Given all of the rules and interpretations related to non-GAAP measures, as well as the increased regulatory scrutiny, why might companies continue to use them?
The term “non-GAAP” measures is used to differentiate financial reporting metrics that don’t follow generally accepted accounting principles (GAAP) as promulgated by the Financial Accounting Standards Board. Earnings Before Interest, Tax, Depreciation and Amortization (EBIDTA) is one example.
Non- GAAP measures aren't included in GAAP financial statements and aren’t audited—they’re generally in press releases or management discussion and analysis (MD&A).
Non-GAAP Figures Look Better.
According to a PwC webcast, held Sept. 13, studies have shown that the number of S&P 500 companies using non-GAAP measures increased from 232 in 2009 to 334 in 2014. The webcast got its numbers from “The Analyst’s Accounting Observer.”
That type of trend shouldn’t be a surprise because there’s a glaring difference between non-GAAP and GAAP results. Non-GAAP numbers typically place companies in a better light.
Case in point: companies in the S&P 500 earned approximately .5 percent more per share on a non-GAAP basis when compared to the prior year, the PwC discussion revealed. However, under GAAP, the S&P 500 actually fell by approximately 13 percent.
Valuable in the Right Context.
That said, both financial statement preparers and users do often see value in non-GAAP measures when they’re presented in the right context.
Non-GAAP numbers provide additional information to financial statement users so they can better understand a company’s underlying financial performance, liquidity, financial position, or future cash flow prospects, said Beth Paul, a partner in PwC’s national professional services group.
They can also convey change of a business whereby growth is internally driven versus through acquisitions. Furthermore, they can separate things that are unusual or infrequent, and can take out things that maybe don’t have a predictive value.
Of key importance in using non-GAAP metrics, said Paul, is not being misleading, but rather transparent.
The Trump Hotels Example.
The use of non-GAAP measures gained popularity back in the 1990s during the first dot com boom. Technology and internet companies especially that didn’t have significant net income and needed a different way to talk about their potential growth found it attractive, Kevin Garry, senior manager in PwC’s national professional services group said.
This resulted in the SEC issuing cost sharing advice in 2001, Garry said.
One month later the SEC had its first enforcement action for the use of non-GAAP measures. Trump Hotels was charged with issuing misleading earnings release. Specifically, the earnings release cited pro forma figures that touted the company’s positive results of operations, but it failed to disclose that those results were primarily attributable to an unusual one-time gain, rather than to operation.
Then, in 2003, as mandated by Sarbanes Oxley, the SEC adopted Regulation D and Item 10E of Regulation SK.
Next, in 2010, the SEC released compliance and disclosure interpretations (C&DIs) that reflected an evolution in the SEC’s thinking on non-GAAP financial measures, said Garry. Specifically, the SEC wanted to encourage companies to consider the SEC findings as communication vehicles as opposed to compliance exercises.
“The staff tried to encourage companies to be consistent with their use of non-GAAP measures in all their communications, including earnings releases, investor calls, analyst reports and their SEC filings,” Garry said.
To do this, their interpretations removed certain constraints in particular those related to ability to create a non-GAAP measure that excluded items that were non-recurring.
This was done by clarifying that such non-GAAP measures couldn’t be presented, however, the adjustments could not be labeled as non-recurring, if the item occurred in the last two years or was likely to occur in the next two.
Questions to Consider.
Fast forward to a year ago and there’s been renewed SEC focus on non-GAAP measures as companies steadily increased the use and the divide between GAAP and Non-GAAP results began to increase.
The topic was highlighted by SEC Chair Mary Jo White during her key note address at the 2015 American Institute of CPAs national conference.
White said non-GAAP measures were being excessively used, can be a source of confusion and deserve close attention to make sure the rules are being followed.
She also questioned whether current rules at that time were sufficient. White encouraged preparers to consider the following when they use non-GAAP measures:
why is the non-GAAP measure being used and how does it provide investors with useful information;
are non-GAAP measures being given greater prominence than GAAP measures;
is the explanation of the non-GAAP measure and its usefulness to the investors accurate and complete; and
are there appropriate controls over the calculation of the non-GAAP measures?
Other SEC staff, including its chief accountant James Schnurr, reiterated White’s concerns and directives. New non-GAAP interpretations were issued in May 2016.
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