Credibility and Non-GAAP Metrics: Good, Bad, or Ugly?
Investors and the Securities and Exchange Commission (SEC) have a love-hate relationship with non-GAAP (Generally Accepted Accounting Principles) metrics. On the one hand, they love information that could help them better determine where to invest capital. On the other hand, they have a hard time gauging the reliability of non-GAAP metrics.
So where does this leave those of us developing a transparent and accurate strategic message for our company? And how do non-GAAP metrics help shape credible investor, analyst, and financial media relationships?
It all comes down to the credibility factor. Non-GAAP metrics can be a critical component of your company’s strategic message, but they shouldn’t be abused. The goal should be transparency and easing investor understanding—not obfuscation.
What is a non-GAAP metric?
Before we discuss how these measurements can increase your company’s credibility and play a key role in both your investor and media strategy, let’s define a non-GAAP metric.
According to the SEC, a non-GAAP metric is “a numerical measure of a registrant’s historical or future financial performance, financial position, or cash flows that:
(i) 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 in the statement of income, balance sheet or statement of cash flows (or equivalent statements) of the issuer; or
(ii) Includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable measure so calculated and presented.”
Essentially, a non-GAAP financial measure is intended to depict a measure of performance or liquidity that is different from those presented in audited financial statements (e.g., sales, net income, cash flow from operations).
To make it even clearer, let’s say your company anticipates conducting a sizeable restructuring this year. If this will have a material impact on net income, you may wish to report net income with restructuring charges (GAAP) and without restructuring charges (non-GAAP). The non-GAAP measure, then, would be: GAAP net income less restructuring charges = Adjusted Net Income.
The non-GAAP challenge.
Over the years, the use of non-GAAP metrics and their prominence in financial discussions has been on the rise. In 2015, just 12% of S&P 500 companies reported only GAAP (audited) numbers in their public filings. That was down from 25% in 2006. Non-GAAP metrics have become a common way for companies to share more about how they view company operations and performance (see the example above).
To be sure, there is value in using appropriate non-GAAP metrics as a supplement to audited GAAP reporting. What we want to avoid are misleading metrics. Unfortunately, over time we have seen that some companies’ non-GAAP metrics veered away from the original intent and may have been used to paint an overly optimistic picture of business operations.
As non-GAAP metrics have increased in usage, so have concerns that such measures might not be as rigorously tested and maintained as their GAAP counterparts. As a result, the SEC updated its guidelines to clarify what might be considered misleading non-GAAP presentations and how to avoid giving non-GAAP measures greater prominence than comparable GAAP measures.
Since updating its guidance on non-GAAP metrics in May, SEC officials have sent significantly more comment letters to companies regarding non-GAAP use and they have cracked down on potentially misleading non-GAAP disclosures.
As we head into quarterly (and annual) reporting, it’s a good time to revisit your disclosure strategy and consider how to communicate your company’s strategic direction and associated metrics.
Guidelines for using non-GAAP in your investor relations strategy.
1. Give GAAP prominence. When presenting a non-GAAP measure it must be presented with the most directly comparable GAAP measure given equal or greater prominence. For example, an earnings press release should cite GAAP net income before a non-GAAP “adjusted net income”.
2. Ensure non-GAAP measures aren’t misleading. Some adjustments specifically called out by the SEC (although not explicitly prohibited) include non-GAAP metrics that
- exclude normal, recurring, cash operating expenses necessary to operate the business;
- are adjusted and presented inconsistently between periods;
- accelerate revenue recognition;
- include nonrecurring charges, but not nonrecurring gains; and
- do not show current and deferred income tax expense commensurate with the non-GAAP measure of profitability and note the income tax effects of the adjustments as a separate item (i.e., rather than showing net income “net of tax” adjustments should show income taxes as a separate adjustment that is clearly explained).
3. Return to the fundamentals of your message. Ask: What is our corporate strategy? What goals and objectives are we (or should we) be discussing in our disclosures to demonstrate progress? What are our milestones?
4. Ensure the non-GAAP metrics you use fit with your strategic message. When considering a non-GAAP metric ask the following questions:
- What is the intent of the metric? Does it help to paint a more complete picture of the company’s performance and/or market opportunity?
- Is this metric meaningful? Is this a metric that your management team uses to discuss the company with employees? Are managers held accountable for this metric?
- What are the measures used by the company to assess progress against annual/long-term strategy?
- What are key metrics in our industry? In my peer group? Are they helpful or outdated?
- If I was a shareholder, would this metric better help me understand my company’s performance against stated strategy and goals?
But don’t overreach. Many investors will only consider GAAP in their models so be honest with investors (and yourself!) about those GAAP numbers and be ready to discuss them. All businesses have challenges, operational quirks, and unique investment and value-creating strategies. Stick to the truth of your operations and your company’s plan to achieve strategic goals.
At Audacia Strategies, credibility is king (and our #1 value). Credibility is all in the way you present and conduct yourself. If your aim is to help your stakeholders make smart investment decisions, you can’t go wrong. Treat your investors the way you would want to be treated.
How do you think about using non-GAAP measures? Do you discuss them with media? Employees? Have you received feedback from shareholders or analysts?
Financial disclosure is a critical component of a comprehensive communications strategy. We can help tighten up your investor relations strategy and integrate your messaging across your stakeholder sets. Let’s talk!
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