Financial Reporting – Presentation Choices

The presentation choices adopted by a company when preparing its financial statements can significantly influence analysts’ and other users’ opinions on these statements. These presentation choices include both GAAP and non-GAAP measures.

Presentation Choices That Influence Analyst Opinions

Earnings before interest, taxes, depreciation and amortization (EBITDA) eliminates noisy reporting signals which are introduced by the employment of different accounting methods for depreciation, amortization of intangible assets, and restructuring charges among companies. Companies may construct and report “adjusted EBITDA” by excluding additional items such as rent payments for operating leases, equity-based compensation, acquisition-related charges, certain impairment charges, litigation costs, and loss/gain on debt extinguishments, from net income.

Lenders may demand that a borrower achieves and maintains a defined performance criteria by using GAAP net income as a starting point but arrive at a more “suitable” measure. The borrowing company may use this measure as its preferred non-GAAP metric in earnings releases. Indeed, it may also use it to describe its liquidity or solvency situation.

The Securities and Exchange Commission (SEC)

If a company uses a non-GAAP financial measure in a SEC filing, it has to display the most directly comparable GAAP measure with equal prominence and provide a reconciliation of the two. The company’s management must also explain why it believes that the non-GAAP financial measure provides useful information regarding the company’s financial condition and operations. Above all, the company must disclose additional material purposes for which it uses the non-GAAP financial measures.

The SEC intended for the definition of non-GAAP financial measures should capture all measures. Note that these measures have the effect of depicting either a measure of performance that differs from the one presented in the financial statements or a measure of liquidity that differs from cash flow from operations computed under GAAP.

The SEC does not allow a company to exclude charges or liabilities requiring cash settlement from any non-GAAP liquidity measures, other than EBIT and EBITDA. The SEC also prohibits the calculation of a non-GAAP performance measure intended to eliminate or smooth items that are tagged as non-recurring, infrequent, or unusual when such items are extremely likely to recur.

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 any 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. Both 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.