Accounting Insights: Non-GAAP Measures Can Shape Decisions and Inform Investors

Within many organizations, the office of the CFO is already compiling a lot of non-GAAP information to help management make decisions. US regulators are also guiding companies to provide more clarity on how business decisions are being made – especially as organizations now have the option to disclose more than one non-GAAP measure in their financial statements. These disclosures are an exercise in transparency, benefiting investors with deeper insights into the business.

For accounting teams, it’s essential to consider the implications of popular non-GAAP metrics used to make decisions and to tackle non-GAAP matters related to segment reporting —which has received considerable attention from regulators and stakeholders in recent months. While non-GAAP disclosures are not mandatory for private companies’ financial statements, alignment with industry best practices will ensure clarity and comparability for their stakeholders.

While the office of the CFO uses the information to assess operating results and make decisions, the chief accounting officer or controller’s group will be responsible for the inputs to the non-GAAP measures, ensuring that the information is accurate. For financial reporting purposes, the accounting team is also responsible for ensuring disclosures are in line with the requirements of the US Securities and Exchange Commission. Although there aren’t strictly defined requirements for what information can be presented, it’s important that disclosures are in line with the expectations set by the SEC’s staff.

Non-GAAP vs. GAAP: Key differences and reasons for reporting

US public companies must adhere to generally accepted accounting principles (GAAP), which is a standardized approach to accounting, and investors rely on US GAAP-compliant financial reports to gauge a company’s health.

For decision-makers and many stakeholders, non-GAAP reporting offers more flexibility than the disclosures required under GAAP. For example, it allows companies to exclude one-time expenses or adjust for specific business models, which in some cases can provide investors with a clearer view of ongoing operations. The variability of and lack of an audit requirement for non-GAAP measures (and the potentially inconsistent approach to presenting these measures) can make the comparison between companies difficult for investors and stakeholders. Understanding the appropriate ways to use both GAAP and non-GAAP measures is key to a well-rounded view of a company’s outlook and performance.

Non-GAAP reporting is prevalent, with nearly all public companies reporting both GAAP and non-GAAP earnings to:

• Provide a comprehensive view of their financial health
• Show industry-specific performance metrics to investors and analysts
• Make adjustments for one-time expenses to provide a baseline view of company results, such as one-time acquisition costs, research and development costs, and stock-based compensation

By excluding certain one-time costs, non-GAAP results offer a nuanced view that sheds light on a company’s management methodology and operational trends.

Non-GAAP measures: What’s allowed?

In December 2022, the SEC published Compliance & Disclosure Interpretations (C&DIs), which provided management teams with additional guidelines for the presentation of non-GAAP measures. Although this guidance is for public companies presenting non-GAAP measures in their public filings, there are many private companies that present results to shareholders, banks, and other investors using non-GAAP measures. These C&DIs —which focus on whether a non-GAAP measure is inconsistently reported or creates a misleading metric— can be used as guidelines for both public and private companies as they are considering what non-GAAP measures to present.

When presenting non-GAAP measures (although the guidance isn’t as rigid as those under GAAP), there is still an expectation that the information will not mislead investors and that it still appropriately represents the health and performance of the company. This is a hot topic of particular interest to the staff at the SEC and has historically been a main topic of comment letters that have been issued. When thinking through what non-GAAP measures a company would like to present, management teams should consider areas that commonly result in comment letters.

Individually tailored accounting principles

Individually tailored accounting principles are scenarios in which management teams present results that modify GAAP recognition and measurement principles to report a company-specific metric that could be misleading. An example of one such measure would be presenting revenue on a cash basis rather than an accrual basis. If revenue were to be presented for a subscription-based revenue stream based on cash receipts (rather than over the time of the subscription period), this would be considered an individually tailored accounting principle.

It can be challenging to identify individually tailored accounting principles, especially when management uses certain metrics internally that may not be based on GAAP. Accounting teams should think about whether the company’s proposed metric changes the recognition and measurement of a financial statement line item in a way that departs from GAAP and may create a metric that is misleading. Practically speaking, any adjustment to a component of a calculation (rather than the calculation itself) may be determined to be an individually tailored accounting principle.

Normal and recurring expenses

Another consistent topic of SEC comment letters is what is being identified as a normal and recurring expense. One of the most common adjustments is to remove irregular or nonrecurring expenses from results to show how the company would have operated in a “normal” period without those one-time costs.

Here, it’s important to consider that “normal and recurring” can be highly industry-specific. For example, retailers who frequently open and close stores would not be able to identify those costs as unusual or infrequent, whereas costs to open or close a plant or location that is significant to a business would be considered one-time costs that would be appropriate to exclude.

Sufficient and clear presentation of non-GAAP measures

One of the benefits of presenting non-GAAP measures is that it provides an opportunity for management teams to give investors additional insights into how management views the business. Here, bias is a concern because the lack of a comprehensive basis of accounting governing non-GAAP measures allows a significant degree of subjectivity in how these metrics are computed. This degree of subjectivity, without meaningful governance and oversight, lends itself toward an inconsistent application of the calculations or opaque adjustments labeled as “nonrecurring” or “other” that minimize the impact of items specific to a company’s results, which creates an increased risk that these metrics could be misleading to investors.

Any non-GAAP measure that’s presented needs to have a clear reconciliation to a GAAP measure, with the GAAP measure being shown with prominence, as well as a sufficient explanation of the adjustments made to get to the non-GAAP metric.

This “prominence” rule is one of the most common comment areas for a company using non-GAAP measures.

Popular non-GAAP metrics

The world of non-GAAP metrics is vast, but some measures are more commonly used than others.

EBITDA

One of the most often reported non-GAAP metrics in company financial statements is EBITDA (earnings before interest, taxes, depreciation, and amortization). Non-GAAP measures, including EBITDA, usually exclude nonrecurring or non-cash expenses, enabling investors to focus on operational performance.

Adjusted earnings

Some companies use non-GAAP adjustments like adding back intangible asset write-offs or excluding restructuring costs to present a different perspective on profitability or core business performance. Non-GAAP earnings descriptions can vary and include terms such as adjusted, underlying, comparable, core, and recurring earnings. Additionally, companies will commonly report these adjusted earnings on a per-share basis.

Free cash flow

Free cash flow (FCF) illustrates the cash flows a company generates that are available for distribution to all security holders, providing an important profitability lens beyond what is conveyed in the income statement alone.

Segment reporting

In addition to consolidated reporting, management teams will also present the non-GAAP measures at the segment level. Among accounting professionals and regulators, there has been much discussion around non-GAAP measures as it relates to segment reporting. The new guidance in ASU 2023-07 provides management teams with the ability to present more than one measure of segment profit or loss, including a non-GAAP measure, in the financial statements if it is used by the chief operating decision-maker. While the new ASU allows for the presentation of more than one measure of segment profit or loss, it isn’t a requirement, and any additional non-GAAP measure presented must follow all SEC reporting guidelines.

For segment reporting or any other non-GAAP measures reported by companies, the SEC aims for more consistency and comparability across companies and industries. This ensures investors have the information they need to make informed decisions and minimizes the potential for misleading practices.

Best practices for reporting non-GAAP measures

For companies looking to effectively utilize non-GAAP measures, accounting and financial reporting professionals can follow these best practices:

• Develop a non-GAAP measure reporting policy: This policy should clearly identify the non-GAAP measures being used by the company, how they are computed (including the specific adjustments made), and the source data used for those adjustments.
• Benchmark against competitors: If a company is the only one in its industry using a particular non-GAAP measure, the information loses value for comparison purposes. Accounting and financial reporting teams should look at what metrics competitors are using to ensure the company’s information enables meaningful analysis by investors.
• Review adjustments for recognition and measurement changes: Accounting teams shouldn’t just focus on what’s being added back or removed. They should scrutinize the adjustments to see if they fundamentally change how income or expenses are recognized or measured according to GAAP principles to avoid creating an individually tailored accounting principle.

By following these practices, companies can ensure their non-GAAP measures provide investors and stakeholders with valuable insights without sacrificing transparency.

Ultimately, as SEC guidance continually evolves based on market developments and feedback, it remains important for the office of the CFO to stay updated on new pronouncements and evaluate how the changes apply to the unique needs of each organization.