Why the FASB Cares about Non-GAAP Performance Measures
One of the growing controversies in financial reporting in 2016 was over public companies’ use of non-GAAP reporting to describe their business performance to investors. For example, 88 percent of S&P 500 companies disclose non-GAAP measures in earnings releases.
I often ask myself: Are these companies — deliberately or otherwise — sending us a signal about ways to improve GAAP?While the number of non-GAAP measures garnered significant attention, the nature of some of the non-GAAP measures were particularly troubling. Those measures lacked credibility because they ignored GAAP recognition and measurement principles altogether and inaccurately depicted the underlying transaction or event.
The challenge lies in the potential for investors to misunderstand performance if they selectively use highly customized or tailored non-GAAP-based figures. The Securities and Exchange Commission (SEC) has clearly signaled to companies it is concerned about this, and companies are on notice that the SEC is paying close attention to how non-GAAP measures are used in investor communications.
As a standard setter, I find the same trend intriguing. I often ask myself: Are these companies—deliberately or otherwise—sending us a signal about ways to improve GAAP?
To answer that question, let’s take a quick look at the performance reporting landscape.
The Different Types of Performance Reporting
You can bracket performance reporting into different categories that I think are reasonably clear and delineated. They are: GAAP, non-GAAP, and key performance indicators (including nonfinancial KPIs). Let’s look at each in turn.
GAAP, or Generally Accepted Accounting Principles, is considered the “gold standard” of financial reporting. For many decades now, it has been developed through a comprehensive and transparent standard-setting process—one through which the FASB solicits and considers views from a broad range of diverse stakeholders.
In its standards that constitute GAAP, the FASB requires GAAP performance measures such as net income, earnings per share, and operating cash flows.
Non-GAAP depicts measures of performance that are alternatives to GAAP. These measures (common ones include adjusted EBITDA, operating earnings, and free cash flow) are based upon information contained in GAAP financial statements. It’s a direct path from the GAAP calculation to the non-GAAP calculation. Such numbers are generally derived directly from GAAP results and thus are easy to reconcile.
Non-GAAP performance measures also include measures that ignore GAAP recognition and measurement principles altogether. In these cases, companies are developing customized or tailored measures of performance to highlight their preferred methods of assessing business growth.
To improve an investor’s understanding of non-GAAP reporting, the SEC’s Division of Corporation Finance recently issued a revised set of Compliance and Disclosure Interpretations that provides examples of existing rules and regulations in this area.
Key performance indicators, or KPIs, are operating and other statistical metrics that cover both financial and nonfinancial reporting information. However, they are not defined by an authoritative standard setter. Some, such as with certain revenue metrics, may be based on GAAP information. Others that provide nonfinancial information—such as number of stores, number of employees, and number of subscribers or advertisers—are not based on GAAP.
Evaluating non-GAAP to improve GAAP
As we think about identifying new ways in which to improve GAAP, it is important to see how companies today use non-GAAP reporting to communicate their performance to shareholders.
Another way to learn from non-GAAP measures is to identify cases in which changes to GAAP might reduce the need for non-GAAP reporting.
We recently discussed non-GAAP reporting with our Financial Accounting Standards Advisory Council (FASAC). FASAC members informed us that investors rely on non-GAAP measures primarily because they are derived from GAAP information and affirmed our thinking about the potential standard-setting implications of non-GAAP reporting. They encouraged us to continue to monitor the use of non-GAAP measures and observed that certain non-GAAP adjustments might help the FASB identify where improvements could be considered.
Another way to learn from non-GAAP measures is to identify cases in which changes to GAAP might reduce the need for non-GAAP reporting. Some non-GAAP reporting develops because investors request and help shape the information provided by companies. Changing GAAP in these situations can help develop a standardized approach that is more consistent with common reporting practices that investors find useful. In other words, it would improve the credibility of financial reporting.
To give one recent example, the FASB decided that debt-valuation adjustments for a company’s own credit risk should be recorded through other comprehensive income rather than net income. This change eliminates the need for companies to make non-GAAP adjustments for such gains and losses, which many investors found to be counterintuitive.
Another example is our current project on hedge accounting. Today, many preparers do not attempt to qualify for hedge accounting because the accounting guidance on derivatives is complex. Some of those preparers account for certain derivatives without applying hedge accounting and then simply use non-GAAP measures to adjust away the accompanying volatility in their GAAP results. Making hedge accounting easier may encourage more companies to apply that guidance and potentially reduce the need for companies to report non-GAAP measures.
If non-GAAP measures developed by management are inconsistent, misleading, and noncomparable—then they don’t enhance consistency and credibility in financial reporting—and won’t be acted on by the FASB.
More broadly, the FASB is conducting a research project on financial performance reporting. This project is specifically focused on evaluating different alternatives for requiring more subtotals or more disaggregation in the income (or performance) statement. As we consider performance reporting improvements, it is important that we study non-GAAP measures that are commonly used in practice.
Our ongoing mission is to write standards that provide useful information to investors and other users of financial reports. As we move forward, the FASB will continue to monitor non-GAAP reporting practices to assess the implications for both active standard-setting projects and our future agenda.
The FASB’s process results in standards that enhance the consistency and credibility of information reported in the markets. If non-GAAP measures developed by management are inconsistent, misleading, and noncomparable—then they don’t enhance consistency and credibility in financial reporting—and won’t be acted on by the FASB. Simply put, financial statement users expect, and deserve, much better.