Non-GAAP Metrics Are a Response to Faulty Reporting Standards

It’s not SEC rules being too strict that is the issue. Rather, it’s the variance in interpretation, guidance, and enforcement of publicly reported non-GAAP measures.

Kris Hutton

The debate over global financial reporting standards is nothing new and is regularly a hot topic among accounting pundits and regulatory oversight bodies. There are enough undeniable accounting minefields in GAAP and IFRS, along with non-GAAP, that steps should be taken to instill greater confidence in reporting.

For financial statements to fulfill their important social and economic function, they must reveal a business’ underlying economic truth. As such, financial reporting is increasingly supplemented with non-GAAP or “adjusted” earnings measures. But to really understand why, we must first understand what’s faulty in today’s financial reporting standards:

Financial statements rely on judgment calls that can be widely off, even when based honestly on established accounting principles.
Traditional accounting metrics intended to enable uniform comparisons between companies may not always be the most accurate way to judge a company’s value. This is magnified by innovative, fast-moving companies in today’s evolving economy, giving rise to imperfect adjusted metrics.
Both companies and management are subject to incentives and pressure to inject misinformation and errors into their statements.

Despite philosophical accounting beliefs, stakeholders seem to value non-GAAP measures and other KPIs when presented within the right context. This additional information can facilitate the understanding of a company’s underlying performance, liquidity, or financial position, as well as its future cash flow potential. Non-GAAP reporting can also convey changes indicating growth that may not be visible with traditional GAAP reporting.

Specific GAAP deficiencies can also muddle things in certain sectors, and a lack of accepted standards in non-GAAP figures makes an apples-to-apples comparison of different companies difficult. For sector-specific comparisons, companies should look to their peers to determine what to disclose, and aim to provide comparability. Where measures differ, they should provide justification as to why.

Revenue recognition, a particularly tricky piece of the regulatory puzzle, is an area where non-GAAP measures are better indicators of performance. For example, in sectors heavy in acquisitions, such as energy and health care, there may be one-time expenses distorting financial performance for the year if they fail to take into account future operating savings. Other one-time write-downs, such as litigation or restructuring costs, can also impact financial reporting. Even Warren Buffet agrees that investors should ignore such write-downs.

Multiple stakeholders impact or are impacted by financial reporting. These include management, boards, audit committees, the SEC, investors, auditors, analysts, creditors, advisers, and even the financial press. Each of these key stakeholders has a particular role in building confidence in financial reporting:

Management: Appropriate disclosure of non-GAAP measures starts with management, which can guarantee the company is assessed in the proper context by ensuring that disclosure controls and procedures in reporting non-GAAP and KPI measures are as robust as financial reporting for GAAP statements. Management should also provide comprehensive explanations when using non-GAAP measures and other KPIs, including methodology and any underlying components. Enhancing confidence in reported non-GAAP measures ensures this and demonstrates confidence in the interpretation of SEC financial reporting rules.
Audit Committee: Prior to disclosing any non-GAAP measures, the audit committee and internal audit function should focus on governance and oversight, evaluating whether disclosed measures provide a fair and accurate view of the company, while ensuring that they adhere to SEC regulations.
Consumers: End consumers should become conversant in non-GAAP measures and in how they impact investment decisions. That reduces the risk of overreliance on non-GAAP measures that—on their own—could paint an incomplete picture of a company.

Ultimately, stakeholders’ efforts to build better financial reporting confidence won’t matter without the SEC’s enforcement. The SEC plays a pivotal role in providing better guidance for companies by setting and enforcing the rules, to encourage better transparency, comparability, and consistency in non-GAAP disclosures.

Kris Hutton is director of product management at ACL, a maker of governance, risk, and compliance software.