Non-GAAP measures - The role of the audit committee
More than 20 years after the dot-com boom sparked a proliferation of non-GAAP financial measures, they continue to expand and remain an important part of the financial reporting process. The measures can play an important role in showing a view of the company’s financial or operational results to supplement what is captured in the financial statements. Non-GAAP measures adjust a company’s operating performance, financial position, or cash flows by excluding or including amounts from the most directly comparable GAAP measure. They can help management tell the company’s story to users of the financial statements that gives a view into the company “through the eyes of management.”
Common non-GAAP financial measures
- Operating income that excludes one or more expense items
- Adjusted revenue, adjusted earnings, and adjusted earnings per share
- EBIT and EBITDA, and adjusted EBIT and EBITDA
- Core earnings
- Free cash flow
- Funds from operations
Where does the audit committee fit in?
Here are some questions audit committees may want to ask management in fulfilling their oversight responsibilities:
Why has management chosen to present the non-GAAP measure?
- What is the purpose of the non-GAAP measure?
- Which competitors and peer companies use non-GAAP measures and how do they compare to those used by the company?
- What questions or feedback has management received from investors or analysts on a specific non-GAAP measure(s)?
What is management’s process to calculate the non-GAAP measure?
- What procedures are in place to ensure the calculations are accurate and consistent with those of prior periods?
- Is the process covered by management’s internal control over financial reporting or other disclosure controls? If not, why not?
- Has the company considered having internal audit perform a review of the internal controls over the derivation of non-GAAP measures to determine whether the controls are effective?
What are the incentives for possible “earnings management”?
- What is the company’s policy on what will give rise to a non-GAAP adjustment? How is materiality considered in this policy?
- What are the areas of judgment?
- How do non-GAAP measures impact management compensation?
- How does management’s disclosure committee focus on non-GAAP measures and consider their appropriateness?
Is the presentation and disclosure fair, balanced, and transparent?
- Are GAAP measures presented with equal or greater prominence?
- Is the disclosure descriptive and transparent or “boilerplate”?
- Has the company received an SEC comment letter focused on any non-GAAP matters?
Do the measures comply with the SEC regulations and the SEC staff’s 2018 interpretive guidance?
- Can the measures potentially be considered misleading?
- Are prohibited measures excluded?
- Are adjustments to arrive at a non-GAAP measure labeled as non-recurring, infrequent, or unusual expected to recur in the next two years?
Are KPIs clearly defined and appropriately disclosed?
- Is additional disclosure necessary to ensure the metric is not materially misleading, including further information on any estimates or assumptions underlying the metric or its calculation?
- Are the reasons for any changes in the methodology of material KPIs appropriately disclosed?
- What disclosure controls and procedures are in place to ensure the completeness and accuracy of KPIs?
- Why are non-GAAP measures relevant?
- What are the rules around non-GAAP information?
- Can the non-GAAP adjustments be trusted?
Why are non-GAAP measures relevant?
More companies now use non-GAAP measures, and the majority of the time, their non-GAAP results are better than those reported under GAAP. The last time the SEC updated its interpretive guidance by releasing additional Compliance & Disclosure Interpretations (C&DIs) was in May 2018. Since those C&DIs were released, the SEC has reiterated their views on non-GAAP.
What are the rules around non-GAAP information?
The disclosure requirements vary based on the applicable regulation. Regardless of the source, all of the governing regulations share an overarching principle that non-GAAP information cannot be misleading. Companies may also be subject to express prohibitions depending on which regulation governs a particular non-GAAP disclosure.
Can the non-GAAP adjustments be trusted?
The use of GAAP provides uniformity in how companies report their financial performance. But most S&P 500 companies choose to report non-GAAP metrics in addition to GAAP measures. If done appropriately, non-GAAP measures can provide insights into a company’s business, past performance, and its potential prospects.
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