Non-GAAP measures and other presentation choices

What is a non-GAAP measure, and why does it matter?

Non-GAAP financial measures are performance or liquidity figures that differ from the ones the accounting standards produce. Net income and cash flow from operations are the standard measures. Adjusted earnings and adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) are the company’s own versions. Other names are pro forma earnings , non-IFRS measures and alternative performance measures .

Management likes them for reasons that sound fair. The adjusted number removes noise, makes companies comparable, and often matches what lenders measure in covenants. The concern is that leaving out only the bad items, and leading with the result, is an aggressive way to present the year. It draws attention away from a weak GAAP result.

Adjusted EBITDA is the typical case. EBITDA itself is net income plus interest, taxes, and depreciation and amortization. Companies then add their own items: operating lease rentals (earnings before interest, taxes, depreciation, amortization, and rent, or EBITDAR), share-based compensation, acquisition costs, impairments, litigation costs, gains or losses on debt extinguishment.

$$EBITDA = NI + \text{interest} + \text{taxes} + \text{depreciation and amortization}$$

What rules apply when a company reports one?

The answer differs by regime, but the principle is the same: show the standard number, link the two, and explain.

Since 2003, any SEC filing that contains a non-GAAP financial measure must also include:

1. the most directly comparable GAAP measure with equal or greater prominence ;
2. a reconciliation from the non-GAAP measure to the GAAP one, which is the reconciliation requirement ;
3. an explanation of why management thinks the measure is useful, plus any other purpose it serves.

The SEC also sets prohibited adjustments . A non-GAAP liquidity measure may not exclude charges that need cash settlement, except earnings before interest and taxes (EBIT) and EBITDA. And a performance measure may not eliminate or smooth items labeled non-recurring, infrequent or unusual when they are likely to occur again, which the SEC tests as similar items within two years before or after the reporting date.

Under IFRS, the management commentary statement (2010) asks for a definition and explanation of any measure not defined by IFRS, including why it is relevant, and a reconciliation to the IFRS statements. Guidelines from the European Securities and Markets Authority (ESMA), issued in October 2015, on alternative performance measures add that the measure must be presented consistently over time.

Presenting an adjusted measureallowed, with conditions

• SEC filings (US GAAP and IFRS filers) Memorize since 2003
  • Required
    • Most comparable GAAP measurewith equal or greater prominence
    • Reconciliationfrom the non-GAAP figure to the GAAP one
    • Explanationwhy it is useful, and any other purposes
  • Prohibited
    • Excluding cash-settled charges from a liquidity measureexcept EBIT and EBITDA
    • Calling an item non-recurring, infrequent or unusualif it is likely to recur or occurred within the past two years
• IFRS and Europe Use it management commentary; ESMA guidelines on alternative performance measures
  • Define and explain including why it is relevant to users
  • Reconcile to the IFRS financial statements
  • Keep it consistent over time

Exam tip When a question asks what is “required”, pick GAAP equal prominence plus reconciliation. When it asks what is “prohibited”, think “leading with the non-GAAP number” or “calling a repeat a one-off”.

How do you judge an adjustment?

Ask three questions of each add-back. Does it keep coming back? Does it use cash? Do owners still bear it? An item that recurs or costs owners something is part of the business, whatever label it carries.

$$NI_{adj} = NI + \sum \text{accepted add-backs}$$

The same logic applies to adjusted EBITDA.

What other presentation choices can steer you?

Numbers are not the only lever. Presentation choices shape which number you see first and how you read it.

• The favorable metric leads the press release and the GAAP figure sits deep in a table.
• Recurring costs are relabeled “special items” year after year.
• A loss is placed in other comprehensive income or equity instead of the income statement, so the location of recognition hides it.
• Management commentary stresses the good news, or stays the same from period to period.
• Segment definitions change or segments are aggregated, hiding a weak unit.

Go deeper Operating metrics are different

Subscribers, same-store sales or units shipped are operating metrics, not non-GAAP financial measures, so the reconciliation rule does not apply to them. Judge them the other way: are they defined the same way each period, and do they link to revenue and cash?

Go deeper Why adjusted figures spread

Three forces helped. In the 1990s, large restructuring charges were routine, so companies excluded them to show “operating” performance. Before 2001, goodwill amortization dragged on acquirers’ profits, so they presented earnings before it. And lenders often write covenants on a net income variant, which companies then reuse in their releases. EBITDA became popular because it removes differences in depreciation, amortization and restructuring across companies.