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Mind the GAAP: How to ensure transparency when using non-GAAP metrics

At Financial Executives International’s Corporate Financial Reporting Insights Conference last November, staff from the Securities and Exchange Commission (SEC) expressed concerns related to the use of financial metrics that don’t conform to U.S. Generally Accepted Accounting Principles (GAAP). Companies continue to have trouble complying with the SEC’s guidelines on non-GAAP reporting, said Lindsay McCord, chief accountant of the SEC’s Division of Corporation Finance.

Here’s some guidance that may help as you prepare your company’s financial statements for the first quarter of 2024.

Ongoing concerns

GAAP is 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 by the SEC 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.

Specifically, companies may include unaudited performance figures — such as earnings before interest, taxes, depreciation and amortization (EBITDA) — to cast the company in a more favorable light. Non-GAAP metrics may appear in the management, discussion and analysis section of their financial statements, earnings releases and investor presentations.

For example, a company’s EBITDA is typically higher than its GAAP earnings. That’s because EBITDA is commonly adjusted for such items as stock-based compensation, nonrecurring items, intangibles and other company-specific items.

In addition, non-GAAP metrics or adjustments may be cherry-picked to present a stronger financial picture than what appears in audited financial statements. Some companies also may erroneously present non-GAAP metrics more prominently than GAAP numbers — or fail to clearly label and describe non-GAAP measures.

10 key questions

The Center for Audit Quality (CAQ) recommends considering the following 10 questions to help ensure transparent non-GAAP metric disclosures:

1. What’s the purpose of the non-GAAP measure, and would a reasonable investor be misled by the information?

2. Has the non-GAAP measure been given more prominence than the most comparable GAAP measure?

3. How many non-GAAP measures have been presented, and are they all necessary and appropriate for investors to understand performance?

4. 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?

5. Does the company’s disclosure provide substantive detail on its purpose and usefulness for investors?

6. 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?

7. How does management use the measure and has that use been disclosed?

8. Is the non-GAAP measure sufficiently defined and clearly labeled as non-GAAP or could it be confused with a GAAP measure?

9. 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?

10. Does the company have material agreements, such as a debt covenant, that require compliance with a non-GAAP measure? If so, are they disclosed?

The CAQ provides additional questions that address the consistency and comparability of non-GAAP metrics.

We can help

Non-GAAP metrics can provide greater insight into the information that management considers important in running the business. However, care should be taken not to mislead investors and lenders. Contact us to discuss your company’s non-GAAP metrics and disclosures.

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