Generally Accepted Accounting Principles (GAAP) is commonly known as the benchmark for financial reporting in the United States. However, both public and private entities occasionally use non-GAAP metrics in their press releases and disclosures or when seeking financing.
GAAP vs. Non-GAAP
GAAP comprises a framework of rules and procedures that accountants typically follow to record and summarize business transactions. These guidelines establish the basis for consistent, accurate, and fair financial reporting. While private companies are not generally obligated to comply with GAAP, many choose to do so. Public companies, on the other hand, have no choice—they’re required by the Securities and Exchange Commission to follow GAAP.
The use of non-GAAP measures has grown over the years, and some executives and investors maintain that certain unaudited figures provide a more meaningful representation of financial performance compared to customary earnings figures reported under the GAAP. With that said, it’s crucial to understand what’s included and excluded to avoid making misinformed investment decisions.
Spotlight on EBITDA
One prominent example of a non-GAAP metric is earnings before interest, taxes, depreciation, and amortization (EBITDA). This metric was created in the 1970s to help investors assist in forecasting a company’s long-term profitability and cash flow. EBITDA is considered one of the most valuable benchmarks investors use when evaluating a company that is being bought or sold.
Unfortunately, some companies manipulate EBITDA figures by omitting certain costs, such as stock or options-based compensation, which are undeniably a cost of doing business. This practice has made it difficult for investors and lenders to make accurate comparisons and understand the items that have been removed.
Last year, the Financial Accounting Standards Board (FASB) added a project to its research agenda to explore the standardization of key performance indicators (KPIs) within the existing regulatory framework, including the development of a standardized definition for EBITDA. During a March meeting of the Financial Accounting Standards Advisory Council, senior accountants assessed the feasibility of establishing a GAAP definition of EBITDA for use as either a one-size-fits-all formula or as a starting point for companies to make adjustments based on their specific business requirements.
For instance, a company might tailor its EBITDA calculation to align with the definition specified in its loan agreements. Any modifications to EBITDA would need to be transparently disclosed in the company’s footnotes.
Adopt a balanced approach
Many organizations opt to report EBITDA and other non-GAAP metrics to help stakeholders and investors make better-informed choices. However, it is crucial for these entities to avoid making assertions that could potentially mislead investors and lenders.
Have questions? Smolin can help
If you’re unsure of how the regulations on reporting non-GAAP measures will affect your business, or if you want to know more about which reporting style works best for you, contact our team of professionals at Smolin and let us walk you through the ins and outs of these rules.