Accounting 300 words. 3hrs

OCTOBER 2015 / THE CPA JOURNAL48

What is a non-GAAP performance financial measure?Regulation G defines it as a number representingcompany’s historical or future financial performance, financial position, or cash flows that excludes amounts other- wise included in—or includes amounts otherwise excluded from—the most directly comparable U.S. GAAP measure.

Generally, when a non-GAAP financial measure is pub- licly disclosed, it must be accompanied by both the most direct- ly comparable GAAP measure and a reconciliation between the two amounts. In addition, when presented in an SEC fil- ing, Item 10(e) of Regulation S-K requires that this disclo- sure include a description of the reasons that management believes the non-GAAP measure is useful to investors and, if applicable, an explanation of the purpose for which manage- ment uses the non-GAAP measure. (Item 10[e] does not pro- hibit presentation of a non-GAAP measure that is not used in managing the business.)

As it applies to a non-GAAP performance measure (i.e., an alternative to GAAP earnings), Item 10(e) expressly prohibits eliminating or smoothing items identified as “non-recurring,” “infrequent,” or “unusual” when there has been a similar charge or credit within the prior two years or the nature of the charge or credit indicates that it is likely to occur again within the ensu- ing two years. While it is inappropriate to state that a charge or credit is nonrecurring, infrequent, or unusual because it does not meet the two-year threshold, the fact that a charge or credit can- not be so described does not, of itself, mean that an adjustment to eliminate it may not be made; in other words, a company may make any adjustment it believes appropriate, subject to Regulation G and other Item 10(e) requirements. THE PROLIFERATION OF NON-GAAP PERFORMANCE MEASURES

Non-GAAP performance measures have been around since the 1960s, when they were referred to as “pro forma earnings” and included mainly in earnings announcements. When the SEC issued Regulation G and Item 10(e) in January 2003, to implement section 401(b) of the Sarbanes-Oxley Act, it replaced the term “pro forma financial information” with the more focused term "non-GAAP financial measure.” Such mea- sures have since become a prominent part of the performance narratives of more and more U.S. and foreign companies.

The companies that present non-GAAP performance met- rics [e.g., earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization ( EBITDA), adjusted EBITDA] believe that they provide insight into a company’s core operations beyond one-size-fits-all GAAP and, as such, afford investors a view of a company through management’s eyes. Many companies using non-GAAP performance metrics believe that, by doing so, they are furnishing investors with a better understanding of the busi- ness, resulting in a reduced cost of capital. Indeed, a recent Price water house Coopers survey revealed that nearly 60% of IPOs over the past three years included at least one non-GAAP performance measure, with nearly two-thirds of such measures focusing on EBITDA or a variation thereof.

The perceived value of non-GAAP performance measures is by no means one-sided, and there is widespread interest in adjusted GAAP earnings among providers of both equity and debt capital as well. In 2001, Standard & Poor’s formalized the concept of core earnings to arrive at an entity’s profit from ongoing, underlying activities, and it has since incorporated core earnings into its ratings process. Moody’s performs a sim- ilar analysis. Another recent PricewaterhouseCoopers global survey of investment professionals revealed that investors do, in fact, value non-GAAP financial measures; they like being able to see management’s view of what is core to the company. GLOBAL FLEXIBILITY

Recognizing the growing use of non-GAAP metrics, vari- ous securities regulators around the world (including those in the EU, Canada, Australia, and New Zealand) have issued guidelines or rules covering their presentation. Although their rules necessarily differ in some respects from the SEC’s rules (and from one another’s), international regulators have, by and large, taken the SEC’s lead and chosen to treat such mea- sures with a light touch to permit companies the flexibility to present non-GAAP performance measures as they see fit.

In a very real sense, this approach is not unlike the funda- mental notion underlying U.S. GAAP and International Finan- cial Reporting Standards (IFRS) regarding segmental report- ing: Under both sets of standards, an operating segment is

C O L U M N S s e c i n s i g h t s

Non-GAAP Performance Measures By Allan B. Afterman

Virtue or Vice?

defined as one whose operating results are regularly reviewed by the company’s chief operating decision-maker to assess the performance of the individual segment, and to make decisions about resources allocated to the segment. Defin- ing a segment this way is intended to provide financial state- ment users with management’s perspective. PROS AND CONS

There is no lack of criticism of non-GAAP performance metrics. Some critics have labeled them as “income before the bad stuff,” and a large body of evidence supports the con- tention that companies present non-GAAP earnings oppor- tunistically to overturn a GAAP loss, to report positive earn- ings growth (when growth is negative on a GAAP basis), and to meet or beat the earnings consensus when the GAAP surprise itself is negative. Substantial evidence also shows, however, that the quality of non-GAAP earnings has improved considerably since Regulation G was issued, attributable in large part to the requirement to reconcile non-GAAP metrics to the most directly comparable GAAP measure. On the pos- itive side, there is evidence that, because non-GAAP earn- ings are likely to exclude transitory items, non-GAAP report- ed amounts tend to be a better predictor of future earnings and cash flows. ADJUSTED EBITDA, A FAVORITE OF FILERS

A recent study of 40 U.S. companies (conducted by the author) showed that adjusted EBITDA was one of the most frequent non-GAAP performance measures presented in SEC filings. In 2010, the SEC staff clarified that non-GAAP mea- sures calculated differently from pure EBITDA (i.e., that exclude items other than interest, taxes, depreciation, and amor- tization) may be presented as performance measures, but they must be characterized as different from—and their titles distinguished from—EBITDA; the SEC staff suggested adjust- ed EBITDA as an umbrella term.

The study revealed that the most frequent items subtracted from or added to net income to arrive at adjusted EBITDA (i.e., to reconcile to the most directly comparable GAAP mea- sure) were as follows: n Stock compensation n Asset impairment charges and write-offs n Merger and acquisition related costs n Restructuring charges n Losses on debt extinguishments n Changes in fair values of assets and liabilities n Gains or losses on the sales of assets.

Overall, there were more than 30 different types of recon- ciling items, including some as company-specific as changes to the last-in, first-out (LIFO) reserve, the cost of a non- recurring audit of internal controls, the effect of the 53rd week in a 52/53-week fiscal year, litigation costs, and the effects of volatility in pension expense due to fluctuations in the finan- cial markets. The sheer number of reconciling items reflects

both the flexibility management has in arriving at its version of core earnings and the difficulty regulators face in estab- lishing hard-and-fast rules about the selection of items. WHAT INVESTORS WANT; HOW COMPANIES RESPOND

A major drawback of non-GAAP performance measures is that they are not likely to be comparable with those of other companies, even those in the same sector or industry. Of course, this same criticism could also be leveled at pure GAAP earnings, which—because of company-specific facts and cir- cumstances—often make unadjusted comparisons meaning- less. Investors understand that the lack of comparability among non-GAAP performance metrics is the byproduct of manage- ment’s flexibility. Nevertheless, most investors agree that their value could be enhanced if they were to be accompanied by clear explanations of the reconciling items and the rationale for including or excluding them, and a discussion of the manner in which the non-GAAP measure is utilized by man- agement in operating the business. WHAT’S IN A NAME?

Though regulators have chosen to steer clear of prescribing the nature of specific reconciling items that may properly be included or excluded in arriving at a non-GAAP performance measure, it is my opinion that the reliability and credibility of any such metric would be strengthened by an appropriate and uniform name. As a term, adjusted EBITDA is overly gener- al and insufficiently descriptive of what it is intended to con- vey. The terms “core earnings” and “underlying profit” (the latter is popular in Australia, New Zealand, and Europe) bet- ter characterize management’s intentions. A PROMISING FUTURE

FASB has undertaken a research project aimed at improving the relevance of information presented in the income statement, which includes developing a framework for defining operating activities and distinguishing between recurring and infrequent items. At least one FASB member, Marc Siegel, who happens to represent the investor community on the board, has been quot- ed as saying that, because they complement each other, the com- bination of GAAP and non-GAAP metrics represents a power- ful analytical tool in understanding a company’s underlying business. Siegel notes that empirical research does not indicate that the demand for non-GAAP information points to a funda- mental GAAP recognition and measurement problem; instead, it points to a need for better organization and presentation of per- formance information. This sounds like a plan. q

Allan B. Afterman, PhD, CPA, is the author of numerous treatises on financial reporting and SEC practice and has con- sulted with governments on the establishment of national secu- rities laws and financial reporting standards. He is a former adjunct professor in the Booth School of Business at the Uni- versity of Chicago, and was assistant to the national director of SEC practice at a major public accounting firm.

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