The Securities and Exchange Commission is taking a hard look at non-GAAP measures in reaction to the increased use of these measures. As a result, companies and audit committees need to consider reexamining their non-GAAP measures and related controls and procedures for disclosure of such measures. Here are some practical considerations to help companies tackle the challenge.
What Is a Non-GAAP Measure?
Financial reporting based on generally accepted accounting principles (GAAP) provides a solid and consistent foundation for understanding a company’s financial performance, financial position, and cash flows. However, in some cases, a company may believe that the standard measures associated with GAAP are unable to convey subtle but important nuances that an investor would find relevant and useful. That’s where non-GAAP measures come in.
A non-GAAP measure is calculated and presented using a methodology not outlined in GAAP. Some of the most common non-GAAP measures include earnings before interest and taxes (EBIT); earnings before interest, taxes, depreciation, and amortization (EBITDA); and adjusted earnings.
Some companies supplement their GAAP financial reporting with non-GAAP measures in order to provide investors and other stakeholders with additional insight. For example, non-GAAP measures are often used outside of the financial statements to highlight non-recurring items that could affect the comparability of financial performance from year to year.
Because non-GAAP measures are—by definition—not standard, companies should have controls and procedures to help ensure clear and accurate disclosure of those measures, and to help ensure compliance with SEC rules and regulations. In establishing those controls and procedures, companies should consider focusing on seven key areas:
Documenting Non-GAAP policies
A critical aspect of disclosure controls and procedures is involvement by the appropriate levels of management. Depending on the situation, this could include reviewing the selection and determination of non-GAAP measures with a disclosure committee, the audit committee, or both.
To help maintain compliance with SEC rules, companies should consider establishing a written policy that (1) clearly describes the nature of allowable adjustments to GAAP measures, (2) defines the non-GAAP measure(s) to be used under the policy, and (3) explains how potential changes in the inputs, calculations, and adjustments will be evaluated and approved.
For example, a policy might describe qualitatively the types of adjustments that are non-recurring and unusual, and are thus within the defined policy. It might also outline specific quantitative thresholds for which income and/or expense items would be evaluated to determine whether they should be included in non-GAAP adjustments. This could help ensure appropriate non-GAAP measures are used, as well as eliminate the need for numerous immaterial adjustments in the reconciliation that could confuse investors.
Disclosure Committees and Governance
Some companies find it helpful to use a disclosure committee to assist the CEO, CFO, and audit committee in preparing and overseeing disclosures, including those related to non-GAAP measures. Disclosure committees are typically management committees; however, some companies prefer that the disclosure committee function as a subcommittee of the board and audit committee.
Disclosure committees can set parameters for (and determine the appropriateness of) disclosures related to non-GAAP measures. In particular, a disclosure committee could review draft earnings releases to provide input and oversight based on the seven criteria outlined above. As part of its review, the disclosure committee could also provide effective governance and play an integral role in the accuracy, completeness, timeliness, and fairness of a company’s disclosures.
Here is a sample approach for controls over non-GAAP measures. In this example, the manager of external reporting calculates the non-GAAP measures before drafting the disclosure for the company’s earnings release. The controller and/or CFO reviews the draft disclosure.
- Re-compute each non-GAAP measure and agree the underlying GAAP measure to the general ledger.
- Consider the income tax effects of the adjustments made to the GAAP measure. (Note: adjusting revenue or income before tax could affect the tax expense or benefits assumed in the calculation of the tax provision. For measures of performance, a current and deferred income tax expense commensurate with the non-GAAP measure of profitability should be calculated and included in the disclosure.)
- Consider whether the non-GAAP measures contain misleading adjustments (see note at bottom of story*).
- Review a list of prohibited presentations of non-GAAP financial measures to ensure the measures are consistent with SEC guidance.
- Consider whether each adjustment is appropriate under company policy and is consistent with adjustments made in prior periods.
- Review each reconciliation of the GAAP measure to the non-GAAP measure, which includes agreeing the adjustments to the trial balance or other support, then considering whether the reconciliation clearly labels and describes the nature of each adjustment.
- Verify that adjustments for income taxes are presented separately, and that there is disclosure of how the adjustment for income taxes was determined.
In addition, as part of the review and monitoring controls described earlier, the disclosure committee performs a review to assess compliance with Regulation G and other SEC guidance, and to help ensure the measures are:
- neither misleading nor prohibited;
- presented with — and reconciled — to the most directly comparable GAAP measure, with no greater prominence than the GAAP measure;
- defined and described appropriately, and labeled clearly as non-GAAP;
- balanced (i.e., adjusts not only for nonrecurring expenses, but also for nonrecurring gains);
- not presented on the face of the GAAP financial statements, nor in the accompanying notes or on the face of any pro forma financial statements required to be disclosed by Regulation S-X, Article 11;
- not titled the same as, nor confusingly similar to, titles or descriptions used for GAAP financial measures; and
- prepared consistently from period to period in accordance with the defined policy, and comparable to measures used by the company’s peers.
The disclosure committee can also help ensure there is transparent and company-specific disclosure of the substantive reason(s) why management believes a particular non-GAAP measure is useful for investors and, if material, the purpose for which management uses the measure.
Lastly, as part of its oversight and review of external financial reporting, the audit committee confirms that the non-GAAP measures are appropriately disclosed in accordance with policy and are consistent with SEC rules, regulations, and guidance.
At this point, it is clear that the SEC expects companies to be more vigilant in their use of non-GAAP measures. Now is the time for companies to take a fresh look at their non-GAAP measures and evaluate the controls and processes in place to ensure appropriate use and disclosure of such measures.
*Note: Misleading adjustments may include those that: (1) exclude normal, recurring cash operating expenses necessary for business operation, (2) adjust an item in the current reporting period but do not adjust for a similar item in the prior period, (3) exclude certain nonrecurring charges but do not exclude nonrecurring gains, (4) are based on individually tailored accounting principles, including certain adjusted revenue measures.
Jeff Aughton is a partner in the audit practice of Deloitte & Touche LLP, and serves as national office audit assurance services – internal control lead. Jennifer Burns is a partner in the audit practice of Deloitte & Touche LLP, serving the regulatory group.
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