Non-GAAP Measures: Seeking Clarity

IASB moves to increase the relevance of non-GAAP measures like EBITA and EBITDA in financial reporting.

Earnings before income taxes and amortization (EBITA) and earnings before income taxes, depreciation, and amortization (EBITDA) and related non-GAAP measures are in the news again. Berkshire Hathaway’s Charlie Munger recently made headlines by calling them “BS” earnings. According to an annual summation by PwC, non-GAAP earnings were second only to revenue recognition in the number of U.S. Securities and Exchange Commission (SEC) comment letters. The SEC has acknowledged that “non-GAAP financial measures can be useful disclosure metrics intended to provide insight into company performance and prospects” and “in certain cases, they more accurately describe the financial picture than the comparable GAAP measures.”

However, on multiple occasions, the SEC has also expressed concern that non-GAAP measures can be misleading to investors and has gone so far as to publish a Q&A specifying the measures that may be misleading if presented inconsistently from period to period. Despite the concerns, non-GAAP measures are more popular than ever. The use of non-GAAP measures in the S&P 500 increased from 59 percent to 96 percent of SEC filers between 1996 and 2017, while the number of metrics per filing increased from an average of 2.35 to 7.45 in the same period, according to Audit Analytics. Clearly there is demand for non-GAAP measures but are non-GAAP metrics more useful than GAAP?

Earnings before income taxes (EBIT) is often viewed as a proxy for operating income. EBITA includes depreciation expense while EBITDA excludes it on the argument that the “D” reflects financing and accounting decisions related to capital expenditures needed to grow or maintain the business and should be excluded.

A recently published academic paper by Doron Nissim at Columbia University updates the relationship between EBIT, EBITA, and EBITDA. Professor Nissim points out that the average amount of amortization as a percentage of EBITDA has more than tripled since 2003 due to changes in the accounting for business combinations. Internally generated intangible assets are generally expensed while acquired assets are initially accounted for at fair value and then subsequently at amortized cost, making comparisons between companies with different growth strategies problematic. EBITDA remains controversial as adjustments are subjective.

How well do these measures explain stock prices? According to the study’s results, throughout the sample period (March 1989 – February 2019), EBITDA performed better than EBITA, which in turn performed better than EBIT in explaining stock prices. However, EBITA’s dominance over EBIT has been increasing over time, consistent with the increase in the significance of amortization.

What about predicting future returns? Here the picture is less clear. EBIT, EBITA, and EBITDA performed well in predicting future returns during the 1990s and 2000s but not more recently. This could be an indicator that any potential for “beating the market” using these measures has been arbitraged away.

Of course, many firms use adjusted EBITDA. As noted, there are no standards for giving guidance on what could be considered an adjustment since the measurement is non-GAAP. Common exclusions include stock option expense and restructuring costs, but acquisition costs and various non-cash costs, such as impairments, may be excluded depending on management’s judgment. This remains controversial. Jim Leisenring, CPA, a former FASB vice chair and member of the IASB (and a frequent speaker at ICPAS events), has been known to describe such adjustments as “earnings before undesirable debits and, less frequently, undesirable credits.”

So, is it time for a new measure? The FASB and the IASB tried to reformulate the income statement during the heyday of convergence fever between 2008-2011. Now, the IASB is trying again. A new exposure draft, “General Presentation and Disclosures,” which prescribes the presentation of certain key subtotals in the income statement and increases “transparency and discipline around the calculation and presentation of those subtotals,” is out for comment.

The IASB makes it clear in the invitation to comment that they do not intend to eliminate the use of non-GAAP or non-IFRS metrics. Rather, the goal is to introduce guidelines. The IASB notes that, in practice, both preparers and investors use subtotals to better explain and understand business performance. Subtotals, such as operating profit and EBITDA, are very commonly used but are defined in very different ways across companies. The IASB staff reviewed 60 companies in different countries and industry sectors in coming to this point of view. For example, it found about 70 percent of companies used the operating profit subtotal, but more than nine different calculations were used to reach the subtotal. Some companies included investment income while others didn’t; some excluded various items they considered non-operating or non-recurring, others didn’t. The consequence? An increasing use of “self-defined” subtotals, or non-GAAP measures, due to the lack of a standard definition. The IASB is therefore proposing that non-IFRS measures, or “management performance measures,” be addressed by bringing the measures into a single note in the audited financial statements. This wouldn’t restrict the use of these performance measures, but it would require more transparency and a reconciliation to the most directly comparable total or subtotal specified by IFRS.

The exposure draft is available at www.IFRS.org and the comment period runs until June 30, 2020. Will you be seeking clarity or submitting a comment on the IASB’s proposal?

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Author’s note: This article features contributions from John Hepp, Ph.D., clinical assistant professor of accountancy in the University of Illinois’ Geis School of Business.