Pharma relying more on non-GAAP accounting and the SEC is noticing

accounting

Valeant Pharmaceuticals got chastised by the SEC this year for its use of non-GAAP accounting to make its performance look better than it might have actually been, one in a long list of issues that are dogging the company. But Valeant is far from the only pharma company playing a little loose with the rules and the trend is getting worse, even as investors and the SEC are watching more closely, a Credit Suisse report finds.

GAAP accounting was developed so investors can get an apples-to-apples comparison of how companies are doing quarter to quarter and year after year. But some companies are not all that crazy that the rules make it harder to make themselves look good to investors. Companies have been using non-GAAP measurements, sometimes on individual line items, and the SEC has been taking note of its extensive use these days. In May, the SEC updated guidance on the use of non-GAAP reporting, detailing how it should and--more importantly--shouldn’t be used.

In its report to investors, the Credit Suisse analysts Vamil Divan and Muriel Chen say they have noticed “a meaningful increase in the amount of attention investors are starting to pay to GAAP earnings” after some companies were called out on it by the SEC. The analysts looked at the differences between GAAP and non-GAAP results from 2013 through 1Q 2016 for the 7 largecap pharmas they follow closely.

What they found was that the spread between GAAP and non-GAAP results has widened, with non-GAAP net income about 40% higher than GAAP over the past 13 quarters. Amortization expenses and accounting for tax impacts and business development activities are some of the key drivers of the divergence.

Of the 7 companies, Teva showed the highest spread, with non-GAAP results at more than double, or 225%, of results following GAAP rules. For AbbVie, Pfizer and Merck the spread was more than 50%, while for Eli Lilly and Johnson & Johnson, the spread was less than 50%.

The analysts said they are not making any stock calls based on these differences, but will continue to monitor them on a quarterly basis to see if any of the 7 companies adjust their practices given the increased scrutiny.

The SEC in May made it clear what the rules are and focused on some of the practices it finds most troubling. For example, it does not want companies to come up with their own accounting rules for individual line items, like accelerating revenue that is recognized over time.

In Valeant’s case, the SEC questioned the company's practice of stripping out acquisition-related expenses from its non-GAAP measures--considering “acquisition” has basically been Valeant’s middle name over its past few years of serial dealmaking. The SEC also found “potentially misleading” Valeant’s disclosure of the tax effects of the costs it stripped out of its non-GAAP measures.  

At the time, the drugmaker said it believed its financial reported was “in accordance with applicable SEC rules,” but that in response to SEC concerns, it would change its disclosures in the future.

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