Believe it or not, the most immediate risk to stock prices may have nothing to do with Brexit or a tumultuous presidential election.
Rather, it's some significant and worthwhile changes to corporate financial reporting made by the Securities and Exchange Commission staff back in mid-May. Wait, you missed this? Of course you did.
Who wants to read about changes devised by SEC pencil pushers when you can trade on up-to-the-second news headlines? In short, the SEC updated guidance on companies providing misleading non-GAAP presentations and on those placing greater emphasis in financial releases and during earnings calls on non-GAAP measures relative to comparable GAAP measures. "Whoa" was my initial reaction when I heard of the news.
The updated guidance offers example disclosures that would cause a non-GAAP measure to be more prominent than the most directly comparable GAAP measure. They include:
- Omitting comparable GAAP measures from headlines or captions
- Presenting a non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption)
- Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes non-GAAP over the comparable GAAP measures
- Presenting a full income statement of non-GAAP measures
- Describing non-GAAP measures (e.g., "record performance," "exceptional") without equally prominent description of the comparable GAAP measure
- Providing tabular disclosure of non-GAAP information without including the GAAP information in the same table or an equally prominent tabular disclosure
- Excluding the quantitative reconciliation to the most directly comparable GAAP measure for forward-looking non-GAAP measures due to the "unreasonable efforts" exception of Regulation S-K without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence
- Including unbalanced discussion and analysis of non-GAAP versus GAAP presentations
Although hardly surprising, these changes come as CEOs and CFOs over the last two years have pushed the boundaries of fair reporting (for instance, calling currency fluctuations non-GAAP and advising investors look at "organic" revenue). I still thought "whoa" initially when reading the details. Here is why:
Companies have fluffed up their performance for years by excluding certain "one-time items," in effect training investors to avoid actual performance. Take a look at the last five years of results for videogame manufacturers such as Take-Two Interactive (TTWO), Electronic Arts (EA) and Activision Blizzard (ATVI). These companies have feasted on the ability to neatly present usually rosier non-GAAP earnings in order to win new investors and maintain their investor bases. By forcing them to place equal emphasis on GAAP earnings, the results of many high-flying companies may come under more intense scrutiny.
CEOs and CFOs who love painting amazing pictures of the businesses they oversee will need to talk in a completely different way to investors. Whereas at this time last year a CEO could hop on an earnings call and only focus on more upbeat non-GAAP earnings, now he or she will be forced to speak about the raw business performance. Unfortunately for many companies, that raw business performance may not be so hot, and that could open the door for a whole new range of questions by analysts and investors.
Headlines on corporate earnings releases will need to be written differently by communications teams. That could cause some initial stress for institutions that trade on headlines and media that are covering the results, especially for the news machines that now churn out the first takes on a company's results. Here is a basic example of what could transpire: XYZ Company misses by five cents on a GAAP basis, an outcome that will need to be worked into the press release headline. But, upon greater analysis of the quarter (meaning using non-GAAP measures), it's found the company actually beat earnings estimates by two cents a share amid a decent quarter and share repurchases. In effect, the changes by the SEC staff may add increased volatility to earnings season.
A good test case on how the SEC staff changes will impact investor perception on a company's quarterly performance will be PepsiCo (PEP). The beverage and snack giant reports earnings on Thursday morning. The company has streamlined its earnings releases (at least I think so) over the past two years, with an emphasis on showcasing the performance of the business minus any unusual items. I think the company is still rocking, but it will be interesting to see how the new guidelines alter how performance is presented and the subsequent market reaction.
Either way, best dust off your college accounting book -- it could be an interesting second-quarter earnings season.