Abstract: Public entities and many private ones follow U.S. GAAP for financial reporting purposes. But some may use non-GAAP metrics in their disclosures and press releases or when applying for financing. These metrics are a frequent area of focus by the SEC and other regulators. This article explains the role non-GAAP metrics play in financial reporting and how misuse of these unaudited figures can sometimes mislead stakeholders. A sidebar discusses a recent request from a state CPA board to create a slimmed-down package of accounting rules for U.S. private companies, similar to the rules under the International Financial Reporting Standards for Small and Medium-Sized Entities.
Public entities and many private ones follow U.S. Generally Accepted Accounting Principles (GAAP) for financial reporting purposes. But some may use non-GAAP metrics in their disclosures and press releases or when applying for financing. These metrics are a frequent area of focus by the Securities and Exchange Commission (SEC) and other regulators.
Comparing GAAP vs. Non-GAAP metrics
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.
However, the use of non-GAAP measures has grown in recent years. These unaudited figures can provide 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. For example, companies may use earnings before interest, taxes, depreciation and amortization (EBITDA) to cast the company in a more favorable light than net income does.
Non-GAAP figures may be cherry-picked to present a stronger financial picture than the ones that appear in their audited financial statements. In turn, these companies often see their stock prices go up when the earnings are announced three to four weeks before audited financial statements are filed with the SEC.
Increasing comment letters
The SEC Division of Corporation Finance (CorpFin) sends out staff comment letters to public companies when they find deficient disclosures. In October, at the SEC Speaks 2021 conference, Chief Accountant of CorpFin Lindsay McCord reported a continued increase in comment letters related to the use of non-GAAP metrics. She took an example of how companies have been increasingly adjusting EBITDA for such items as stock-based compensation, revenue recognition methods and other company-specific items.
In general, CorpFin staff doesn’t object to the presentation of adjusted EBITDA. Rather, comment letters typically focus on compliance with non-GAAP rules, regulations and guidance. In certain circumstances, companies are allowed to use non-GAAP metrics outside the financial statements, because it helps management explain the company’s financial conditions to Wall Street analysts.
The use of non-GAAP metrics is voluntary, but most large companies tout them during quarterly earnings calls. Still, companies must follow the rules that govern adjusted GAAP. In particular, disclosures about the adjustments must be clear, transparent and in sufficient detail for an investor to understand all material components.
Measuring COVID effects
The pandemic has also brought attention to this subject. Many companies have been confronted with hard questions about whether non-GAAP measures should be used to adjust for or explain the impact of COVID-19 when reporting earnings and financial results.
A company may choose to reflect the business impact of the pandemic by creating a COVID-related line-item adjustment or redefining an existing non-GAAP financial measure. For example, “other income” may include costs incurred to prevent the spread of the virus. In determining whether a non-GAAP measure requires a COVID-19-related adjustment, a company should consider whether the adjustment is:
- Directly related to COVID-19 or the resultant economic fallout
- Expected to become part of the new normal, and
- Objectively quantifiable.
Regardless of how management decides to make the adjustment, the description of the adjustment must not be misleading.
A balanced approach
One of the most common problems on the use of non-GAAP metrics is prominence. McCord commented that CorpFin staff often “see a discussion of non-GAAP results before any discussion of GAAP results or even without any discussion of GAAP results.” Non-GAAP metrics play an important role in helping stakeholders better understand a company’s financial performance. But they must not be more prominent than the official GAAP figures. Contact your CPA for more information or to obtain external assurance on the consistency of your company’s non-GAAP metrics and disclosures.
Sidebar: Big GAAP, little GAAP
Private companies are the largest business demographic in the United States, accounting for more than one million companies. Many are small and have limited resources. These smaller organizations often complain that U.S. Generally Accepted Accounting Principles (GAAP) are unnecessarily complicated and sometimes provide information that’s not relevant to financial statement users.
Examples of complex GAAP topics that smaller companies often struggle with include:
- Stock-based compensation
- Derivatives and other financial instruments
- Revenue recognition, and
- Intangible asset impairment and fair value measurements.
In October, the California Society of CPAs (CalCPA) wrote a letter to the Financial Accounting Standards Board (FASB), asking for a slimmed-down package of accounting rules for private companies that aren’t required to issue audited financial statements. The package would provide “a separate comprehensive accounting framework that is substantially less in size and complexity than the full GAAP, and that private companies would be able to elect to adopt in its entirety.”
CalCPA suggested the package should be similar to the guidance provided under the International Financial Reporting Standards for Small and Medium-Sized Entities (IFRS for SMEs). More than 80 countries permit the use of this alternate framework, a significantly reduced and simplified version of full IFRS. The International Accounting Standards Board developed IFRS for SMEs in 2009 for companies that prepare general purpose financial statements and aren’t publicly accountable. The simplified rules focus on the information needs of lenders, creditors, and other users of private company financial statements who are interested primarily in information about cash flows, liquidity and solvency.
Here in the United States, the FASB established the Private Company Council (PCC) in 2012 to help develop simpler, less expensive GAAP alternatives for private companies. However, CalCPA said efforts by the PCC to simplify certain aspects of private company accounting haven’t made a significant difference to date. Rules developed by the PCC are merely “layered on top of the existing GAAP,” and, therefore, are still difficult for small private companies to follow. As a result, accountants at private companies typically must be aware of more — not less — authoritative guidance than those who work at public companies.
CalCPA’s letter was sent in response to the FASB’s Invitation to Comment (ITC) No. 2021-004, Agenda Consultation, which was published to solicit broad public feedback about the board’s five-year technical agenda. The FASB will discuss this letter, along with other stakeholder feedback, in the coming months.