Companies must periodically report financial performance information to the public. When they do, they rely upon the United States Generally Accepted Accounting Principles (GAAP) to prepare their financial statements. However, subject to certain rules, companies may include non-GAAP financial metrics in their investor reports.
GAAP measures are informative, but many companies face unique circumstances. GAAP measures alone might not adequately capture those circumstances. Non-GAAP disclosures can paint a more accurate and comprehensive picture of the core financial performance of a company. According to a study by Audit Analytics, almost 90% of S&P 500 companies used these measures in their public filings.
Non-GAAP disclosures are in use across a range of public company filings with the Securities of Exchange Commission (SEC). Usage includes in company earnings releases, on corporate websites, in investor presentations, and on earnings calls. Startups are sometimes less experienced in navigating the complex web of financial regulations. Therefore, it is important they understand when companies use these complementary financial measures. They also must learn how to report them in a compliant manner.
Regulation G of the Securities Act of 1933 contains many of the rules regarding non-GAAP financial metrics. This Regulation defines a non-GAAP financial measure as a “numerical measure of historical or future financial performance, financial position or cash flows that excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the most directly comparable measure calculated and presented in accordance with GAAP.” These can appear in a variety of company financial statements. These statements include income statements, balance sheet, statement of cash flows, or other similar financial statements.
The SEC rules have an “equal or greater prominence requirement” for non-GAAP measures. If company uses such a metric, the company must present the most directly comparable GAAP financial metric with equal or greater prominence.
SEC Focus on Non-GAAP Financial Measure Reporting
The SEC prioritizes following proper protocols when reporting non-GAAP financial measures to the public. Jay Clayton is a former chair of the SEC. During his tenure, he ramped up efforts to increase disclosures for investors regarding the use of these financial metrics. Clayton remarked in 2017: “We are watching non-GAAP measures very closely and are poised to act through the filing review process, enforcement, and further rule making, if necessary, to achieve the optimal disclosures for investors and the markets.”
In many respects, the SEC has followed through with that agenda. A recent survey of SEC comment letters (letters that companies forward to the SEC when they submit a Form S-1 registration statement to the SEC for review before going public) revealed that such measures have been one of the most frequently scrutinized topics.
One of the biggest areas of concern raised in respect to the use of non-GAAP financial metrics is that there is no reconciliation to, or sometimes incorrect reconciliation, to the most directly comparable GAAP financial measure. The concern is that this could mislead investors.
Common Non-GAAP Measures
The decision to report a specific non-GAAP financial measure can be based on industry-specific practices. In these cases, the definitions of these non-GAAP metrics have become relatively standardized. For example, funds from operations (FFO) and net operating income (NOI) are two commonly accepted non-GAAP financial measure in the real estate industry. In the airline industry, it is standard practice to report return on invested capital (ROIC). In the banking industry, public company disclosures include a non-GAAP metric called the efficiency ratio. Industry analysts evaluate this ratio. Other commonly used non-GAAP metrics are relatively industry agnostic, for example, EBITDA and free cash flow (FCF).
EBITDA: EBIDTA is the most used non-GAAP financial metric by companies of all sizes and industries. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a key measure of a company’s profitability.
Free Cash Flow (FCF): Free Cash Flow (FCF) is the amount of cash a company generates that is clear of obligations. It represents cash freely usable by the company.
Reconciliation of Non-GAAP Financial Measures
To be compliant with U.S. laws and regulations, companies that opt to use non-GAAP financial measures must present the most directly comparable financial measure calculated in accordance with GAAP rules. Companies often present this reconciliation process in a table format.
Although there isn’t much formal guidance for the SEC requirement to present a comparable GAAP measure with “equal or greater prominence”, companies should use common sense to avoid raising issues with the SEC.
SEC Regulations to Prevent Misleading Investors
Non-GAAP calculations can more accurately capture a company’s financial performance. The goal of the SEC’s increased scrutiny of the use and way non-GAAP measures are reported is to prevent misleading investors. Startups, especially those planning to go public, should have robust financial teams to assess the rules surrounding non-GAAP financial measures.