Misleading Non-GAAP Measures: The Costs That Vanish From Adjusted Earnings

Misleading non-GAAP measures can make a company’s performance look better by removing expenses that belong in the result investors think they are seeing. The public explanation may promise to exclude costs tied to a merger, while the adjustment schedule includes work the business would have paid for anyway. If you prepare those schedules, approve expenses or review earnings releases, you may know exactly where the explanation and the calculation part company.

This page follows the adjustments between GAAP results and the alternative measures presented to investors. Our page on accounting restatements follows corrections to the financial statements themselves. Here, the revealing document may be the expense schedule behind an adjusted earnings number.

What Makes a Non-GAAP Measure Misleading?

A non-GAAP financial measure changes a measure of financial performance, financial position or cash flow by including or excluding amounts from the closest comparable GAAP measure. Adjusted net income, EBITDA and free cash flow are familiar examples. The Securities and Exchange Commission’s non-GAAP disclosure rules require the comparable GAAP result and a reconciliation showing the differences, and prohibit materially misleading presentations.

Companies use these measures to explain the performance they want investors to evaluate apart from particular costs or events. That explanation matters as much as the arithmetic: an expense can appear on a reconciliation while its label misdescribes what the company actually paid for.

DXC’s Merger Label Reached Costs Beyond the Merger

The SEC alleged that DXC Technology, an information technology company, excluded expenses that did not fit its public description of transaction, separation and integration-related costs. In its March 14, 2023 settled order, the agency described a mismatch between the costs investors were told had been removed and the costs employees actually classified as transaction, separation or integration costs. DXC’s description covered integration planning, financing and advisory fees associated with its merger and other acquisitions, and costs of separating a business.

The data-center move makes the allegation concrete. The SEC said DXC classified over $38 million of relocation expenses as integration costs across six consecutive quarters. According to the order, the landlord had told the predecessor company before the merger that the lease would not be renewed, so the company would have had to move anyway. We see a remarkably convenient merger benefit in the SEC’s account: even a move the landlord had already required acquired an integration label.

The order also described a consulting contract to identify historical research-and-development tax credits. According to the SEC, financial planning and analysis staff presented that work to the controller’s group as standardizing the merged company’s tax-credit methodology. The agency said the contractual statement of work described finding additional credits and contained no methodology-standardization work. For someone who commissioned or reviewed the project, the contract answered a question the adjustment description obscured.

The internal review supplied its own warning. The SEC’s order reproduced an email from an assistant controller to the controller:

According to the order, the requested supporting details did not arrive, and similar concerns arose in the next quarter. The SEC alleged that DXC issued earnings releases containing the costs despite incomplete reviews. It also described policy drafts circulated internally and to the independent auditor that the controller’s group and disclosure committee never adopted. In that account, the drafts circulated. The expenses stayed excluded.

DXC agreed to an $8 million civil penalty and to develop policies and disclosure controls for its non-GAAP reporting. The SEC alleged that non-GAAP net income was overstated in three quarters. In one, the reported $573 million was overstated by at least $29 million. The SEC’s case concerned misleading non-GAAP disclosures and weak controls.

Which Records Explain a Non-GAAP Adjustment?

The useful comparison joins the company’s public definition, the adjustment schedule and the work or transaction behind each excluded cost. A spreadsheet total tells us how much was removed. The contract, project description, accounting entry and approval tell us why someone thought it belonged there.

DXC’s order described a quarterly spreadsheet with tens of thousands of cost lines, insufficient project descriptions and limited review time. The SEC alleged that some financial planning staff expected the controller’s group to decide which exclusions were appropriate, while the controller’s group assumed that financial planning had already vetted them more thoroughly. The agency also said approvals often lacked a documented basis and previously approved classifications went without reassessment. If you worked at either end of that handoff, you may understand what the next reviewer never received.

The wider securities fraud evidence trail connects transaction records to entries, the accounting close, disclosure review and the released report. For a non-GAAP concern, we compare the same cost across periods, the reason recorded for excluding it, the questions raised during review and the answer reflected in the final disclosure. Committee minutes, auditor communications and comments accompanying internal certifications can show what happened after someone challenged the adjustment.

The accounting literature puts classification alongside timing and presentation as ways to change the picture investors receive. Accounting Fraud: A Literature Review, published in Risk Governance and Control: Financial Markets & Institutions in 2019, describes those mechanisms and connects management’s incentives to compensation, internal goals and outside expectations. Applied to a non-GAAP concern, that gives us questions to examine with you: what the exclusion improved, whose performance it affected and who approved its treatment.

Audit-committee materials can add the intended policy and management’s explanation of it. In a 2016 speech on financial reporting, the SEC’s chief accountant urged audit committees to understand the judgments behind non-GAAP measures and how they differed from other companies’ approaches. For an insider, the test is whether that explanation matches the schedule.

When Do Non-GAAP Adjustments Become an SEC Problem?

The SEC’s concern reaches the content of the adjustment and the way investors encounter it. Its April 2018 staff interpretations on non-GAAP measures address recurring expenses, inconsistent treatment, accelerated revenue, prominence, liquidity and tax effects. Each presents a different comparison for someone who knows how the company assembled the number.

Recurring Costs and Selective Exclusions

Removing normal, recurring cash operating expenses necessary to run the business can make a performance measure misleading. The staff also identifies inconsistent treatment across periods and the exclusion of nonrecurring charges while comparable nonrecurring gains remain in the result. Prior-period schedules can show whether the adjustment policy changed when its effect on earnings changed.

A nonrecurring label also carries a history. The filing rules prohibit describing an adjusted item as nonrecurring, infrequent or unusual when a similar charge or gain occurred in the previous two years or is reasonably likely to recur within the next two. For an employee who sees the same cost return, the label and the repeated work deserve to be read together.

A Reconciliation Must Explain the Difference

A reconciliation connects the non-GAAP measure to the most directly comparable GAAP measure, with the differences quantified. For EBIT or EBITDA presented as performance measures, the staff identifies GAAP net income as the comparison. The explanation must also say why management believes the measure helps investors and disclose material additional uses by management. The SEC’s rules call for an explanation specific to the company, measure and business.

Revenue Cannot Arrive Early Just by Changing the Measure

The staff’s guidance addresses an adjusted performance measure that treats revenue as earned when customers are billed even though GAAP recognizes it over time. It says a company can violate SEC rules by substituting its own methods for deciding when revenue belongs in the adjusted number. Contracts, billing dates and the revenue schedule can show the difference between the customer’s payment obligation and the timing presented to investors.

Adjusted Profit Gets the Headline, GAAP Loss Gets the Paragraph

In filings and earnings releases, the most directly comparable GAAP measure must receive equal or greater prominence. The staff’s examples reach headlines, larger type, the order of presentation, tables and discussion that celebrates adjusted performance without comparable attention to GAAP results. Someone in investor relations or disclosure review may recognize the problem in a marked-up release before looking at the ledger.

The SEC’s December 26, 2018 settlement with ADT shows the presentation problem. The agency alleged that the security company’s earnings-release highlights displayed adjusted net income of $249 million while leaving out the comparable GAAP result. The $157 million GAAP net loss appeared farther down in the text. ADT agreed to a $100,000 civil penalty for the reporting violations. In the SEC’s account, the profit made the highlights. The loss had to find room below.

Cash Measures and Tax Effects Need Their Own Explanation

The substance of a measure determines whether it measures performance or liquidity. The staff says a non-GAAP liquidity measure that measures cash generated cannot appear on a per-share basis in documents submitted to the SEC, even when management calls it a performance measure. Free cash flow commonly subtracts capital expenditures from operating cash flow, but has no uniform definition. A calculation that leaves debt service out cannot fairly imply that all the resulting cash is available to spend freely.

Further adjustments to EBITDA need a distinguishable label, such as adjusted EBITDA, and an explanation of the calculation. The staff also calls for income-tax effects to appear as a separate, explained adjustment instead of burying them in a net-of-tax amount. The tax calculation and the expense schedule can therefore answer different parts of the same earnings claim.

What an Accounting Insider Can Bring

An insider can explain why an expense entered the adjustment schedule, who approved it and what happened when the explanation was questioned. We work with that knowledge to connect the published number to the underlying business decision. Our work on reporting securities fraud to the SEC begins with those connections and the evidence investigators can test.

The SEC’s whistleblower program can pay eligible whistleblowers 10% to 30% of the sanctions it collects in a qualifying case with sanctions over $1 million. Separately, a whistleblower case under the False Claims Act can pay 15% to 30% of what the government recovers. We assess which program fits the conduct with you, alongside the adjustment, your role and the records you know.

You Know What the Adjustment Removed

If you know which costs disappeared from adjusted earnings and why the public explanation does not fit, speak with our whistleblower experts about the adjustment. We work beside you through the whole process to build your strongest securities whistleblower case around the definition, the expense and the decisions behind the published result. We bring in securities fraud whistleblower lawyers who understand financial-reporting cases.