Not Requiring the Amortization of Capitalized Interest Disclosure Is Not Good for Investors
With the SEC’s Disclosure Update and Simplification (Release No. 33-10532; 34-83875; IC 33206; File No. S7-15-16), regulators reduce the disclosure requirements for companies and make it more difficult for investors to analyze the true financial health of publicly-traded companies. The goal of this report is to raise awareness for both regulators and investors of how this change in disclosure affects average investors.
The purpose of the Financial Accounting Standards Board (FASB) is to write and update Generally Accepted Accounting Principles (GAAP) or the rules that govern how publicly-traded companies report their financials. The role of the Securities and Exchange Commission (SEC) is to enforce those rules.
The integrity of the capital markets relies on the FASB and the SEC to do their jobs well. If FASB does not ensure that financial disclosures provide investors the information needed to make informed decisions or the SEC does not enforce compliance with GAAP’s disclosure rules, investors lose.
During my tenure on FASB’s Investor Advisory Committee, it was clear that companies often have more influence on FASB and the SEC than individuals because companies can consolidate more resources and present a more unified voice than investors. In addition, many of the potentially most influential investors prefer less informative financial disclosures because poorer disclosures further enhance their already-strong information advantages.
Background on The Change
The change made by the SEC is intended to reduce the cost of filing for reporting entities by eliminating what the SEC considers redundant or unimportant disclosures. However, one specific change in the Disclosure Update and Simplification eliminates an important disclosure – amortization of capitalized interest– which investors need to accurately assess earnings and cash flow.
SEC Reduced Disclosure Amendment
Effective November 18, 2018, the SEC adopted amendments to disclosure requirements that “have become redundant, duplicative, overlapping, outdated, or superseded, in light of other Commission disclosure requirements, U.S GAAP, or changes in the information environment.”
Through this amendment, the SEC eliminated the requirement that companies report the ratio of earnings to fixed charges exhibit. This exhibit contains a specific line item, amortization of capitalized interest, which is a non-operating expense included in operating earnings. We remove this expense when calculating after-tax operating profit (NOPAT) because it is related to the financing of a company’s operations, not the operations themselves, to provide a more accurate measure of normal, recurring profits.
Most of the time, interest costs are immediately expensed and (for non-financial companies) reported as non-operating. However, in certain cases where debt is used to finance a long-term asset, accrued interest can be capitalized on the balance sheet and expensed as amortization over time. As a result, GAAP allows the cost of interest to be classified as an operating expense, despite the fact that it is really a financing cost.
The SEC specifically noted in its final rule that:
“Certain components commonly used in the ratio of earnings to fixed charges, such as the portion of lease expense that represents interest and the amortization of capitalized interest, are not readily available elsewhere.”
Despite its acknowledgement that the exhibit contained material information not contained elsewhere, the SEC still decided to remove requirements to disclose this information.
Impact of This Change
Figure 1 shows the five companies with the largest amortization of capitalized interest adjustment overall, and the five with the largest value as a percent of NOPAT. With the removal of this disclosure, we will no longer be able to make this adjustment for the majority of firms going forward.