The Right Way to Think about Non-GAAP Measures
IMGCAP(1)]The regulatory focus has sharpened recently on non-GAAP measures, by which I mean financial metrics, presented by companies outside the audited financial statements, that do not conform to GAAP. Across the financial reporting world, discussion around this issue has been percolating for years. At a 2014 investor relations conference, for example, I moderated a lively panel titled, “Non-GAAP Financial Measures: Useful Tool or Smokescreen?”
That panel’s title was provocative, in that it suggested an either/or dichotomy — it seemed to frame the issue as a question of whether non-GAAP measures are either good or bad. The reality, of course, is more nuanced. It all depends on how they’re used.
So how can key players in the financial reporting process — management, audit committees, external and internal auditors — stay on the good side of non-GAAP use? In my view, they should approach these measures armed with questions and an adherence to three fundamental principles.
PRINCIPLE ONE: TRANSPARENCY
Promoting transparency for investors should be a top priority. Non-GAAP financial measures should be presented to supplement GAAP measures, and their purpose and calculation should be clear to investors. Non-GAAP financial measures included in filings with the Securities and Exchange Commission or otherwise released publicly should be clearly labeled as non-GAAP and not given any more prominence than their closest GAAP measures.
While not an all-inclusive list, here are a few transparency-related questions for all in the reporting process to keep in mind:
What is the purpose of the non-GAAP measure? Would a reasonable investor be misled by the information?
Does the disclosure provide substantive detail on the purpose and usefulness of the non-GAAP disclosure for investors?
How is the non-GAAP measure calculated? Does the disclosure clearly and adequately describe the calculation as well as the reconciling items between the GAAP and non-GAAP measure?
PRINCIPLE TWO: CONSISTENCY
Non-GAAP financial measures should be consistent and accurate indicators of a company’s performance. They should not be calculations solely aimed at showing the company in a favorable light.
Unfortunately, some companies fall short on this principle. Researchers at the University of Washington and the University of Georgia, for example, found that a significant number of companies disclose non-GAAP earnings figures that exclude one-time losses — while not similarly reporting adjusted figures for one-time gains. (Their paper is available at http://faculty.washington.edu/smcvay/CMW_2014.pdf.)
Questions like the following can help promote consistency:
Are the non-GAAP measures presented by the company balanced? Do the measures eliminate similar items that effect both revenue and expense, or do they only eliminate one or the other?
Has the company presented this measure before? Has the company stopped presenting certain measures?
Has the method or nature of the inputs to the calculation changed since the last time it was presented? If so, why and have the comparable periods been revised consistently?
PRINCIPLE THREE: COMPARABILITY
There is no authoritative framework that defines the calculation of each non-GAAP financial measure. This allows for flexibility, in that it enables non-GAAP financial measures to be tailored from one company to the next. However, the more tailored the calculation, the less comparable the measure may be across an industry. Comparability over time is another key consideration. The less comparable the measure, the more confusing it may be to investors. Here are a few questions to counter the confusion:
Do other companies present this measure or similar measures? If not, why is this measure important for this company but not its peers?
Is management aware of differences in their calculation compared to other companies? Why are the calculations different?
If there are differences from peers, is the disclosure transparent about how the measure is calculated differently than peers?
Like so many issues in financial reporting, the use of non-GAAP financial measures requires robust communication and dialogue. Asking questions like the ones above will help spur that dialogue and make sure all of us approach non-GAAP financial measures with a probing, principled mindset.
Cindy Fornelli has served as the executive director of the Center for Audit Quality since its establishment in 2007. A new CAQ publication, Questions on Non-GAAP Measures: A Tool for Audit Committees, is available free of charge on the CAQ Web site.