Presentation Choices That Influence Analyst Opinions

Numerous choices in applying accounting standards contribute to the extensive volume of accounting literature and textbooks. Understanding the choices companies make in financial reporting is crucial for evaluating the overall quality of the reports—both in terms of financial reporting quality and earnings quality.

Presentation choices reflecting financial reporting quality are often more visible to investors, whereas choices in calculating financial results (earnings quality) are more challenging to discern as they can be deeply embedded in the construction of reported outcomes.

The availability of accounting choices allows managers to influence the reporting of financial results. For instance, some choices are aggressive, while others are conservative choices. More specifically, a manager aiming to boost current performance and financial position might:

• Recognize revenue prematurely;
• Use non-recurring transactions to increase profits;
• Defer expenses to later periods;
• Measure and report assets at higher values
• Measure and report liabilities at lower values.

Conversely, a manager aiming to improve performance and financial position in a future period might:

• Defer current income to a later period (saving income for a “rainy day”);
• Recognize future expenses in the current period, setting the stage for better future performance.

Note that in addition to choices within GAAP, companies may also prepare fraudulent reports, such as including non-existent revenue or assets.

Presentation Choices That Influence Analyst Opinions

During the technology boom of the 1990s and the early 2000s internet bubble, many popular companies couldn’t generate enough current earnings to justify their stock prices using traditional price-to-earnings ratio (P/E) valuation methods. Investors rationalized this by suggesting that conventional focus on profits and valuation methods no longer applied to these companies. This led to the emergence of new metrics for assessing operating performance, such as “eyeballs” captured by websites or the “stickiness” of their pages for user visits. Various versions of “pro forma earnings” or “non-GAAP earnings measures” became prevalent during this period.

Evolution of Proforma Reporting

While technology companies popularized pro forma reporting, they were not the first to use it. In the early 1990s, downsizing large companies often led to massive restructuring charges that obscured operating performance. For instance, IBM reported significant restructuring charges in 1991, 1992, and 1993 as it adapted to a market favoring personal computers over mainframes. Companies sanitized earnings releases by excluding these restructuring charges in pro forma financial performance measures to counter the perception of floundering operations.

Accounting principles for business combinations also boosted pro forma earnings’ popularity. Before 2001, acquisitions often resulted in goodwill amortization charges, weakening subsequent earnings reports. The pooling of interests and purchase methods were two accounting methods for recording acquisitions. Pooling of interest was difficult to achieve but desirable because it did not result in goodwill amortization charges. During the technology boom, acquisitions were common, and many were reported as purchases, leading to goodwill amortization and dragging down earnings. Companies responded by presenting earnings adjusted to exclude amortization of intangible assets and goodwill.

EBITDA and Adjusted EBITDA

Investors sought to compare companies on a consistent basis, leading to the popularity of earnings before interest, taxes, depreciation, and amortization (EBITDA) as a performance measure. EBITDA is seen as eliminating noisy reporting signals caused by different accounting methods among companies. Companies might construct their own version of EBITDA, referred to as “adjusted EBITDA,” by excluding additional items from net income, such as:

• Rental payments for operating leases (EBITDAR)
• Equity-based compensation, justified as a non-cash expense
• Acquisition-related charges
• Impairment charges for goodwill or other intangible assets
• Impairment charges for long-lived assets
• Litigation costs
• Loss/gain on debt extinguishments

Loan covenants also drive the use of non-GAAP earnings measures. Lenders may require performance criteria based on GAAP net income, adjusted to suit the lender’s needs. Companies might use this measure as their preferred non-GAAP metric in earnings releases and management commentaries.

The SEC requires that if a company uses a non-GAAP financial measure in an SEC filing, it must display the most comparable GAAP measure with equal prominence and provide a reconciliation between the two. Management must explain why the non-GAAP financial measure is useful for understanding the company’s financial condition and operations and disclose any additional purposes for which it is used. Similarly, IFRS requires definitions and explanations of non-IFRS measures in financial reports, including why they are relevant to users and reconciliations with IFRS measures.

The SEC’s definition of non-GAAP financial measures captures all measures that depict:

• A performance measure differing from that presented in financial statements according to GAAP
• A liquidity measure differing from cash flow or cash flow from operations computed in accordance with GAAP

The SEC prohibits excluding cash-settled charges or liabilities from non-GAAP liquidity measures, other than EBIT and EBITDA. It also prohibits calculating a non-GAAP performance measure to eliminate or smooth items labeled as non-recurring, infrequent, or unusual when such items are likely to recur within two years before or after the reporting date.

Question 1

Which of the following statements is the least accurate?

1. Companies may construct and report “adjusted EBITDA” by including additional items with net income.
2. In SEC filings, a comparable GAAP measure must be displayed with equal prominence beside non-GAAP financial measures.
3. The SEC prohibits a company from excluding charges or liabilities requiring cash settlement from non-GAAP liquidity measures, other than EBIT and EBITDA.

Solution

The correct answer is A.

Companies may construct and report “adjusted EBITDA” by excluding and not including additional items from net income.

Options B and C are accurate statements.

Question 2

If a company uses a non-GAAP measure in its financial reports, it must disclose:

1. The reason for using that measure.
2. A reconciliation between that measure and the closest GAAP measure.
3. The reason for using that measure and reconciliation between that measure and the closest GAAP measure.

Solution

The correct answer is C.

To use a non-GAAP measure, a company must disclose the reason for using the measure so that investors can judge its viability. In addition, the company must reconcile the measure to the closest measure to guide an investor to the closest alternative GAAP measure. Further, the company must clarify the difference between the two measures.