In a gradual shift from decades of skepticism about corporate financial metrics that depart from generally accepted accounting principles, regulators have come to see non-GAAP measurements in a more positive light. And nowhere has their use become more routine than in initial public offerings, a new analysis by PwC suggests.
Over the past three years, nearly 60% of IPOs have used at least one non-GAAP measurement (NGM) in their financial statements, according to the analysis of more 400 IPOs completed between 2011 and 2013.
Those four years coincide nicely with the start of Securities and Exchange Commission moves to relax its strictures on non-GAAP metrics involving adjustments for such things as non-recurring, unusual or infrequent events in 2011. Before that, under the auspices of the Sarbanes-Oxley Act of 2002, the SEC had cracked down on the use of NGMs, more commonly called “pro-forma” measurements.
In 2003, the agency issued a new disclosure rule, Regulation G, that requires public companies that disclose or release NGMs to include, in that disclosure or release, “a presentation of the most directly comparable GAAP financial measure and a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure.” The requirements extend to the registration statements that issuers of IPOs must file with the SEC.
Since 2011, however, the commission has become more benign about NGMs. In fact, SEC operatives have even begun to encourage IPO issuers to include valid NGMs in their registration statements, according to Mike Gould, the U.S. public offerings leader at PwC. “They’ll go on your website, they’ll look at your press release,” he says. “If you have a non-GAAP measure you’ve disclosed and talked about in public, they’ll be asking, ‘Why isn’t that in your documents?’”
As a result, IPO issuers are disclosing NGMs more in the registration statements and other public documents than they had before 2011, he added.
Asked if he, as a CPA, had any hesitations about counseling clients to use NGMs, considering the stigma they once had, Gould said, “I don’t think there’s any stigma around non-GAAP measures these days. The issues are around how … you describe them and making sure you disclosed how you’ve calculated them and what the weaknesses and risks are.”
Still, some regulators express ambivalence about the use of NGMs by established companies as well as IPOs. At a Standard & Poor’s Ratings’ accounting conference on September 30, Greg Jonas, director of the office of research and analysis of the Public Company Accounting Oversight Board, acknowledged that he has “a very schizophrenic relationship” with NGMs.
“On the one hand, I really like them because [they allow] management to tell the story of the company through their eyes, which I think many analysts want – to step into the shoes of management when they analyze a company. They may not agree with management, but they want to understand management,” he said.
On the other hand, Jonas said, he’s seen increasing abuse by some companies in the use of NGMs. A key problem with their use is that “they tend to become the language of the Street,” he said during a panel discussion, “even if they are in some ways abusive.”
Jonas told of recently observing that a company “excluded board of director costs from current income in a non-GAAP measure, arguing that they related to governance – which was unrelated to the companies’ operations.” The audience responded with laughter, presumably at the company’s assumption that proper governance bears no connection to company operations.
Not unexpectedly, the most commonly used NGM in recent IPOs is earnings before interest, income taxes depreciation and amortization (EBITDA), which was deployed by more than 65% of the IPOs analyzed by PwC. (See Figure 1.)
Of the IPOs employing EBITDA, 46% of the IPOs issued adjusted versions of the metrics. More than 70% of those adjustments were for equity-based compensation. Other common EBITDA adjustments included ones made for impairment (33%), acquisitions (20%) and restructuring and reorganization effects (15%). (See Figure 3.)
The panoply of EBITDA adjustments can create confusion among investors trying to compare two companies in the same industry, as well as risk for the issuers, Gould acknowledges. “If they don’t understand all of the adjustments that are going into it, it can perhaps mislead the reader into different conclusions,” he says.
Gould cautions CFOs against using NGMs in a way that presents the firm as an “outlier” among comparable companies. Especially, they should avoid “creating a new non-GAAP metric no one else has used,” he says. “There’s going to be an expectation from investors that you’re going to use the same non-GAAP measure.”
Joyce Joseph, a Standard & Poor’s managing director who oversees the rating agency’s global accounting and governance group, feels that it would benefit analysts and investors if there were more standardization of the definitions of NGMs. “Is company A making similar adjustments to its non-GAAP metrics compared to what company B is making?” she asks.
Still, she finds widely used NGMs such as EBITDA and free cash flow useful in her analysis. In fact, some non-GAAP metrics often “represent the economic reality or the underlying business better than some GAAP measures,” Joseph says.