U.S. Generally Accepted Accounting Principles (GAAP) are a set of rules and procedures, created by the Financial Accounting Standards Board (FASB), that accountants typically follow to record business transactions. Private companies generally aren’t required to follow GAAP, but many do. Public companies don’t have a choice; they’re required to follow GAAP.
In recent years, the use of non-GAAP measures — such as earnings before interest, taxes, depreciation and amortization (EBITDA) — has grown. These unaudited figures can provide added insight when they’re used to supplement GAAP performance measures. But they can also mislead investors and artificially inflate a public company’s stock price. As a result, the Public Company Accounting Oversight Board (PCAOB) wants non-GAAP measures to be audited, just like GAAP financial information.
No standards for non-GAAP data
Public companies routinely say that non-GAAP measures provide a better reflection of how they manage their business than many U.S. GAAP metrics do. And many investors find it useful to get management’s perspective on the company’s operations.
But these metrics aren’t calculated consistently or audited. Moreover, when companies use them during quarterly earnings calls and in press releases to present a better financial picture to investors, it may lead to a short-term boost to stock prices.
This lack of standardization and auditing has made non-GAAP metrics “potentially dangerous to the stability and efficiency of the markets,” said Tony Sondhi, who serves as the co-lead of the PCAOB’s Investor Advisory Group (IAG).
“We are concerned that corporations are selectively reporting one-time and recurring items as non-GAAP financial measures that may make ‘core’ operations look more favorable and not disclosing one-time adjustments that would make ‘core’ operations look worse,” explained Sondhi, who’s also a member of the FASB’s Emerging Issues Task Force (EITF).
As a result, the IAG wants input from the FASB to help promote the accuracy of a public company’s key performance indicators. In particular, the IAG recently asked the FASB to identify and define non-GAAP metrics that would then be audited. The IAG believes that expanding the scope of today’s audit procedures would help investors gain greater, more reliable insight into a company’s financial condition.
Time for change
The IAG’s discussion comes as the Securities and Exchange Commission has been stepping up its efforts to prevent misuse of non-GAAP measures over the past two years. At the same time, the PCAOB staff has been studying whether auditors should have a greater involvement in examining their clients’ key performance indicators, including non-GAAP measures.
If the FASB were to decide it doesn’t have the authority to define key non-GAAP measures, the IAG suggested alternatively that the FASB specify for non-GAAP measures:
- The location and presentation,
- Appropriate methods of reconciliation, and
- The disclosure requirements.
Then the company’s management would select and define the non-GAAP measures. Once management selects a particular non-GAAP measure, it would be required to present that information for at least three years — even if management subsequently decided to drop it in future reporting periods. This would provide a framework around those measures and would give investors the extra information they want in a consistent manner.
It will take significant time and effort for the FASB to respond to the IAG’s request. Key performance indicators vary by industry, so there’s no one-size-fits-all list of non-GAAP measures or definitions. But the changes could be worth the wait: Expanding the scope of audit procedures to cover the non-GAAP metrics would help companies present these measures in a fairer and more reliable manner.