Non-GAAP metrics in the COVID-19 era
Published November 1, 2020
Concerns related to the use of financial metrics that don’t conform to U.S. Generally Accepted Accounting Principles (GAAP) are nothing new. But the pandemic has sparked renewed interest in this subject, particularly as it relates to adjustments for COVID-19 when reporting earnings. Concerns from investors and lenders have prompted increased scrutiny from the Securities and Exchange Commission (SEC). Here’s recent guidance that should prove beneficial for third-quarter reporting.
U.S. GAAP is a set of rules and procedures that accountants typically follow to record and summarize business transactions. These guidelines provide the foundation for consistent, fair, honest and accurate financial reporting. Private companies generally aren’t required to follow GAAP, but many do. Public companies don’t have a choice; they’re required by the SEC to follow GAAP.
Over the years, the use of non-GAAP measures has grown. These unaudited figures can provide added insight when they’re used to supplement GAAP performance measures. But they can also be used to mislead investors and artificially inflate a public company’s stock price.
Specifically, companies may include unaudited performance figures, such as earnings before interest, taxes, depreciation and amortization (EBITDA), to cast the company in a favorable light, in the management, discussion and analysis section of their financial statements, earnings releases and investor presentations.
These unaudited figures may be cherry-picked to present a stronger financial picture than the ones that appear in their audited financial statements. In turn, these companies often see their stock prices go up when the earnings are announced three to four weeks before audited financial statements are filed with the SEC.
New pandemic-induced considerations and financial reporting challenges related to the presentation of non-GAAP measures have emerged. The first quarter of 2020 may have seen little activity regarding non-GAAP measures, because many public companies didn’t feel the economic impact of the pandemic until March or later. Now, companies affected by the pandemic are confronted with hard questions about whether non-GAAP measures should be used to adjust for, or explain the impact of, COVID-19 when reporting earnings and financial results.
A company may choose to reflect the business impact of COVID-19 by creating a new COVID-19-related line-item adjustment or redefining an existing non-GAAP financial measure. For example, “other income” may now include costs incurred to prevent the spread of the virus. In determining whether a non-GAAP measure requires a COVID-19-related adjustment, a company should consider whether the adjustment is:
- Directly related to COVID-19 or the resultant economic fallout,
- Expected to become part of the new normal, and
- Objectively quantifiable.
Regardless of how management decides to make the adjustment, the description of the adjustment must not be misleading.
Use (and abuse) of non-GAAP metrics
In the age of COVID-19, William Hinman, director of the SEC’s Division of Corporation Finance, said that his staff has seen mixed quality of non-GAAP measures: some good, some not so good. He warned companies against using speculative estimates in non-GAAP disclosures, especially in adding back revenues that might have been received had it not been for the pandemic.
“We’ve seen a range of non-GAAP disclosures that mentioned COVID items,” Director Hinman told Julie Bell Lindsay, executive director of the Center for Audit Quality (CAQ), an affiliate of the AICPA. “Some are starting to push the envelope.”
In March, the Division of Corporation Finance issued Corporate Finance Disclosure Guidance: Topic No. 9, Coronavirus (COVID-19). It advises companies against presenting “non-GAAP financial measures or metrics for the sole purpose of presenting a more favorable view of the company.” Instead, the guidance encourages companies to share “why management finds the measure or metric useful and how it helps investors assess the impact of COVID-19 on the company’s financial position and results of operations.”
External assurance on non-GAAP metrics
Separately, on September 29, the CAQ — an autonomous, nonprofit public policy organization composed of accounting professionals — published a report. It highlights how independent auditors could play a useful role in enhancing the reliability and comparability of non-GAAP measures and other key performance indicators (KPIs).
Currently, auditors don’t perform audit procedures on non-GAAP measures because they’re outside audited financial statements. They do look for overall consistency, but investors have increasingly been asking for greater assurance of such “other information.”
“In their public interest role, public company auditors play a role in the flow of comparable and reliable information for decision making,” said Executive Director Lindsay. “Having auditors associated with non-GAAP financial measures and KPIs could bring additional discipline to management’s process and help enhance the trust and confidence in such information.”
“One of the general principles we have when we look at non-GAAP disclosure is, is this something the company is actually using itself or managing itself or its relationships with lenders or others,” Hinman said in explaining the SEC’s review of disclosures. “Or is this something that is intended more or less to paint a rosier picture. Obviously, the latter are of concern.”
Some COVID-related items may warrant adjustments to non-GAAP measures. Examples include the impact of hazard pay, additional cleaning expenses and supply chain disruptions that required air flights instead of trains. Hinman believes these types of metrics would be useful to investors.
“If you can identify those and highlight that these are things that are affecting margins and affecting the business, you know, put that in a non-GAAP number that gets reconciled with the GAAP numbers,” Hinman said. “We don’t have any trouble with that at all.”
Conversely, when companies provide disclosures that add back in revenue that might have been lost because they were closed during COVID-19-related shutdowns, those estimates are largely speculative and could be manipulated to put a better spin on things. Hinman said, “Adding back revenue that was lost is a very subjective, difficult process to go through. Who knows where you would have been? It’s very difficult to associate expenses and to take those into account and sort of add back the revenue.”
For more information
Regardless of whether a business is public or private, when in crisis mode, management may feel pressure to present the most favorable view of financial health. However, the use of non-GAAP metrics may not enhance consistency and credibility in financial reporting and can lead to a misleading picture of performance.
Before your company reports its earnings and financial results for the third quarter of 2020, it’s important to understand your disclosure obligations related to non-GAAP financial measures in the context of COVID-19. Contact your CPA for more information or to obtain external assurance on the consistency of your company’s non-GAAP metrics and disclosures.
Sidebar: 10 questions about the use of non-GAAP metrics
The Center for Audit Quality (CAQ) has identified several issues to consider before relying on non-GAAP metrics. Here are 10 questions that address the transparency of non-GAAP disclosures:
- What’s the purpose of the non-GAAP measure, and would a reasonable investor be misled by the information?
- Has the non-GAAP measure been given more prominence than the most comparable GAAP measure?
- How many non-GAAP measures have been presented, and are they all necessary and appropriate for investors to understand performance?
- Why has management selected a particular non-GAAP measure to supplement GAAP measures that are already established and consistently applied within its industry or across industries?
- Does the company’s disclosure provide substantive detail on its purpose and usefulness for investors?
- How is the non-GAAP measure calculated, and does the disclosure clearly and adequately describe the calculation, as well as the reconciling items between the GAAP and non-GAAP measures?
- How does management use the measure? Has that use been disclosed?
- Is the non-GAAP measure sufficiently defined and clearly labeled as non-GAAP or could it be confused with a GAAP measure?
- What are the tax implications of the non-GAAP measure, and does the calculation align with the tax consequences and the nature of the measure?
- Does the company have material agreements, such as a debt covenant, that require compliance with a non-GAAP measure? If so, is it disclosed?
The CAQ provides additional questions that address the consistency and comparability of non-GAAP metrics. Contact your CPA for more information.