Exercising caution with non-GAAP measures and disclosures

Many companies supplement GAAP financial reporting with individually tailored accounting information. While these non-GAAP disclosures might provide useful information about an entity, financial statement preparers and users need to exercise increased caution when encountering non-GAAP measures on a balance sheet or an income statement.

Company CFOs and controllers, in addition to ensuring non-GAAP disclosures comply with SEC requirements if their company is public, should be watchful that more favorable non-GAAP measures don’t mislead internal and external stakeholders about the company’s actual financial performance and future viability.

Non-GAAP financials can be a red flag for finance professionals and accountants involved in (or advising clients on) an acquisition and for auditors dealing with new or recurring clients. Acquirers and auditors should take non-GAAP disclosures into account when assessing the integrity of management, especially when the disclosures inflate revenue or stakeholder equity. An understanding of non-GAAP measures and the related SEC reporting requirements prepares CPAs and finance professionals to spot concerns and possibly prevent or avoid negative consequences.

WHAT’S A NON-GAAP MEASURE?

While privately held companies do not widely publish non-GAAP mea-sures, publicly traded companies do, as evidenced by the overwhelming popularity of such disclosures among S&P 500 companies. Between July and September 2015, 88% of the S&P 500 used non-GAAP measures in their financial reports, according to Audit Analytics. By the first calendar quarter of 2020, 94% did, according to the Center for Audit Quality, which is affiliated with the AICPA.

SEC rules apply only to public companies, yet the rules provide good guidance for private companies and their auditors about financial reporting best practices. The SEC defines a non-GAAP financial measure as a numerical measure of a reporting company’s historical or future financial performance, financial position, or cash flows that either:

•  Excludes amounts that are included in the most directly comparable GAAP measure; or
•  Includes amounts that are excluded from the most directly comparable GAAP measure.

SEC compliance requires that non-GAAP financial measures not exclude expenses or liabilities that require cash settlement or have an earnings “smoothing” effect from excluding nonrecurring or infrequent charges. Companies may not present non-GAAP measures on the face of a GAAP financial statement and may not use titles that are the same as, or confusingly similar to, GAAP titles.

The SEC also requires that a company reporting non-GAAP financial measures add the following disclosures to reduce the potential that the information is misleading (for more, see the SEC rule “Conditions for Use of Non- GAAP Financial Measures” and the SEC Compliance & Disclosure Interpretations on “Non-GAAP Financial Measures.”):

• Present the most directly comparable GAAP financial measure with equal or greater prominence than the non-GAAP measure.
• Reconcile the differences between the non-GAAP measure and its most directly comparable GAAP measure.
• Disclose management’s reasons why the non-GAAP measure provides useful information to financial statement users along with management’s internal operating application for the non-GAAP measure.

WHAT’S OK AND WHAT’S NOT OK

The goal of the SEC’s rules and related guidance is to provide transparency about non-GAAP measures and disclosures and clarify how they could be misleading. But they don’t fully address when non- GAAP information is strategically cherry-picked to present a more favorable financial performance. To separate what is acceptable from what is misleading, here are some examples:

Non-GAAP financial measures that are generally not misleading:

• KPIs. Management uses KPIs to evaluate operational performance, make business decisions, and monitor progress toward achieving strategic goals. FASB has an open Invitation to Comment (ITC) for stakeholders to share their views on financial KPIs. The ITC features examples of financial KPIs including earnings before interest, taxes, depreciation, and amortization (EBITDA); free cash flow; organic sales growth; and adjusted net income. The deadline to comment on the ITC is April 30.
• Debt covenants. Debt covenants can indicate liquidity, solvency, borrowing capacity, and financial risk. They may require GAAP disclosures for credit agreement terms.

In contrast, misleading non-GAAP measures would:

• Alter revenue or expense recognition timing from one period to another, resulting in, for example, earlier revenue recognition or later expense recognition.
• Alter expense classification. FASB Topic ASC 842, Leases, for an operating lease requires lessees record a single lease expense over the lease term. Topic 842 for a financing lease requires that Lessees record lease depreciation expense (and interest expense). Incorrectly applying non-GAAP measures to imply the existence of a financing lease (that is truly an operating lease) would alter the expense classification from GAAP lease expense to non-GAAP depreciation expense. Showing a higher depreciation expense would incorrectly show an increased cash flow from operating activities (and non- GAAP EBITDA) after adding back depreciation expense.
• Impact comparability by inconsistently adjusting charges or gains in one period differently than for similar charges or gains in another period.
• Exclude charges, but not favorable items, in the same period, also referred to as cherry-picking. This may occur when excluding normal business operating expenses, which creates the appearance of improved profitability.

Cherry-picked non-GAAP measures and disclosures may omit costs while retaining the related benefits. Examples include:

• Omitting public company costs but retaining the company benefits from publicly raised capital. These costs may be for stock issuance, directors’ and officers’ liability insurance, stock exchange fees, SEC reporting compliance, legal fees, Sarbanes-Oxley compliance, or investor relations.
• Failing to include store opening and closing costs but retaining the company benefits from having multiple retail locations. Although management may appropriately exclude such costs from an individual store manager’s performance evaluation, for the company overall such costs are relevant to fulfilling its growth strategy.
• Leaving out acquisition costs when the company growth strategy is heavily reliant on mergers and acquisitions. These costs may be for acquisition target due diligence evaluation, legal and financing, transition, and integration. The company would include the new acquisition operations in its financial statements.
• Excluding technology investment costs while the company benefits operationally and competitively from the technology use. These costs may be for implementing an enterprise resource planning system.

CASE STUDIES IN FALLING PREY TO NON-GAAP MEASURES

Silicon Valley Bank (SVB) with its balance sheet and cloud software company CrowdStrike with its income statement are two examples of why auditors, accountants, and finance professionals need to be more diligent and exhibit higher professional skepticism when encountering non-GAAP measures.

A thorough financial analysis of SVB’s held-to-maturity (HTM) debt security investments, which were disclosed as required under GAAP, would have shown higher financial risks hiding in plain sight before the bank failed in March 2023 (see “Identifying and Analyzing the Risks of ‘Risk-Free’ Securities,” JofA, Sept. 1, 2023).

Non-GAAP disclosures by SVB were an additional red flag.

Many banks have extolled economic value of equity, representing a non-GAAP unrealized value of their depositors, justified by paying low interest rates on customer deposits even as interest rates rose for banks’ lending operations. Adding this non-GAAP measure to equity makes it look like shareholders’ equity is significantly higher, giving the illusion of a financially stronger bank.

In 2021, SVB presented a favorable alternative non-GAAP equity value that was 25% higher, but it did not reduce this alternative equity value by unfavorable, unrealized net losses on its HTM securities. In 2022, SVB’s unrealized net losses on its HTM securities became so large that it would have effectively wiped out 93% of its equity value. Three months into 2023, SVB collapsed.

In its 2021 Form 10-K filing (see the chart “SVB’s GAAP and Non- GAAP Equity Measures,” below), SVB included a $4.1 billion favorable non-GAAP economic value of equity measure in its equity value disclosure. This gave financial statement users the impression that SVB’s equity value was higher than the GAAP equity value. At the same time, SVB excluded the unfavorable non-GAAP equity impact of unrealized net losses on HTM debt investments that would have reduced its equity value. In its 2022 Form 10-K filing, the unfavorable impact of unrealized net losses on its HTM securities became much larger and eclipsed the favorable non-GAAP equity impact SVB management once touted.

CrowdStrike: The danger of assumptions

CrowdStrike, which publishes 13 non-GAAP income statement adjustments, is an example of enhancing income statement performance with non-GAAP measures. One of these, annual recurring revenue (ARR), is based on the optimistic view that any existing customer contract expiring in the next 12 months will be renewed on the same terms. The financial reporting impact is to puff up revenues, especially when including ARR prominently as the lead item in a quarterly earnings report (see the chart “CrowdStrike Fiscal 2024 Q2 Earnings,” below).

A sales assumption that all customers will renew their contracts defies economic and business reality. More concerning is that the first line in its quarterly earnings release is an annual non- GAAP revenue figure that may result in some readers anchoring on a revenue figure that is 3.2 times higher than the GAAP figure.

WHO CAN BE MISLED?

When reporting non-GAAP financial performance measures, management and those charged with governance should ensure that these measures are not misleading to both internal and external financial statement users. SEC non-GAAP guidance is used by external financial users, but it is also critical to internal management. Enhancing evaluation of non-GAAP measures may prevent management from believing financial performance is stronger than it actually is, a misconception that may distract them from addressing true operating problems.

About the author

Mark D. Mishler, CPA, CMA, MBA, is a fractional CFO and principal at CFO Resource Management in Morristown, N.J., and an adjunct professor of accounting, finance, and management at Seton Hall University in South Orange, N.J., and Rutgers University in New Brunswick, N.J. To comment on this article or to suggest an idea for another article, contact Jeff Drew at Jeff.Drew@aicpa-cima.com.

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