In 2003, the SEC first officially adopted rules (following Sarbanes-Oxley in 2002) related to the reporting of non-GAAP financial metrics. The new regulations called for a reconciliation of GAAP versus non-GAAP results to be included in various investor resources and to refrain from excluding non-recurring items from non-GAAP metrics if they are reasonably likely to reoccur, which is subject to wide interpretation. Since then, it seems the perceived importance among investors of non-GAAP financial performance has been elevated above traditional GAAP measures. Between 2015 and 2017, less than 10.0% of companies in the S&P 500 did not report a non-GAAP income calculation. However, the ability for management to subjectively decide what is or is not relevant to a company’s core business leaves plenty of room for earnings manipulation.

On the one hand, companies tend to justify their exclusion of various transactions as necessary for “comparability” to historical results, given that GAAP rules have changed over time. Fair enough. However, when an investor chooses to rely upon non-GAAP results when comparing a given company’s results to another’s, the comparisons can be deeply misleading as management has great leeway for subjective (and sometimes ad-hoc) adjustments in their exclusions – i.e., what one company concludes should be excluded in a non-GAAP calculation may not be consistent with what another company may exclude.

In fact, in 2010 former SEC chief accountant Howard Scheck identified non-GAAP performance metrics as a “fraud risk factor.” The SEC even created a taskforce to analyze non-GAAP earnings metrics that could be misleading. Then, in an effort to provide more clarity, the commission provided Compliance and Disclosure Interpretations (C&DIs) which detailed ways in which the SEC may find non-GAAP disclosures to be misleading, but more on that later.

Here at Gradient Analytics, our focus on earnings quality analysis (for both short idea generation and vetting of long candidates) regularly includes an examination of non-GAAP adjustments to determine whether they are appropriate in helping represent the true performance of the firm, or whether they are misleading. There is a plethora of unique adjustments a company could make to a non-GAAP income calculation; however, some are more common than others. One of the more frequent adjustments to GAAP income is the exclusion of restructuring costs. Read on….

Raising the ire of Warren Buffett:

Costs associated with corporate restructuring, including reorganization, consolidation, or discontinuation of one or more business operations, are usually one-time charges (expenses). Examples include closing plants, acquisitions, changes to the supply chain, employee severance and termination benefits, or the general impairment of the carrying value of certain productive assets.

Most of the time, we’ve observed that companies have appropriately excluded these one-time restructuring charges from the calculation of non-GAAP income. However, there are more than a few firms we have come across that appear to have continually excluded restructuring costs over many periods (sometimes going back several years), and in our opinion, inappropriately.

In fact, adjusting out restructuring costs to calculate non-GAAP income is so pervasive that Warren Buffett had strong criticism about the practice in a 2016 letter to Berkshire Hathaway shareholders. He began by stating:

“Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, ‘adjusted earnings’ that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of ‘restructuring costs’ and ‘stock-based compensation’ as expenses.”

Buffett went on to deride the “don’t count this” mantra that some firms have fallen into and that those same firms may not be counting restructuring costs for years on end. However, Buffett did acknowledge that large companies can undoubtedly have large (and potentially prolonged) one-time costs as a result of large business combinations and/or reorganizations, but those costs and the reason for their exclusion must be explained and rationalized clearly by management.

The SEC provides unclear guidance:

In the SEC’s C&DIs, the regulator attempted to provide answers to questions related to both non-GAAP adjustments generally and restructuring costs specifically. The first question related to Item 10(e) of Regulation S-K, which:

“…prohibits adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years.”

Based on this statement, despite a transaction being labeled as “non-recurring, infrequent, or unusual”, if the “nature” of the charge (we believe nature to mean the exact charge or one of similar character) had occurred in the previous two years or is likely to occur in the next 24 months, it should be labeled as recurring. Consequently, excluding the transaction from non-GAAP income calculations would be deemed inappropriate (although admittedly, in our opinion two years is a broad window). However, the SEC’s so-called “clarification” on that guidance (following the initial statement above) is anything but:

“…while there is no per se prohibition against removing a recurring item, companies must meet the burden of demonstrating the usefulness of any measure that excludes recurring items, especially if the non-GAAP financial measure is used to evaluate performance.”

So, the SEC “prohibits” smoothing non-GAAP performance measures with recurring metrics, but it’s not a “per se” prohibition if its defensible. Clear as day, right? They rationalize this subjective position by asserting that companies must justify the usefulness of this measure (non-GAAP income) and how it’s calculated. Such justification would come from analyzing the “nature” of the transactions and include materiality, frequency, importance to investors (to measure financial performance/condition), connection to known or unknown trends, and other (all) facts and circumstances related to the transaction. The SEC then states when recurring items may be excluded:

“Such measures more likely would be permissible if management reasonably believes it is probable that the financial impact of the item will disappear or become immaterial within a near-term finite period.”

A couple of questions arise from that statement: 1) What’s the threshold for materiality? 2) Is “near term” less than two years? Because if so, it renders the SEC’s “within two years” frequency statement somewhat useless.

How does this guidance specifically apply to restructuring costs? Well it turns out that the SEC also addressed this question in the C&DIs. Pointedly, the question was asked:

“Is it permissible to use non-GAAP financial measures that eliminate recurring restructuring charges or other recurring items if those charges or items are not labeled as non-recurring?”

The SEC answered by restating their objection to the practice of classifying recurring transactions as non-recurring but also called for the examination of the totality of circumstances. However, they concluded with:

“…if there is a past pattern of restructuring charges, no articulated demonstration that such charges will not continue and no other unusual reason that a company can substantiate to identify the special nature of the restructuring charges, it would be difficult for a company to meet the burden of disclosing why such a non-GAAP financial measure is useful to investors. In such circumstances, Item 10(e) of Regulation S-K would not permit the use of the non-GAAP financial measure. Similar considerations may apply under Item 12 of Form 8-K.”

So, it appears that if restructuring costs don’t follow the guidelines 10(e) S-K, then it should not be permissible. Nevertheless, the issue remains that restructuring costs can come in many different forms (as described previously). If there are restructuring costs within a two-year period related to an impairment of an asset and severance of employee benefits, those two transactions would likely be valid as “dissimilar in nature” and thus permissible for exclusion.

Examples of questionable exclusions:

For example, back in 2016 Coca-Cola (NYSE:KO) successfully defended the company’s continual use of restructuring charges (ironic, given Berkshire Hathaway’s large position in the company), essentially using a “dissimilar in nature” argument. However, in the body of their defense was the following excerpt:

“…while these initiatives have been, and will continue to be, implemented over multiple years, the timing of the charges are unpredictable and the amount of the charges vary significantly across reporting periods and across operating segments, which can affect comparability. Finally, these charges are not expected to continue indefinitely.”

While the SEC apparently accepted this explanation, it seems that these restructurings weren’t entirely “unpredictable” given the company’s statement noting they will take “multiple years.” This would also seemingly violate the SEC’s two-year recurring window guidance. In fact, over a five-year timeframe (Q2 2009 - Q2 2014) Coca-Cola reported restructuring costs in 20 out of 21 quarters for a total of $3.21 billion (or 10.2% of reported GAAP income over the same period). Those supposedly “unpredictable” costs certainly appear to have occurred quite frequently over a significant period. Indeed, is anything truly predictable in the world of business? Coca-Cola’s assertion that these charges were not representative of (or relevant to) the company’s underlying operations seem questionable.

Another example of a company successfully defending (also in 2016) its use of restructuring costs is Medtronic plc (NYSE:MDT). Medtronic reported restructuring costs in 19 of 21 quarters (Q2 2019 - Q2 2014) for a total of $1.71 billion (or 9.6% of reported GAAP income over the same period). In their defense, Medtronic went on to list the differences in where their restructuring expenses originated, including contract termination costs, shifts in selling strategies, employee terminations, restructuring programs to achieve cost synergies, integration costs, and other program terminations. The firm also stated, “Restructuring charges are not necessary to operate the business and are not necessary to generate revenue,” and just like Coca-Cola, it cited “unpredictability” and “relevance” to core business results.

Despite the explanation that these transactions are not part of the core business operation, their continued recurrence causes us to doubt this explanation. For example, if a company consistently engages in M&A, should restructuring costs (even if they emanate from different acquisitions) be considered an ongoing business expense? We believe so – and in fact for many such “serial acquirers,” M&A is their primary growth strategy. Nevertheless, they typically have been able to skirt such a classification with the SEC.

However, Coca-Cola and Medtronic are far from alone in this practice. In a recent look at the S&P 500 constituents, we found 73 companies (11.9% of the data set) that reported restructuring costs in every quarter going back to Q2 2014. Additionally, 168 companies (40.4% of the data set) reported restructuring costs in at least 15 of the last 21 quarters. Over the five-year period, companies with restructuring costs in every quarter reported a total of $57.6 billion, or 16.0% of their $360.9 billion of total GAAP income over the same period.

Furthermore, there are companies that elect not to engage in the calculation of non-GAAP income metrics. In fact, 200 of our S&P 500 sample did not report any restructuring costs in the five-year period. One of the more surprising companies in this category is Amazon (NASDAQ:AMZN). One might think, given the variety of industries, acquisitions, and operations it takes on, that excluding “unpredictable costs” would be as justifiable for Amazon as any other company. However, Amazon has not reported any restructuring costs in the last five years (and beyond).

Other well-known names without reported restructuring costs include Home Depot (NYSE:HD), Apple Inc. (NASDAQ:AAPL), Costco (NASDAQ:COST), Nike (NYSE:NKE), Boeing (NYSE:BA), Exxon Mobil (NYSE:XOM), and Home Depot (NYSE:HD), among others. In a 2016 article from the Wall Street Journal, Home Depot finance chief Carol Tome reasoned, “By doing this, there is never any confusion about the starting point.” She essentially suggested that adjusting for restructuring costs indeed creates confusion for the investor – precisely one of the tenets that the SEC is charged with enforcing.

Can it be reined in?

While there are companies like Home Depot that elect not to adjust GAAP financials, we are not saying there is no utility in calculating non-GAAP figures. On the contrary, there certainly is. Our issues stem from the habitual exclusions by some companies and the inconsistent enforcement, or even inquiry, from the SEC. Since the beginning of 2017, of the 95 companies we identified in our sample that reported restructuring costs in at least 20 of 21 quarters, just eight were found to have had any correspondence with the SEC.

And of those eight, only two were questioned about their practice of continually excluding restructuring costs from a non-GAAP income calculation. In both instances, each company defended its continual exclusion of those costs with some variation of “non-core”, “non-recurring”, “non-cash”, “comparability,” etc. Again, the frequency of these charges would suggest otherwise.

From what we can find, it does not appear that any company in the last five years has had any significant punitive consequences levied against it for the inappropriate exclusion of recurring restructuring costs from non-GAAP income calculations. And it’s not just restructuring costs that are so questionably excluded – for example, stock-based compensation adjustments are also an issue (as Warren Buffett pointed out in the earlier quote). Why would this be so? Perhaps it is because large companies have such significant resources (both legal and financial) to defend themselves against the vague (and sometimes contradictory) guidelines put forth by the SEC, making successful prosecution or settlement unlikely. Or perhaps it’s simply because investors have not made enough noise about the issue – and ultimately it is investors that the SEC seeks to protect.

So, given the importance non-GAAP metrics have assumed across the investor community and the complexity of the topic, perhaps the SEC should provide a more in-depth analysis and interpretation as to what is appropriate and above board, for the benefit of investors and their difficult investment decisions. In any case, we at Gradient are here to help our institutional investor clients sort it out.

In 2003, the SEC first officially adopted rules (following Sarbanes-Oxley in 2002) related to the reporting of non-GAAP financial metrics. The new regulations called for a reconciliation of GAAP versus non-GAAP results to be included in various investor resources and to refrain from excluding non-recurring items from non-GAAP metrics if they are reasonably likely to reoccur, which is subject to wide interpretation. Since then, it seems the perceived importance among investors of non-GAAP financial performance has been elevated above traditional GAAP measures. Between 2015 and 2017, less than 10.0% of companies in the S&P 500 did not report a non-GAAP income calculation. However, the ability for management to subjectively decide what is or is not relevant to a company’s core business leaves plenty of room for earnings manipulation.

On the one hand, companies tend to justify their exclusion of various transactions as necessary for “comparability” to historical results, given that GAAP rules have changed over time. Fair enough. However, when an investor chooses to rely upon non-GAAP results when comparing a given company’s results to another’s, the comparisons can be deeply misleading as management has great leeway for subjective (and sometimes ad-hoc) adjustments in their exclusions – i.e., what one company concludes should be excluded in a non-GAAP calculation may not be consistent with what another company may exclude.

In fact, in 2010 former SEC chief accountant Howard Scheck identified non-GAAP performance metrics as a “fraud risk factor.” The SEC even created a taskforce to analyze non-GAAP earnings metrics that could be misleading. Then, in an effort to provide more clarity, the commission provided Compliance and Disclosure Interpretations (C&DIs) which detailed ways in which the SEC may find non-GAAP disclosures to be misleading, but more on that later.

Here at Gradient Analytics, our focus on earnings quality analysis (for both short idea generation and vetting of long candidates) regularly includes an examination of non-GAAP adjustments to determine whether they are appropriate in helping represent the true performance of the firm, or whether they are misleading. There is a plethora of unique adjustments a company could make to a non-GAAP income calculation; however, some are more common than others. One of the more frequent adjustments to GAAP income is the exclusion of restructuring costs. Read on….

Raising the ire of Warren Buffett:

Costs associated with corporate restructuring, including reorganization, consolidation, or discontinuation of one or more business operations, are usually one-time charges (expenses). Examples include closing plants, acquisitions, changes to the supply chain, employee severance and termination benefits, or the general impairment of the carrying value of certain productive assets.

Most of the time, we’ve observed that companies have appropriately excluded these one-time restructuring charges from the calculation of non-GAAP income. However, there are more than a few firms we have come across that appear to have continually excluded restructuring costs over many periods (sometimes going back several years), and in our opinion, inappropriately.

In fact, adjusting out restructuring costs to calculate non-GAAP income is so pervasive that Warren Buffett had strong criticism about the practice in a 2016 letter to Berkshire Hathaway shareholders. He began by stating:

“Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, ‘adjusted earnings’ that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of ‘restructuring costs’ and ‘stock-based compensation’ as expenses.”

Buffett went on to deride the “don’t count this” mantra that some firms have fallen into and that those same firms may not be counting restructuring costs for years on end. However, Buffett did acknowledge that large companies can undoubtedly have large (and potentially prolonged) one-time costs as a result of large business combinations and/or reorganizations, but those costs and the reason for their exclusion must be explained and rationalized clearly by management.

The SEC provides unclear guidance:

In the SEC’s C&DIs, the regulator attempted to provide answers to questions related to both non-GAAP adjustments generally and restructuring costs specifically. The first question related to Item 10(e) of Regulation S-K, which:

“…prohibits adjusting a non-GAAP financial performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years.”

Based on this statement, despite a transaction being labeled as “non-recurring, infrequent, or unusual”, if the “nature” of the charge (we believe nature to mean the exact charge or one of similar character) had occurred in the previous two years or is likely to occur in the next 24 months, it should be labeled as recurring. Consequently, excluding the transaction from non-GAAP income calculations would be deemed inappropriate (although admittedly, in our opinion two years is a broad window). However, the SEC’s so-called “clarification” on that guidance (following the initial statement above) is anything but:

“…while there is no per se prohibition against removing a recurring item, companies must meet the burden of demonstrating the usefulness of any measure that excludes recurring items, especially if the non-GAAP financial measure is used to evaluate performance.”

So, the SEC “prohibits” smoothing non-GAAP performance measures with recurring metrics, but it’s not a “per se” prohibition if its defensible. Clear as day, right? They rationalize this subjective position by asserting that companies must justify the usefulness of this measure (non-GAAP income) and how it’s calculated. Such justification would come from analyzing the “nature” of the transactions and include materiality, frequency, importance to investors (to measure financial performance/condition), connection to known or unknown trends, and other (all) facts and circumstances related to the transaction. The SEC then states when recurring items may be excluded:

“Such measures more likely would be permissible if management reasonably believes it is probable that the financial impact of the item will disappear or become immaterial within a near-term finite period.”

A couple of questions arise from that statement: 1) What’s the threshold for materiality? 2) Is “near term” less than two years? Because if so, it renders the SEC’s “within two years” frequency statement somewhat useless.

How does this guidance specifically apply to restructuring costs? Well it turns out that the SEC also addressed this question in the C&DIs. Pointedly, the question was asked:

“Is it permissible to use non-GAAP financial measures that eliminate recurring restructuring charges or other recurring items if those charges or items are not labeled as non-recurring?”

The SEC answered by restating their objection to the practice of classifying recurring transactions as non-recurring but also called for the examination of the totality of circumstances. However, they concluded with:

“…if there is a past pattern of restructuring charges, no articulated demonstration that such charges will not continue and no other unusual reason that a company can substantiate to identify the special nature of the restructuring charges, it would be difficult for a company to meet the burden of disclosing why such a non-GAAP financial measure is useful to investors. In such circumstances, Item 10(e) of Regulation S-K would not permit the use of the non-GAAP financial measure. Similar considerations may apply under Item 12 of Form 8-K.”

So, it appears that if restructuring costs don’t follow the guidelines 10(e) S-K, then it should not be permissible. Nevertheless, the issue remains that restructuring costs can come in many different forms (as described previously). If there are restructuring costs within a two-year period related to an impairment of an asset and severance of employee benefits, those two transactions would likely be valid as “dissimilar in nature” and thus permissible for exclusion.

Examples of questionable exclusions:

For example, back in 2016 Coca-Cola (NYSE:KO) successfully defended the company’s continual use of restructuring charges (ironic, given Berkshire Hathaway’s large position in the company), essentially using a “dissimilar in nature” argument. However, in the body of their defense was the following excerpt:

“…while these initiatives have been, and will continue to be, implemented over multiple years, the timing of the charges are unpredictable and the amount of the charges vary significantly across reporting periods and across operating segments, which can affect comparability. Finally, these charges are not expected to continue indefinitely.”

While the SEC apparently accepted this explanation, it seems that these restructurings weren’t entirely “unpredictable” given the company’s statement noting they will take “multiple years.” This would also seemingly violate the SEC’s two-year recurring window guidance. In fact, over a five-year timeframe (Q2 2009 - Q2 2014) Coca-Cola reported restructuring costs in 20 out of 21 quarters for a total of $3.21 billion (or 10.2% of reported GAAP income over the same period). Those supposedly “unpredictable” costs certainly appear to have occurred quite frequently over a significant period. Indeed, is anything truly predictable in the world of business? Coca-Cola’s assertion that these charges were not representative of (or relevant to) the company’s underlying operations seem questionable.

Another example of a company successfully defending (also in 2016) its use of restructuring costs is Medtronic plc (NYSE:MDT). Medtronic reported restructuring costs in 19 of 21 quarters (Q2 2019 - Q2 2014) for a total of $1.71 billion (or 9.6% of reported GAAP income over the same period). In their defense, Medtronic went on to list the differences in where their restructuring expenses originated, including contract termination costs, shifts in selling strategies, employee terminations, restructuring programs to achieve cost synergies, integration costs, and other program terminations. The firm also stated, “Restructuring charges are not necessary to operate the business and are not necessary to generate revenue,” and just like Coca-Cola, it cited “unpredictability” and “relevance” to core business results.

Despite the explanation that these transactions are not part of the core business operation, their continued recurrence causes us to doubt this explanation. For example, if a company consistently engages in M&A, should restructuring costs (even if they emanate from different acquisitions) be considered an ongoing business expense? We believe so – and in fact for many such “serial acquirers,” M&A is their primary growth strategy. Nevertheless, they typically have been able to skirt such a classification with the SEC.

However, Coca-Cola and Medtronic are far from alone in this practice. In a recent look at the S&P 500 constituents, we found 73 companies (11.9% of the data set) that reported restructuring costs in every quarter going back to Q2 2014. Additionally, 168 companies (40.4% of the data set) reported restructuring costs in at least 15 of the last 21 quarters. Over the five-year period, companies with restructuring costs in every quarter reported a total of $57.6 billion, or 16.0% of their $360.9 billion of total GAAP income over the same period.

Furthermore, there are companies that elect not to engage in the calculation of non-GAAP income metrics. In fact, 200 of our S&P 500 sample did not report any restructuring costs in the five-year period. One of the more surprising companies in this category is Amazon (NASDAQ:AMZN). One might think, given the variety of industries, acquisitions, and operations it takes on, that excluding “unpredictable costs” would be as justifiable for Amazon as any other company. However, Amazon has not reported any restructuring costs in the last five years (and beyond).

Other well-known names without reported restructuring costs include Home Depot (NYSE:HD), Apple Inc. (NASDAQ:AAPL), Costco (NASDAQ:COST), Nike (NYSE:NKE), Boeing (NYSE:BA), Exxon Mobil (NYSE:XOM), and Home Depot (NYSE:HD), among others. In a 2016 article from the Wall Street Journal, Home Depot finance chief Carol Tome reasoned, “By doing this, there is never any confusion about the starting point.” She essentially suggested that adjusting for restructuring costs indeed creates confusion for the investor – precisely one of the tenets that the SEC is charged with enforcing.

Can it be reined in?

While there are companies like Home Depot that elect not to adjust GAAP financials, we are not saying there is no utility in calculating non-GAAP figures. On the contrary, there certainly is. Our issues stem from the habitual exclusions by some companies and the inconsistent enforcement, or even inquiry, from the SEC. Since the beginning of 2017, of the 95 companies we identified in our sample that reported restructuring costs in at least 20 of 21 quarters, just eight were found to have had any correspondence with the SEC.

And of those eight, only two were questioned about their practice of continually excluding restructuring costs from a non-GAAP income calculation. In both instances, each company defended its continual exclusion of those costs with some variation of “non-core”, “non-recurring”, “non-cash”, “comparability,” etc. Again, the frequency of these charges would suggest otherwise.

From what we can find, it does not appear that any company in the last five years has had any significant punitive consequences levied against it for the inappropriate exclusion of recurring restructuring costs from non-GAAP income calculations. And it’s not just restructuring costs that are so questionably excluded – for example, stock-based compensation adjustments are also an issue (as Warren Buffett pointed out in the earlier quote). Why would this be so? Perhaps it is because large companies have such significant resources (both legal and financial) to defend themselves against the vague (and sometimes contradictory) guidelines put forth by the SEC, making successful prosecution or settlement unlikely. Or perhaps it’s simply because investors have not made enough noise about the issue – and ultimately it is investors that the SEC seeks to protect.

So, given the importance non-GAAP metrics have assumed across the investor community and the complexity of the topic, perhaps the SEC should provide a more in-depth analysis and interpretation as to what is appropriate and above board, for the benefit of investors and their difficult investment decisions. In any case, we at Gradient are here to help our institutional investor clients sort it out.