Non-GAAP financial measures and key performance indicators

By Laura Hay, CPA, CAE, OSCPA executive vice president

In the post-pandemic environment, business transformations, strategy changes and management views offer important information to the future valuegenerating activities of an organization that may not be conveyed through traditional GAAP measures.

Financial reporting is working to keep pace with:

• Efforts to quantify non-financial capitals that create value

• Identification of risks and uncertainties to achievement of strategy

• Environmental, social and governance metrics

While some non-financial measures and key performance indicators (KPIs) are communicated in Management Discussion and Analysis (MD&A), companies are increasingly reporting other non-GAAP financial measures. The AICPA Center for Audit Quality reports that by 2020, 94% of S&P 500 companies included at least one non-GAAP financial measure in their earnings releases. What are non-GAAP financial measures and KPIs, how are they incorporated in financial reporting, and what are the responsibilities of the auditor for these measures?

What are non-GAAP financial measures?

Non-GAAP financial measures supplement GAAP disclosures by including or excluding amounts from the GAAP measure that “in the eyes of management” present a more relevant depiction of performance for the nature of that business. Examples include:

• Presenting earnings before depreciation to provide a more accurate depiction of cash flows

• Operating income that excludes one or more expense items

• Core earnings derived from a company’s principal business

• Free cash flow, after cash needed to support operations and capital expenditures

• Funds from operations, before depreciation and income tax

The use of non-GAAP measures has been met with SEC scrutiny that they are potentially misleading to investors and skepticism, since they most frequently present more positive results. While non-GAAP measures have become a popular SEC comment topic, the use of non-GAAP measures is not new. Following the accounting scandals of the early 2000s, the SEC issued cautionary guidance followed by regulations. SEC Regulation G, Item 2.02 of Form 8-K and Regulation

S-K Item 10(e) include the following requirements:

• The non-GAAP financial measure must not be misleading.

• The most directly comparable GAAP measure must be presented with equal or greater prominence.

• A reconciliation between the non-GAAP and most directly comparable GAAP measure must be presented.

• The disclosure must include a statement on why management believes the non-GAAP measure provides useful information to the investor and the additional purposes for which management uses the non-GAAP measure, to the extent material.

• The title or description of the non-GAAP measure cannot be the same as or confusingly similar to the GAAP measure.

The pandemic heightened scrutiny over what items may be reported as non-recurring. The SEC has issued guidance on this and other frequentlyasked questions in Compliance and Disclosure Interpretations (C&DIs,) which can be found at: https://www.sec.gov/corpfin/non-gaap-financial-measures.

Key performance indicators (KPIs)

SEC guidance states that registrants should consider the inclusion of KPIs used to manage the business in MD&A when the information is relevant to evaluation of the company’s performance. KPIs typically include financial and non-financial information that is not presented in or derived from information in the financial statements that gives further insight into measurement and evaluation of business operations.

KPIs are not subject to the same SEC rules as non-GAAP measures. Companies are disclosing KPIs in areas other than the MD&A, such as in the business section of quarterly or annual SEC filings and earnings releases.

SEC interpretive guidance provides that the following disclosures should accompany a KPI:

• A clear definition of the KPI and how it is calculated

• The reasons why the KPI provides useful information to investors

• How management uses the KPI in managing or monitoring performance of the business

• Estimates or assumptions underlying the metric or its calculation if disclosure of such items is necessary for the measure not to be materially misleading

Considerations for management

Management has the flexibility to choose what non-GAAP financial measures and KPIs it reports and how they are presented and calculated to be most relevant in telling the company’s individual story. However, this means that companies can report different measures from peers and competitors and that calculations across organizations may not be consistent or comparable. While that presents opportunity for measures to be misleading, such measures can be helpful to users if disclosures are sufficiently transparent and provide information on why adjustments are appropriate. Within an organization, non-GAAP measures and KPIs should be calculated consistently from period to period. If a company changes how a measure is calculated, disclosure should be made of the change in calculation and the impact on prior periods.

A company’s system of internal controls over financial reporting addresses preparation of financial statements in accordance with GAAP and may not incorporate non-GAAP financial measures or KPIs. The SEC has more broadly defined disclosure controls and procedures (DCPs) pertaining to all the disclosures reported by a company. The SEC has indicated that consideration should be given to how DCPs apply to the disclosure of non-GAAP financial measures and KPIs.

And, while internal metrics used for measuring performance understandably change over time with business strategy, it is important that performance measures published with GAAP information is not inconsistent with other information provided in filings.

Considerations for audit committees

Considerations for audit committees include:

• Are the non-GAAP financial measures and KPIs fair, balanced, transparent and not misleading?

• Are there sufficient controls that information published is consistent with regulations?

• Are there management incentives that might provide motivation for earnings management through non-GAAP financial measures?

• Does the organization have governance policies and procedures for when non-GAAP measures should be used?

• Where is management judgement involved?

• Do those charged with governance understand how and why management is disclosing the measures and how and why management is using the measures to evaluate performance?

Considerations for auditors

The external auditor generally has limited responsibility for non-GAAP financial measures and KPIs. Professional standards require that the auditors read the other information in publications including the audited financial statements and consider whether the other information is materially inconsistent with the audited financial statements or contains a material misstatement of fact. While auditors are typically not involved in reviewing or performing procedures related to other publications such as earnings releases, audit committees may consider engaging external auditors in evaluating the quality and consistency of non-GAAP financial measures or KPIs.

Laura Hay, CPA, CAE, is the executive vice president of The Ohio Society of CPAs and the staff liaison to the Accounting, Auditing, Professional Ethics Committee and Peer Review Committee. She can be reached at Lhay@ohiocpa.com or 614.321.2231