In the world of financial reporting, U.S. Generally Accepted Accounting Principles (GAAP) have long been the gold standard. The vast majority of financial statements are prepared using the GAAP basis of accounting, which makes it easier to compare financial statements and reduces the risk of data misrepresentation and fraud. But in recent years, we've seen a surge in the use of non-GAAP financial measures. While these can offer valuable insights to business owners and management, they've also caused quite a bit of controversy. Let's dive into this topic and see what it means for businesses and their stakeholders.  

The Non-GAAP Dilemma  

Non-GAAP financial measures are numerical ways to measure a company’s cash flows or financial position that are not calculated using GAAP. For example, non-GAAP financial measures like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) can paint a clearer picture of a company's operational performance. Non-GAAP financial measures are not bound by the strict rules of GAAP, which allows for more flexibility in reporting. Sounds good, right?  

Here's the catch: this flexibility can be a double-edged sword. While it can provide helpful information, it can also be used to mislead investors and other stakeholders. Some companies might exclude certain expenses from their EBITDA calculation, making their financial statements look better than they truly are.  

A prime example of this is WeWork, which, during its initial public offering (IPO) attempt, introduced a non-GAAP financial measure called "Community Adjusted EBITDA." This measure excluded key expenses like rent, marketing, and several other general administrative expenses, painting an overly optimistic view of the company’s profitability. The backlash from investors and regulators highlighted how non-GAAP financial measures can distort financial health if not used responsibly. In WeWork’s case, its aggressive use of non-GAAP financial measures contributed to the eventual collapse of its IPO plans. 

The Regulatory Response  

The U.S. Securities and Exchange Commission (SEC) has been keeping a watchful eye on this trend. The SEC is not saying non-GAAP financial measures are inadequate, but they want to ensure they're used responsibly. Here's what they're focusing on:  

1. Equal Prominence

Non-GAAP financial measures can't overshadow GAAP figures in financial reports.  

2. Clear Reconciliations

Companies should reconcile their non-GAAP financial reports with GAAP financial reports to make it clear how the non-GAAP financial measures impact their financial reports.

3. Audit Report Adjustments 

Companies should disclose what non-GAAP financial measures were used in the financial statements and the overall impact on the financial statements if GAAP had been used. This could result in a qualified opinion in the auditors’ report instead of an unqualified opinion. 

Investor Perspective  

For investors, non-GAAP financial measures can be both enlightening and confusing. On one hand, they can provide insights into how management views the company's performance. On the other, they can make it tricky to compare companies or understand their financial position.  

The key for investors is to approach non-GAAP financial measures with a healthy amount of skepticism. Always look for the GAAP figures, understand the reconciliation between GAAP and non-GAAP, and question why certain adjustments are being made.  

Strike a Balance 

For businesses, using non-GAAP financial measures is about finding the right equilibrium between providing additional insights and maintaining transparency. When implementing non-GAAP financial measures, focus on telling your company's financial story clearly and consistently. Consider how these measures align with your long-term strategy and industry trends. Most importantly, be prepared to explain your rationale for using specific non-GAAP financial measures to investors, analysts, regulators, and other stakeholders. 

Remember, the goal is to enhance understanding of your company's performance, not to obscure it. By thoughtfully applying non-GAAP financial measures, you can provide valuable insights while maintaining the trust of your stakeholders and staying compliant with regulatory guidelines.  

Looking Ahead  

The debate over non-GAAP financial measures isn't going away anytime soon. As businesses evolve and face new challenges (current economic conditions, labor shortages, increased competition, natural disasters, rapid technological changes, etc.), there will always be a desire to explain performance in ways that go beyond traditional GAAP metrics.  

At the same time, regulators will continue refining their approach to ensure investors get a fair and accurate picture of a company's financial health. We might see more standardization of non-GAAP financial measures or increased auditor involvement in reviewing these figures.  

Lutz can Help Navigate Non-GAAP Complexities 

Navigating the complexities of non-GAAP financial measures requires expertise and vigilance. At Lutz, we are committed to helping you and your company balance insightful reporting with regulatory compliance. Our financial statement reporting and consulting services can help you develop robust non-GAAP financial measures, ensuring clear reconciliations and maintaining transparency in your financial statements. Contact us today to ensure your non-GAAP financial measures are both meaningful and compliant. 

Contributor: Maddie Payne, Accounting Intern