One of the goals of GAAP is to present a full picture of a company’s financial situation, but for various reasons, companies often find it necessary to present performance measures that lie outside of GAAP. The use of these measures, their treatment by accountants and auditors, and their utility for investors continues to be a controversial topic. The author discusses the history of the SEC’s regulation of non-GAAP measures and gives an overview of research into how those measures are arrived at by companies and treated by stakeholders.
As the reporting of non-GAAP financial performance measures has gained popularity, these measures have raised concerns at the SEC as to whether they are more prominent than GAAP measures or misleading to investors. This article provides background information on the nature of non-GAAP financial measures, an overview of recent key research findings that address these measures, and the implications of those findings.
The SEC defines a non-GAAP financial measure as a numerical measure of a registrant’s historical or future financial performance, financial position, or cash flows that adjusts selected amounts from the most directly comparable GAAP measure. Non-GAAP financial measures can be found in SEC filings, including annual (10-K) and quarterly (10-Q) reports, proxy statements, registration statements, prospectuses, earnings press releases, and other disclosures (e.g., earnings calls/web-casts, investor and industry presentations). For example, within a 10-K, such measures are often presented in Part II, Item 6, “Selected Financial Data,” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” According to a report by Audit Analytics, 72% of S&P 500 companies reported adjusted earnings per share (EPS), 71% reported adjusted income, 28% reported adjusted cash flow, and 20% reported earnings before interest, taxes, depreciation, and amortization (EBITDA)/adjusted EBITDA (“Trends in Non-GAAP Disclosures,” Dec. 1, 2015). This is shown in Exhibit 1.
S&P 500 Companies Using a Particular Type of Non-GAAP Metric
The use of non-GAAP financial measures first became popular among companies (often Internet technology companies) during the 1990s and continues today. In 2001, the SEC issued “Cautionary Advice” warning investors that a non-GAAP financial measure “under certain circumstances can mislead investors if it obscures GAAP results.” In 2002, the SEC brought its first enforcement action based on non-GAAP financial measures.
As directed by the Sarbanes-Oxley Act (SOX) of 2002, the SEC adopted Regulation G and Item 10(e) of Regulation S-K in 2003. Regulation G requires that non-GAAP financial measures include a presentation of the most directly comparable GAAP financial measure and a recollection to that measure.
In 2010, the SEC released new Compliance and Disclosure Interpretations that allowed more liberal use of non-GAAP financial measures by companies in public disclosures. Since then, companies have steadily increased their use of these measures. In 2011, the SEC’s Division of Corporation Finance warned companies against abusing non-GAAP financial measures under the new guidance; related SEC comments led to removal of a non-GAAP financial measure from Groupon’s 2011 IPO registration statement.
In 2013, the SEC Enforcement Division’s Financial Reporting and Audit Task Force focused its attention on the use of non-GAAP financial measures. SEC Chair Mary Jo White and SEC Chief Accountant James V. Schnurr gave speeches in December 2015 and March 2016, respectively, on non-GAAP financial measures, describing the SEC’s renewed effort to scrutinize their use.
In May 2016, the SEC issued interpretive guidance on non-GAAP financial measures that provided clarifying examples on presentation of these measures that is either misleading or gives them greater prominence than comparable GAAP measures. Since then, many tech companies, including Facebook, Amazon, Google, and Electronic Arts (EA), have started disclosing GAAP earnings more prominently in their financial reports. In October 2017, the Division of Corporation Finance released an update to certain compliance and disclosure interpretations related to non-GAAP financial measures associated with business combinations.
Responses to Regulation
Managers’ reporting of non-GAAP metrics increased from 26% in 2006 to 49% in 2013 (Jeremiah Bentley et al., “Disentangling Managers’ and Analysts’ Non-GAAP Reporting,” Journal of Accounting Research, February 2018, http://bit.ly/2MIsVKH). Dirk Black et al. reviewed S&P 500 firms from 2009 to 2014 and found that the non-GAAP reporting frequency increased across all sectors (“Non-GAAP Earnings: A Consistency and Comparability Crisis?” working paper, 2017, June 2018, http://bit.ly/31wI4lN). They also examined the magnitude of firms’ adjustments and found that total expense exclusions increased 40.6% on an annual basis. Audit Analytics reports that in 2015, 88% of the S&P 500 disclosed non-GAAP metrics in earnings releases (December 2015).
Audit Analytics also examined responses to the SEC guidance (“Corporate Implementation of SEC’s Compliance & Disclosure Interpretations regarding Non-GAAP Financial Measures,” December 2016, http://bit.ly/2ttWtll). Of the Fortune 500 companies, 475 included at least one non-GAAP metric in financial reports issued in the period of July–September 2016. Many companies, however, made changes to how they reported non-GAAP measures; there was a significant decrease in the number of companies disclosing non-GAAP measures more prominently than GAAP measures (from 202 companies in April–June 2016 to 28 in July–September 2016). There was also a significant decrease in companies using non-GAAP measures without presenting GAAP measures or reconciling the two.
Many companies reacted to the SEC guidance by no longer disclosing certain types of non-GAAP measures or changing the way they disclosed non-GAAP financial measures. One example is EA, which has been reporting both GAAP and non-GAAP financial measures externally since fiscal year 2008, along with the required reconciliation between the two measures. It has also indicated that these non-GAAP financial measures are used internally to assess the company’s operating results and as a factor in management team compensation. After the SEC issued its May 2016 guidance, EA announced during its investor conference call that it would no longer externally report many non-GAAP financial measures, including net revenue, gross margin, and EPS. EA explained that it would separately provide guidance and report the financial data that management uses internally to calculate adjustments to its GAAP financial measures so that investors may be able to calculate measures comparable to the historical non-GAAP financial measures.
Other companies, such as Twitter, made less significant changes in their non-GAAP reporting. Beginning in Q2 2017, Twitter changed its method of calculating its non-GAAP provision for income taxes in accordance with the SEC’s Non-GAAP Financial Measures Compliance and Disclosure Interpretation. Other than this calculation, from 2014 to 2017 Twitter consistently reported net profit using non-GAAP financial measures while reporting net losses using GAAP measures, as shown in Exhibit 2. In its 10-K, Twitter argues that its use of non-GAAP financial measures is to assist investors in seeing Twitter’s core business operating results. Twitter also says that its management team uses the non-GAAP financial measures to establish budgets and operational goals for managing its business and evaluating its performance.
Twitter, Inc. Non-GAAP Net Income (Loss)
Incentives for Using Non-GAAP Measures
Researchers frequently focus on two incentives—informativeness and opportunism—when investigating why companies use non-GAAP reporting. Numerous studies find evidence suggesting that providing informative or value-relevant earnings information for stakeholders is a significant motivation for managers to report non-GAAP earnings metrics. Studies indicate that non-GAAP earnings are typically more informative, more persistent, and more associated with current return and future earnings than GAAP earnings. Managers can systematically exclude one-time gains or losses to provide a more accurate depiction of core performance. Researchers also have found that non-GAAP earnings are used more frequently when management believes that GAAP does a “worse” job of reporting a company’s actual situation.
Contrary to concerns that managers inconsistently calculate non-GAAP earnings from year to year to obscure financial performance, studies have also found that many companies modify their non-GAAP calculations over time to provide more informative earnings metrics. Dirk Black et al. examined the comparability and consistency of firms’ non-GAAP reporting and concluded that, on average, managers vary their non-GAAP calculations over time and diverge from other companies for informative reasons (“Non-GAAP Earnings: A Consistency and Comparability Crisis?” working paper, updated June 2018, http://bit.ly/31wI4lN). In addition, they found that managers have expertise in determining the persistence of earnings components and use this insight to inform their choices of what to exclude.
The possibility of using non-GAAP measures to obscure financial performance represents a very different motivation for their use. Excluding certain items in non-GAAP earnings calculations can allow managers to focus on and emphasize non-GAAP earnings to obscure the business’s true performance. As indicated above, this type of behavior has been a concern for regulators and standards setters.
Several early studies document that some companies emphasize non-GAAP metrics that portray the most favorable performance to meet or beat analysts’ forecasts and thereby gain higher valuation. Available research finds numerous examples of potentially misleading non-GAAP disclosures. For example, several studies argue that, while the exclusion of one-time items creates a performance metric that better reflects sustainable performance, the exclusion of recurring items seems less justifiable. Using this same logic, several studies evaluate the “quality” of non-GAAP exclusions based on the extent to which they are associated with future operating performance and find that recurring items exclusions are the lowest quality non-GAAP adjustments and can mislead investors.
When managers meet expectations by managing GAAP earnings, they are significantly less likely to report non-GAAP earnings; conversely, when managers miss expectations after managing GAAP earnings, they are significantly more likely to employ non-GAAP reporting (Ervin L. Black et al., “The Relation between Earnings Management and Non-GAAP Reporting,” Contemporary Accounting Research, November 2016, http://bit.ly/2Zj2Djx).
Several early studies found that, dating to the late 1990s, companies often excluded one-time items (e.g., gains and losses on asset disposals, merger and acquisition costs, extraordinary items) in an effort to focus investors’ attention on sustainable earnings. Evidence on the current non-GAAP reporting environment indicates that nonrecurring items are still the most common form of non-GAAP adjustments; these adjustments most frequently relate to restructuring charges, tax resolutions, and acquisition-related charges, which managers claim are “nonoperating” or “noncash” in nature. Some recent studies have also reported that certain recurring transactions—such as stock compensation, amortization, and investment gains (losses)—remain common.
While managers are often criticized for excluding one-time expense items and not excluding one-time gains, empirical evidence indicates that some managers also exclude one-time gains, which results in lower non-GAAP performance. According to Asher Curtis et al., approximately one-half of businesses with one-time gains report non-GAAP earnings in a manner that easily allows investors to assess operating performance without the gain (“The Use of Adjusted Earnings in Performance Evaluation,” working paper, updated May 2018, http://bit.ly/2WFaT0f).
While the exclusion of one-time items creates a performance metric that better reflects sustainable performance, the exclusion of recurring items seems less justifiable.
Regulation G and Non-GAAP Reporting
Available research reports a significant decrease in the frequency of non-GAAP reporting immediately after the 2003 implementation of Regulation G. Studies also document that fewer managers release non-GAAP earnings in their earnings announcements press releases and that fewer managers use non-GAAP earnings numbers to meet analyst forecasts.
Consistent with its intent, Regulation G appears to have mitigated the opportunistic use of non-GAAP earnings numbers. Studies generally find that the quality of non-GAAP disclosures has improved subsequent to Regulation G, with examples such as—
- a decline in the frequency of special and other items exclusions from reported earnings,
- a decline in the magnitude of the excluded item,
- exclusions becoming more transitory in nature,
- cessation of reporting of non-GAAP earnings by companies with the lowest quality exclusions in the pre–Regulation G period, and
- less prominent reporting of non-GAAP performance metrics.
Several recent studies find that investors appear to react more readily to non-GAAP earnings than GAAP earnings in the post–Regulation G environment. These studies also conclude that Regulation G’s reconciliation requirement reduced the extent of investor mispricing, particularly for entities that improved the transparency of their non-GAAP disclosures, and that investors are less likely to be misled post–Regulation G.
Other Monitoring Mechanisms
Existing research finds that board independence is positively associated with the quality of non-GAAP earnings and that a strong board of directors can decrease aggressive non-GAAP reporting. Research also finds that a higher analyst following is associated with a lower frequency of non-GAAP disclosure. When managers report non-GAAP earnings, the quality of their exclusions is higher (and the aggressiveness of their reporting is lower) when analysts closely follow the company. In particular, the quality of non-GAAP reporting improves following debt covenant violations, suggesting that both creditors and shareholders take on a stronger monitoring role (Theodore Christensen et al., “Non-GAAP Reporting following Debt Covenant Violations,” Review of Accounting Studies, March 2019, http://bit.ly/2XPzg7W). Several studies also find that companies increase their non-GAAP reporting activity when litigation risk decreases, and vice versa.
A study by Long Chen et al. found that during the pre-SOX period, optimistic non-GAAP financial differences are associated with higher audit fees and a higher likelihood of auditor resignations, and that auditors seem to be more concerned with non-GAAP earnings disclosures since SOX (“Pro Forma Disclosures, Audit Fees, and Auditor Resignations,” Journal of Accounting and Public Policy, May-June 2012, http://bit.ly/2F7y9JB).
In March 2018, the Center for Audit Quality (CAQ) released a new tool, “Non-GAAP Measures—A Roadmap for Audit Committees” (http://bit.ly/2MTqdlo). The roadmap was based on the identification of several key discussion topics for audit committees to follow to ensure that non-GAAP measures provide a balanced presentation of company performance. The CAQ concluded that “greater awareness and discussion of non-GAAP measures by audit committees will contribute to high quality reporting that meets the needs of its users.”
Investors and other Stakeholders
Several studies have documented that investors respond more to non-GAAP earnings than to GAAP earnings and concluded that non-GAAP information is relevant to investors. Mark Bradshaw et al. provide evidence that non-GAAP earnings decrease investor consensus about future performance (“The Impact of Earnings Announcements on a Firm’s Information Environment,” working paper, updated April 2018, http://bit.ly/2wPrZt3). Many other studies find that less sophisticated investors rely on non-GAAP information to a greater extent than more sophisticated investors. Examples include the following:
- Analysts, who are viewed as more sophisticated investors, react to non-GAAP performance measures when revising their future earnings forecasts, but are more skeptical than investors of potentially misleading earnings exclusions.
- Short sellers, who are also deemed informed parties, trade as if non-GAAP earnings disclosures are a signal of lower reporting quality and future underperformance.
- Retail investors, who are viewed as less sophisticated, trade significantly more when non-GAAP information is present in the press release compared to more sophisticated institutional investors.
Asher Curtis et al. find that the majority of businesses in the S&P 500 use adjusted earnings benchmarks to evaluate CEO performance. Other researchers find that compensation committees commonly use non-GAAP performance metrics when evaluating manager performance to determine executive compensation. Related studies show a strong association between compensation incentives and managers’ propensity to disclose non-GAAP numbers to external stakeholders. Moreover, the form of executive compensation can influence managers to have a short- or long-term focus on non-GAAP disclosure, as indicated by the aggressiveness of their non-GAAP reporting practices.
In addition to management, creditors also use non-GAAP information, often in framing debt covenants. Christensen et al. find that the frequency of non-GAAP reporting drops off significantly following debt covenant violations. The quality of exclusions for companies that continue to disclose non-GAAP performance metrics increases significantly, consistent with the notion that managers are reluctant to disclose adjusted performance metrics when they are under scrutiny. Nevertheless, managers who decide to report a non-GAAP number are much less aggressive in their exclusions.
Auditors and Non-GAAP Financial Measures
Non-GAAP financial measures, when included in a document with audited financial statements, fall under the aegis of the PCAOB’s Auditing Standard (AS) 2710 and the AICPA’s AU-C section 720. This is primarily, although not entirely, an issue relating to public companies and companies considering becoming public companies. Both the AICPA and PCAOB require that auditors read such other information to consider whether the information or the manner of its presentation is inconsistent with the financial statements. Auditors may provide a report on compliance of non-GAAP financial measures with the rules for such disclosures under an agreed-upon procedure engagement, but only if requested by the client.
As indicated above, non-GAAP financial measures are also often included in earnings releases or other communications, such as calls with analysts and information on the company’s website. Under current PCAOB standards, auditors have no responsibility to perform specific procedures related to corporate earnings releases, investor presentations, or other communications.
The PCAOB and AICPA are both currently considering expanding auditors’ responsibility for reporting on other information, including non-GAAP measures. Suggested modifications include a greater emphasis on whether the other information omits or obscures information necessary for a proper understanding of a matter.
On November 28, 2017, the Auditing Standards Board (ASB) issued a proposal, “The Auditor’s Responsibilities Relating to Other Information Included in Annual Reports,” which has drawn significant concerns from large CPA firms. A primary concern is the broadening of auditor responsibility introduced by the proposed definition of a misstatement of other information and the corresponding performance requirements. In May 2019, the ASB voted to issue its final Statement on Auditing Standards, The Auditor’s Responsibilities Relating to Other Information Included in Annual Reports. This standard will benefit users of audited financial statements by bringing greater consistency regarding auditors’ consideration of other information and enhancing the auditor’s responsibility with respect to the other information.
Implications of Research Findings
Auditors play an important role in providing investors with high-quality, decision-useful information. Thomas Selling and Gregory Sommers point out that the popular use of non-GAAP financial measures may devalue the financial statements upon which the audit is based (“Why Accountants Should Care About Non-GAAP Financial Metrics,” The CPA Journal, June 2016, http://bit.ly/2MJdrWO). Auditors therefore need to have a good understanding of the non-GAAP financial measures to meet this challenge.
When non-GAAP financial measures are used as performance metrics for management, the tendency to engage in opportunistic behavior may be accentuated.
As a starting point, auditors need to understand why non-GAAP financial measures have gained in popularity. Research shows that non-GAAP earnings are often more informative compared to GAAP earnings and frequently used when GAAP earnings are deemed insufficient. This raises questions about the relevance of GAAP; if non-GAAP is truly more informative, accounting and auditing standards setters must consider this issue.
The other motivation for adopting non-GAAP reporting is opportunistic in nature. Auditors need to be aware of this motivation and incorporate it in their risk assessment. For example, research has found that companies with earnings that do not meet expectations are more likely to engage in opportunistic behavior. Research findings also indicate that SEC regulation has resulted in decreased opportunistic use of non-GAAP financial measures; this will likely result in decreased inconsistency between non-GAAP financial measures and financial statements.
Auditors should expect most non-GAAP financial measures to be related to infrequent or one-time events; however, they should also consider non-GAAP financial measures that relate to frequently occurring events. In both cases, a key element is the reasonableness of the measure.
Auditors have long considered corporate governance and its effects on internal control. They should be aware that a situation with comparatively weak corporate governance is more likely to result in aggressive non-GAAP financial measures. Also, when non-GAAP financial measures are used as performance metrics for management, the tendency to engage in opportunistic behavior may be accentuated.
Investors, management, and creditors rely on non-GAAP financial measures in their decision making. Auditors should be aware of the relevant issues raised by the used of non-GAAP financial measures, as they have professional responsibilities when such measures are included in documents containing audited financial statements.