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Non-GAAP measures continue to draw attention

Scott Taub | May 17, 2016

When I’m not writing this column, I spend most of my professional time helping companies with difficult accounting and reporting questions. At the end of many of these consultations, my client often has one final question: “Can we non-GAAP this?”

In one regard, it’s an easy question. A non-GAAP measure is a measure of financial performance or cash flows computed in a way that isn’t completely in accordance with Generally Accepted Accounting Principles. Generally, non-GAAP measures are derived by making adjustments to a GAAP measure for a specific item. And there are no laws or regulations that prohibit particular items from being adjusted out of a non-GAAP measure. So I never need to answer “no” when I’m asked that question.

That being said, I also can never just answer “yes.” Because while the rules don’t specify what can and can’t be adjusted for in a non-GAAP measure, they do require that any non-GAAP measure be explained and—here’s the big catch—be useful to investors in better understanding the company. So my response to the “Can we non-GAAP this?” question is some version of “What would be the purpose of making a non-GAAP adjustment for this?” And that, it seems, is a hard question to answer.

Investors have been vocal about their dismay at the increasing frequency of non-GAAP measures (90 percent of public companies, apparently) and the expanding number of adjustments that are included. The chief accountant of the SEC’s Division of Corporation Finance has warned that comment letters focused on non-GAAP measures are forthcoming, and I’ve already seen a few.

So, although I wrote about non-GAAP measures just a few months ago, it’s time to do so again. For those who wonder “Can we non-GAAP this?”, here are my questions in response.

Why do you need to ask?

The answer to “Can we non-GAAP this?” should really be pretty easy to figure out. All we need to do is look at how the non-GAAP measure is defined, and then see whether this item fits into it or not. Unfortunately, many companies define their non-GAAP measure by listing the adjustments. I blame EBITDA. EBITDA is obviously a widely used measure, but its name is just an explanation of how it’s calculated. There’s no hint of its purpose—of what it’s supposed to allow readers to better understand.

The answer to “Can we non-GAAP this?” should really be pretty easy to figure out. All we need to do is look at how the non-GAAP measure is defined, and then see whether this item fits into it or not.

While EBITDA is weak in explaining is what it’s supposed to measure, at least it describes the adjustment—you know what gets added back and what doesn’t. Of course, that certainty means EBITDA is inflexible. Not to worry, as the most common non-GAAP measure these days seems to be “Adjusted EBITDA,” which, as the name suggests, provides all the flexibility one could possibly want. And that leads to the question that started off this column.

Another problem that comes out of measure like “Adjusted EBITDA” is that it isn’t clear what the resulting measure is, other than earnings plus or minus a bunch of stuff that management would rather not be evaluated against. If you can define what the non-GAAP measure actually shows (Core earnings? Free cash flow? Foreign exchange neutral results? Earnings before unusual items?), rather than simply how it is calculated, you’ll be in a position to answer the question of whether something should be adjusted in calculating the measure.

The uncertainty can be remedied if the definition of the measure describes the population of the things that will be adjusted if they occur, rather than simply the items that have been adjusted in the current period. For example, “Core Earnings represents operating income adjusted to remove gains or losses on dispositions of businesses, goodwill impairments, and unusual items (as defined in ASC 225).” A definition like that is helpful in deciding whether a new item that comes up should be adjusted for the non-GAAP measure. And that’s what we should be shooting for. So check the description of your non-GAAP measure—if it merely describes the adjustments you made this period, try to do better. Try to explain the universe of items you will adjust for when they happen.

This will also help to mitigate the tendency to look for negative things each period and consider whether just one more adjustment could be added. That is, of course, what many in the investor community think companies are doing in the first place. And I have to admit—it kind of sounds like that when I’m asked, “Can we non-GAAP this?”

Is this the real life? Is this just fantasy?
 
The other main consideration that comes into play when thinking about whether it is acceptable to make a non-GAAP adjustment for a matter is whether the adjustment tells the reader something useful. After all, given the flexibility of a measure like “Adjusted EBITDA,” we could justify anything. For example, we could conceivably just present a measure that cuts labor costs in half. But it wouldn’t be a useful disclosure, because cutting labor costs in half without affecting the rest of the income statement is not something that could reasonably have occurred.

Along those lines, there are some who believe the SEC staff is uncomfortable with non-GAAP measures that appear to be measures of what the results would be if only costs were less or fulfilling contracts with customers was easier. For example, some companies provide a non-GAAP measure that adjusts out deferred revenue. If revenue has been deferred because services haven’t yet been delivered to the customer, this adjustment is a fantasy.

In contrast, adjusting for revenue that has been deferred not due to performance, but due to extended payment terms or variable consideration might well be acceptable, because those adjustments provide a measure of earnings that will occur after the passage of time, without any further efforts by the company, so long as things play out as expected.

Non-GAAP measures that provide insight into the actual business and operations are good. Measures that show what results might be if things were better than they actually are might be helpful if explained as sensitivity analyses, or in a strategy discussion, but they aren’t measures of the company’s actual performance or cash flow. As Queen said in response to the question leading off this section, “No escape from reality.”

How will you present it?
 
GAAP net income is standardized—non-GAAP measures of income aren’t. Because of that, SEC rules are clear that non-GAAP measures cannot be used with greater prominence than the related GAAP measure. But it happens all the time. For example, does your press release:

  • Mention non-GAAP measure in the headline without mention of the comparable GAAP measures?
  • Discuss non-GAAP measures first, with GAAP measures being acknowledged only at the end?
  • Focus on non-GAAP measures and then describe the adjustments made to get from GAAP to non-GAAP, without ever really spending time discussing GAAP results?

All of these things, which are very common, are violations of the rules. The simple (although not only) solution here is to start with GAAP results, and then discuss non-GAAP results by pointing out the incremental information that can be gleaned from the non-GAAP results. After all, it’s that incremental information that justifies presenting the non-GAAP measure in the first place.

Where do we go from here?

Ok, so that’s not really a question I ask my clients regarding non-GAAP measures. That’s a question about what’s going to happen a year from now, once we see how the renewed focus on non-GAAP measures shakes out.

Although this column has been pretty negative, I actually think non-GAAP measures can be very useful, and I encourage companies to use them. Non-recurring items, non-core items, unusual items, and items that are artifacts of certain GAAP requirements (e.g., revenue deferral due to a fee that isn’t fixed or determinable) are all things that could affect results in a way that might obscure what’s really going on and make predicting future cash flows of the business more difficult. The SEC’s rules provide a lot of flexibility so that companies can adjust for these kinds of items.

I hope regulators don’t feel the need to limit that flexibility, because I fear that will eliminate the ability for companies to present many measures that really are useful. But if the SEC’s efforts to rein in practices that have crossed the bounds of reasonable judgment are unsuccessful, I fear more restrictions will be on the way. That’d be a disservice to companies, investors, and even then FASB, which would be under increased pressure to create GAAP definitions to facilitate reporting, if non-GAAP presentations weren’t allowed. Hopefully, we can find a middle ground before that happens.