Indirect to Direct Method
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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.
Earnings before interest, taxes, depreciation, and amortization (EBITDA) eliminate noisy reporting signals introduced by employing 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 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 to describe its liquidity or solvency situation.
Suppose a company uses a non-GAAP financial measure in a SEC filing. In that case, 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 the non-GAAP financial measure provides useful information regarding its 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 to define non-GAAP financial measures should capture all measures. Note that these measures depict 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 non-GAAP liquidity measures other than EBIT and EBITDA. The SEC also prohibits calculating a non-GAAP performance measure intended to eliminate or smooth items tagged as non-recurring, infrequent, or unusual when such items are highly likely to recur.
Question 1
Which of the following statements is the least accurate?
- Companies may construct and report “adjusted EBITDA” by including additional items with net income.
- In SEC filings, a comparable GAAP measure must be displayed with equal prominence beside non-GAAP financial measures.
- 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:
- The reason for using that measure.
- A reconciliation between that measure and the closest GAAP measure.
- 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.