U.S. Generally Accepted Accounting Principles (GAAP) are a set of rules and procedures that accountants typically follow to record and summarize business transactions. These guidelines provide the foundation for consistent, fair, honest and accurate financial reporting. Private companies generally aren’t required to follow GAAP, but many do. Public companies don’t have a choice; they’re required to follow GAAP.
Over the years, the use of non-GAAP measures has grown. These unaudited figures can provide added insight when they’re used to supplement GAAP performance measures. But they can also be used to mislead investors and artificially inflate a public company’s stock price. Here’s more on this controversial trend — and why it’s led to a backlash from some business groups and regulators.
Non-GAAP measures can sometimes mislead investors
Some investors and executives argue that unaudited performance figures, such as earnings before interest, taxes, depreciation and amortization (EBITDA), provide a more meaningful proxy of financial performance than net income as defined in U.S. GAAP. In recent years, however, some companies have manipulated EBITDA figures by excluding certain costs. This trend has made it difficult for analysts to do fair comparisons and understand the items taken out.
Some companies include these EBITDA figures, along with other non-GAAP measures that cast the company in a favorable light, in the management, discussion and analysis (MD&A) section of their financial statements, earnings releases and investor presentations. These unaudited figures may be cherry-picked to present a stronger financial picture than the ones that appear in their audited financial statements. In turn, these companies often see their stock prices go up when the earnings are announced three to four weeks before audited financial statements are filed with the Securities and Exchange Commission (SEC).
Business groups join in
The widespread use of EBITDA has long been the subject of skepticism from investors and regulators. Recently, however, a coalition of more than a dozen corporate and financial industry executives called on companies to rein in their use of non-GAAP measures. The executives included the demand in an open letter entitled “Commonsense Corporate Governance Principles.” The six-point letter covers several areas of corporate governance, including calls for greater corporate board independence and diversity and less focus on quarterly results.
Executives specifically criticized a tendency to exclude stock- or options-based compensation from non-GAAP earnings. “All compensation, including equity compensation, is plainly a cost of doing business and should be reflected in any non-GAAP measurement of earnings in precisely the same manner it is reflected in GAAP earnings,” the letter said.
SEC updates Regulation G
During her keynote address at the International Corporate Governance Network Annual Conference in June, SEC Chair Mary Jo White reiterated her concerns about the use of unaudited performance figures: “In too many cases, the non-GAAP information, which is meant to supplement the GAAP information, has become the key message to investors, crowding out and effectively supplanting the GAAP presentation.”
She identified a number of troublesome practices that can make non-GAAP disclosures misleading, such as a lack of equal or greater prominence for GAAP measures, individually tailored non-GAAP revenues, lack of consistency and the use of cash per share data. She urged audit committees to revisit their approach to non-GAAP disclosures to ensure transparency, consistency and comparability. (See “Questions about non-GAAP measures for audit committees.”)
Just before her keynote speech, the SEC had updated its Compliance and Disclosure Interpretations (C&DIs) for non-GAAP information, laying out the circumstances under which the market regulator could crack down on the figures. While certain adjustments aren’t explicitly banned by the SEC, an adjustment may amount to a violation of Rule 100(b) of Regulation G if it results in a misleading presentation of non-GAAP measures. Regulation G, which went into effect in 2003, set forth disclosure requirements for issuers that use non-GAAP financial measures.
PCAOB project on non-GAAP measures
The Public Company Accounting Oversight Board (PCAOB) has also been reviewing input through its advisory groups about whether auditors should provide some sort of assurance on non-GAAP metrics. Given that the measures move the stock markets, some investors believe auditors should at least review key measures to make sure they are presented fairly.
Some members of the PCAOB’s Standing Advisory Group have suggested that the audit regulatory board tighten the rules around the “read and consider” aspect of auditing that deals with “other information” outside the financial statements. They want auditors to evaluate the consistency of the information within and outside the financial statements. Currently, some non-GAAP information is found in press releases or elsewhere and not considered “other information.”
It remains unclear if the SEC will crack down on the use of non-GAAP figures — or if the PCAOB will change the auditing standards for public companies — given the varying views among investors about the best regulatory responses. But one thing is certain: Non-GAAP measures are under greater scrutiny, so companies that decide to disclose such information should exercise caution and avoid making claims that could potentially mislead investors.
Questions about non-GAAP measures for audit committees
The Center for Audit Quality — an autonomous, not-for-profit public policy organization composed of accounting professionals — has compiled a checklist of possible questions for audit committees to ask management and external auditors before using non-GAAP metrics. Here are 11 of its questions that address the transparency of non-GAAP disclosures:
- What’s the purpose of the non-GAAP measure, and would a reasonable investor be misled by the information?
- Has the non-GAAP measure been given more prominence than the most comparable GAAP measure?
- How many non-GAAP measures have been presented, and are they all necessary and appropriate for investors to understand performance?
- Why has management selected a particular non-GAAP measure to supplement GAAP measures that are already established and consistently applied within its industry or across industries?
- Does the company’s disclosure provide substantive detail on its purpose and usefulness for investors?
- How is the non-GAAP measure calculated, and does the disclosure clearly and adequately describe the calculation, as well as the reconciling items between the GAAP and non-GAAP measures?
- How does management use the measure? If so, has that use been disclosed?
- Is the non-GAAP measure sufficiently defined and clearly labeled as non-GAAP; could it be confused with a GAAP measure?
- Are per-share non-GAAP measures in substance per-share non-GAAP liquiditymeasures, which are prohibited, or could they be used as liquidity measures even if disclosed as a performance measure?
- What are the tax implications of the non-GAAP measure, and does the calculation align with the tax consequences and the nature of the measure?
- Does the company have material agreements, such as a debt covenant, that require compliance with a non-GAAP measure? If so, is it disclosed?
This list isn’t all-inclusive. The Center for Audit Quality provides additional questions that address the consistency and comparability of non-GAAP metrics. Each company requires audit committees to take a customized approach in evaluating whether non-GAAP will enhance GAAP performance measures — or mislead investors into believing a rosier story about the company’s short-term performance than what’s told by U.S. GAAP figures.
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