Generally Accepted Accounting Principles (GAAP) is generally considered the gold standard in financial reporting in the United States. But private and public entities may sometimes use non-GAAP metrics in their disclosures and press releases or when applying for financing.
GAAP vs. Non-GAAP
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 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 Securities and Exchange Commission to follow GAAP.
Over the years, the use of non-GAAP measures has grown. Some investors and executives argue that certain unaudited figures provide a more meaningful proxy of financial performance than customary earnings figures reported under GAAP. Before relying on non-GAAP metrics, however, it’s important to understand what’s included and excluded to avoid making misinformed investment decisions.
Spotlight on EBITDA
One popular example of a non-GAAP metric is earnings before interest, taxes, depreciation and amortization (EBITDA). It was developed in the 1970s to help investors project a company’s long-term profitability and cash flow. The figure is said to be one of the most valuable yardsticks that investors consider when a company is being bought or sold. However, some companies manipulate EBITDA figures by excluding certain costs, such as stock- or options-based compensation, that are plainly a cost of doing business. This trend has made it difficult for investors and lenders to make fair comparisons and understand the items taken out.
Last year, the Financial Accounting Standards Board added a project to its research agenda to consider the interaction with standardizing key performance indicators (KPIs) within the current regulatory framework, including whether to develop a standard definition of EBITDA. During a March meeting of the Financial Accounting Standards Advisory Council, senior accountants evaluated whether it makes sense to have a GAAP definition of EBITDA, to use either as a one-size-fits-all formula or as a starting point from which companies could make adjustments based on their business needs. For example, a company might tailor its EBITDA calculation to sync with the definition found in its loan agreements. Adjustments to EBITDA would then need to be clearly disclosed in the company’s footnotes.
Adopt a balanced approach
Many organizations decide to report EBITDA and other non-GAAP metrics to help investors and other stakeholders make better-informed decisions. However, these entities should also avoid making claims that could potentially mislead investors and lenders. Contact an Axley & Rode advisor to responsibly and transparently report non-GAAP figures for your company.
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