcap companies always should strive for transparency, for consistency in how measures are calculated, provide appropriate disclosure, and a thoughtful discussion of why non-GAAP use is valuable in their particular reporting process.

Corey Fischer, CPA, is Firm Managing Partner of Weinberg & Company, a multi-office, PCAOB and CPAB-Registered firm specializing in the audit, assurance and tax needs of micro and small cap companies. He has more than 25 years of experience, having worked with the Big 4 accounting firms, and as an SEC reporting officer for a number of NASDAQ-listed companies. He is based in Los Angeles and is an expert in financial reporting, SEC compliance, raising debt and equity, mergers and acquisitions and structuring accounting operations. E-mail: coreyf@weinbergla.com or 310-601-2200.

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