Mind the (non-)GAAP

The Securities and Exchange Commission recently brought its first enforcement action under Regulation G. [SafeNet, Inc. Litig. Rel. No. 21290]. Although the SEC’s complaint alleges multiple intentional violations of the federal securities laws, including improper accounting and backdating of options, a review of the Regulation G elements of the action provides useful guidance for public companies that regularly use non-GAAP financial measures when discussing their operating results.

The SEC complaint noted that SafeNet issued earnings guidance on both a GAAP and non-GAAP basis. Regulation G applies whenever a reporting company discloses publicly any material information that includes a non-GAAP financial measure, which is a measure of financial performance or position that is not calculated in accordance with generally accepted accounting principles in the United States (GAAP) and that makes adjustments to the most directly comparable GAAP financial measure. Regulation G requires a reconciliation of the non-GAAP and comparable GAAP measures and prohibits reporting companies from providing investors with false or misleading presentations of non-GAAP financial measures.

SafeNet, like many public companies, excluded integration costs for recent acquisitions from its presentation of non-GAAP earnings. The SEC’s complaint alleges that over several quarters in 2004 and 2005, SafeNet, in order to meet its non-GAAP guidance and Wall Street estimates, deliberately misclassified ordinary operating expenses as integration expenses to exclude them from SafeNet’s non-GAAP presentation of net earnings. For the second quarter of 2005, SafeNet continued to exclude misclassified operating expenses and adopted three new categories of “non-recurring” expenses to justify its non-GAAP adjustments to earnings.

The SEC alleged that SafeNet’s actions, together with its other illegal acts, resulted in SafeNet disseminating non-GAAP earnings measures that violated Regulation G. SafeNet and its responsible officers and other employees, without admitting or denying the allegations in the SEC’s complaint, agreed to permanent injunctions against future violations of the federal securities laws, including Regulation G, fines and disgorgements and, in the case of the individuals, bars against them acting as officers or directors of a public company or from appearing or practicing before the SEC.

It would be tempting to dismiss SafeNet due to the deliberate fraud alleged. Public companies and the audit committees that oversee their financial disclosures, however, should consider the lessons flowing from the enforcement action. 

• Take care to analyze and document the rationale for excluding expenses from the calculation of a non-GAAP financial measure. The complaint repeatedly pointed out that the officers and employees of SafeNet did not conduct any analysis or cite any accounting principles to support their exclusion of expenses from the calculation of non-GAAP earnings. A public company that is presenting a non-GAAP financial measure should be sure to conduct a complete analysis of all the adjustments to GAAP financial measure and to document the conclusions of the analysis in the company’s records.
  
  
• Do not exclude ordinary course operating expenses. Excluding ordinary course operating expenses from non-GAAP financial measures may likely result in a misleading presentation in violation of Regulation G, with the notable exception for non-cash charges for stock-related compensation. 
  
  
• A non-ordinary course event does not convert ordinary operating expenses into one-time charges or “non-recurring” expenses. The SEC rejected SafeNet’s attempt to use acquisitions or purported plans to change its business as justifications for reclassifying ordinary operating expenses as one-time charges or “non-recurring” expenses. 
  
  
• Establish guidelines for adjustments included in non-GAAP financial measures. For a public company that issues non-GAAP financial measures, the audit committee should review the analysis in support of the proposed adjustments and establish guidelines for the categories of adjustments that may be used by the public company. These guidelines should be reviewed periodically and updated if a new category of adjustments is proposed by management.