When the SEC criticized Valeant Pharmaceuticals over its use of non-GAAP reporting, it seemed like a regulator barking at a company known for pushing the limits. But now the agency has fired a warning shot across the bow of the industry, saying in a letter to Allergan that it intends to examine how the industry is potentially exploiting the practice.
Generally accepted accounting principles, or GAAP, is the system that public companies are expected to use so that investors 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 about the rules because they make it harder to look good to investors. So some companies have been using non-GAAP measurements, sometimes on individual line items.
In its Jan. 11 letter to Allergan CFO Maria Teresa Hilado, the SEC admonished the company for using non-GAAP in reporting its earnings per share, which Allergan considers “solely a performance measure.” While other companies may do the same thing, the SEC said, it didn’t mean the departure from GAAP is “common,” and the agency said it didn’t agree with its use that way.
Then came the zinger. “Finally, in light of our discussions about this matter, we will evaluate the industry practices you described to us and consider whether additional comprehensive non-GAAP staff guidance is appropriate,” the agency said.
In an emailed statement today, Allergan said that as a result of the SEC comments, "beginning with the Company’s fourth quarter and full year 2016 financial results reported on February 8th, 2017, Allergan changed the nomenclature regarding earnings per share (to Performance Net Income Per Share, from called Adjusted Non-GAAP Earnings Per Share) to better reflect the fact that it is simply a measure that management uses to evaluate its performance. The metric and calculation for this measure did not change. We believe this matter is considered closed with the SEC."
For a year, the Securities and Exchange Commission has focused on the use of non-GAAP measures. Last year it chastised Valeant Pharmaceuticals for stripping out acquisition-related expenses from its non-GAAP measures. But Valeant may have had deeper accounting problems. Federal prosecutors have reportedly also been building a criminal case for potential accounting fraud associated with the Canadian drugmaker’s relationship to now-dead specialty pharmacy Philidor.
While Valeant may have pushed accounting limits to the legal breaking point, the SEC has also noticed that other drugmakers are regularly using non-GAAP measures it considers questionable. Last year the agency updated guidance on the use of non-GAAP reporting, detailing how it should and—more importantly—shouldn’t be used. For one, 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.
After the SEC started calling out some companies on the practice, last year Credit Suisse analysts Vamil Divan and Muriel Chen evaluated just how much difference there was in GAAP and non-GAAP results for the seven large-cap pharmas they follow closely. They looked at results from 2013 through the first quarter of 2016.
They determined that the spread between GAAP and non-GAAP results has widened, with non-GAAP net income about 40% higher than GAAP over the previous 13 quarters. Of the seven companies they looked at, 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%.
Editor's Note: The story was updated with a comment from Allergan.