Non-GAAP Financial Measures: Handle with Care

For years, public companies have used non-GAAP financial measures to provide investors, analysts and other financial statement users with a clearer picture of their financial performance. In May 2016, the SEC updated its Compliance and Disclosure Interpretations (C&DIs) regarding non-GAAP measures. Here are highlights of the SEC’s guidance.

Why non-GAAP

Some companies might use non-GAAP measurements if they omit certain noncash or nonrecurring items. Another reason is to present their earnings before interest, taxes, depreciation and amortization (EBITDA).

Companies must still comply with SEC regulations and guidance when presenting non-GAAP measures in their SEC filings, earnings releases and other communications. SEC officials have expressed concern about non-GAAP information that supplants, rather than supplements, the GAAP presentation and makes a company’s earnings appear stronger than they really are. Thus the release of the C&DIs earlier this year.

Presentation and reconciliation

Companies that present non-GAAP financial measures must reconcile those measures to the most directly comparable GAAP financial measures, and present those GAAP measures with “equal or greater prominence.” The C&DIs offer several examples of presentations that give undue prominence to non-GAAP measures, including:

• Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures,
• Presenting a non-GAAP measure using a style (bold or larger text, for instance) that emphasizes it over the comparable GAAP measure,
• Presenting non-GAAP measures so that they precede their most directly comparable GAAP counterparts,
• Characterizing a non-GAAP measure as “record performance” or “exceptional” without an equally prominent description of the comparable GAAP measure,
• Providing a table of non-GAAP measures that’s not preceded by an equally prominent table of comparable GAAP measures or that doesn’t include comparable GAAP measures in the same table, and
• Providing discussion and analysis of a non-GAAP measure without an equally prominent discussion and analysis of the comparable GAAP measure.

Whether a non-GAAP measure is more prominent than the comparable GAAP measure depends on the facts and circumstances surrounding the disclosure.

Misleading revenue measures

Certain adjustments to GAAP numbers, even if not expressly prohibited, may result in misleading non-GAAP measures. For example, performance measures that exclude normal, recurring cash operating expenses necessary to operate the business can mislead investors.

If your measures omit nonrecurring charges but not nonrecurring gains during the same period, this may create misleading numbers. If you present measures inconsistently between periods, you must properly disclose the changes and the reasons for them. Depending on the significance of a change, it may be necessary to recast prior measures to conform to the current presentation.

Generally, companies can’t use non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those prescribed by GAAP. This prohibition may also extend to financial statement line items other than revenue.

Per-share measures

The SEC recognizes that certain non-GAAP per-share financial measures may be of value, provided they’re reconciled to GAAP earnings per share. But it prohibits the presentation of non-GAAP liquidity measures, such as “free cash flow,” on a per-share basis.

Whether per-share presentation is allowed depends on whether a non-GAAP measure can be used as a liquidity measure, regardless of how it’s characterized. So, for example, it appears that non-GAAP measures such as EBITDA and EBIT may not be presented on a per-share basis.

Free cash flow

Companies can present a measure of “free cash flow” — typically calculated by taking cash flows from operating activities as presented in the GAAP statement of cash flows and subtracting capital expenditures. However, given the lack of a uniform definition of the term, the financial statements should include a description of how the measure is calculated together with the appropriate reconciliation.

Also, to avoid misleading financial statement users, companies shouldn’t inappropriately imply that free cash flow represents the residual cash flow available for discretionary expenditures, since many companies have mandatory debt-service requirements or other nondiscretionary expenditures that they don’t deduct from the measure.

The SEC is watching

Given the SEC’s renewed interest in non-GAAP financial measures, you can expect it to scrutinize these measures and to take action when it feels that financial statements are misleading or overemphasize non-GAAP measures. Audit committees should pay close attention to these issues and put processes in place to ensure that non-GAAP measures are appropriate and reliable.

Non-GAAP tool for audit committees

To help audit committees fulfill their obligation to ensure that non-GAAP financial measures comply with SEC regulations, the Center for Audit Quality (CAQ) has issued Questions on Non-GAAP Measures: A Tool for Audit Committees.

The tool includes questions designed to foster a dialogue that will help audit committees understand management’s reasons for using non-GAAP measures and evaluate whether those measures are reasonable, consistent and compliant with SEC regulations. The questions are divided into three categories: transparency, consistency and comparability. The tool also includes several procedural questions that apply to all three categories.

The CAQ’s goal is to help audit committees determine:

1. Whether management is complying with SEC rules and related interpretations regarding non-GAAP measures, and
2. Whether non-GAAP measures are aiding investors and analysts in understanding the company and its performance.

You can find the tool at http://www.thecaq.org/questions-non-gaap-measures-tool-audit-committees.

© 2017