Subject to certain requirements and prohibitions, a company has flexibility to choose which non-GAAP financial measures and KPIs, if any, it reports and how it presents them. This means that companies can report different measures from what their peers, competitors, and companies in other industries report. This also means that various companies may report similarly titled non-GAAP financial measures or KPIs but calculate the measures differently from each other. These differences can make the measures susceptible to misinterpretation without proper context and explanation. While there is potential for non-GAAP financial measures and KPIs to be misleading, they can be helpful to financial statement users when disclosed appropriately. Quality non-GAAP financial measures and KPI disclosures need to be disclosed transparently and calculated consistently period to period. The following hypothetical scenarios emphasize the importance of these practices.
Non-GAAP financial measures
The importance of transparent non-GAAP disclosures can be illustrated using a hypothetical scenario in which two companies with identical GAAP net income present different non-GAAP results within MD&A in their annual report. As depicted in Table 1, both companies present a non-GAAP adjusted EBITDA financial measure; however, due to differences in how they calculate their adjustments, the non-GAAP financial measure results differ.
In addition to the reconciliation in Table 1, disclosures should accompany the non-GAAP financial measures to meet SEC requirements and provide users a more holistic picture of the non-GAAP financial measure.
The examples highlight the importance of transparency in disclosures. Companies A and B have identical GAAP net income, but different non-GAAP adjusted EBITDA amounts and adjustments to arrive at such amounts. Either presentation may be acceptable under SEC rules; however, in order for users to fully understand the non-GAAP financial measure, it must be accompanied by transparent disclosure. From the disclosures above, users of this information can clearly understand that the non-GAAP financial measures are calculated differently. Without these transparent disclosures, users of this information may not have enough information to understand the differences between Company A’s and Company B’s adjusted EBITDA calculations, and, therefore, may not have the information needed to make an informed investment decision.
Transparent disclosures also are important when reporting on KPIs. Similar to the non-GAAP financial measure example above, two companies may disclose KPIs that have the same or a similar title; however, they may be calculated differently or used for different purposes and, therefore, may not be comparable. In accordance with the SEC’s guidance on KPIs and in order to give users of this information a clear understanding of the KPI, the following should be disclosed:
A clear definition of the metric and how it was calculated: This will allow users of the information to understand the calculation, the comparability of the KPI to that of other companies, and the consistency of the KPI with past disclosures.
A statement indicating the reasons why the metric provides information useful to investors: This will assist investors in understanding the relevance of the KPI.
A statement indicating how management uses the metric in managing or monitoring the performance of the business: This will assist investors in understanding the purpose of the KPI.
As highlighted above, non-GAAP financial measures and KPIs supported by transparent disclosures can provide information that is helpful to investors and other financial statement users.