Non GAAP reporting can be identified as a standard framework and guidelines for financial accounting under a particular jurisdiction, as in general perceived as accounting standards or standard accounting practice for an entity. The report includes the standards, conventions, and rules that accountants state in accordance for recording and summarizing, later included for preparation of financial statements (Tysiac, 2015). As a general observation, many business entities opt out of GAAP practices as they operate on a cash basis, in contrast to an accrual basis as noticed in non-GAAP Accounting framework. Whether financial statements provide accurate and fair information can be tested by examining management’s discretion in preparing financial statements.
The purpose of this report is to provide relevant information about the meaning of non-GAAP reporting together with its effectiveness in the annual reports of companies. Interested parties like shareholders, investors, stakeholders etc depend upon the financial statements of a company that are disclosed in the annual reports and if such reports are complex or contain many different measures, then decision-making become difficult on their part, thereby resulting in the company’s loss (Tysiac, 2015). Hence, this report seeks to provide significant details whether to include non-GAAP measures in the annual reports or not.
This report seeks to provide information on the validity of non-GAAP reporting to the interested parties that can include employees, owners or shareholders, government agencies, suppliers and partners, media, investors, customers etc. These interested parties also include a shareholder group who are primarily non-accountants of the company. It is very significant to understand the expectations and needs of these interested parties because these parties have an impact on the company’s ability to provide goods and services consistently to meet the needs and legal requirements of customers. The above-mentioned audience for this report needs to be educated about the efficacy of including non-GAAP measures in the annual reports because the presence of financial measures like Earnings before interest and tax (EBIT) and Earnings before interest, taxes and depreciation (EBITDA) helps to maximize the usefulness of the report to these parties, especially the shareholders (both accountants and non-accountants).
There are several key decisions that must be implemented by the management so that the efficiency of non-GAAP measures does not minimize. Companies must consult with their counsel as and when necessary and must consider whether enhancements can be made to the efficiency of non-GAAP disclosures. There are few decisions related with the disclosure and construction of such non-GAAP measures that must be made even among companies competing in the same business. Enhanced standardization in the reporting together with transparency in the disclosure can help to improve comparability between companies and maximize communications of financial reporting (Tysiac, 2015). This is especially required in today’s environment where reports of an analyst are required as and when the result of a company is published. Improved transparency and comparability can assist in improving the reliability attributes on such non-GAAP financial measures in the annual reports. This facilitates a reduction in uncertainty and risk for the investors and also lowers the risk premiums associated with valuation of investments. While shareholders and investors needs standardization in non-GAAP reporting, management must be capable to explain such requirements (Imhoff, 1992).
As with the organization, being a mid-ranged business entity is bound to produce the lot of formal and informal transactions that might not just include the cash transaction and thereof a need for a GAAP based accounting framework is expected to provide a lesser accuracy as compared to the ones that are based on non-GAAP Accounting framework. Prior studies (Lang et al., 2006) have been investigative on the level of management’s discretion by determining the level of conservatism and earnings with respect to management in financial statement and inclusive information.( Christen et al. 2008) had observed that these constructs are significantly relevant since they rely on the managerial discretion thereof likely to be influenced by the incentives of those preparing the financial statements.
First and foremost, when it is known that non-GAAP measures are subjective in nature which means that such measures are inconsistent in depicting how they are calculated, the above-mentioned decisions becomes an urgent requirement. Secondly, as non-GAAP financial measures cannot be compared to similarly titled measures used by other companies, it becomes important to include GAAP and maximize the disclosure and transparency. These details are the basic limitations of non-GAAP reporting requirements and management is bound to take relevant decisions either for improving the usefulness of such reporting or eliminating it from the annual reports. However, it is advisable that such measures form part of the annual report but not compromising with the expectations and needs of interested parties of the company (Tysiac, 2015). This information can be found in the limitations or disadvantages of non-GAAP reporting that also accompanies relevant decisions that can be made to enhance the effectiveness and standard of reporting requirements.
Relevant information is that detail which can be applied to solve problems. Finding relevant information becomes a bit difficult when it is related with determination of format and content of financial statements of a company. While finding relevant information (in a database for example), words that explain the research topic can be typed in any order and records that accommodate such terms must be retrieved. Especially in a database, only the descriptors or subject headings that align with the research topic are looked upon. For example, if there is a requirement to find whether or not to include non-GAAP measures in the annual reports of a company, keywords like advantages and disadvantages of non-GAAP reporting can be searched. By this, one does not have to go through the entire database and the required information can be revealed with few keywords itself. Every possible keyword that describes the topic must be considered because going through the entire information is time-consuming. Wild cards and truncated can be adopted for better finding of keywords like if one has to find information on nurses, then on the search bar, ‘nur’ can be written and every word starting with ‘nur’ shall appear.
As with the internal options of the organization as pointed out by the CEO, Dave Richards, the scenario of internal evaluation such as Earnings management is a strategy reserved for the management to manipulate and substantiate the organizational earnings. However, not all forms of earnings management are manipulative on the financial report, for instance, earnings management can also be considered informative when stakeholders have informed accurately about the underlying economic performance of the company. And hence these sources for in the interest of the stakeholders can also be considered as a case for conservatism that tends to understate the actual economic performance of companies and organizations.
Companies use non-GAAP financial reporting to emphasize its cash flow, which is why Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) and (EBIT) Earnings before Interest and Tax are presented in its financial statements. This type of reporting is used to report corporate income and earnings which is not defined by GAAP (Generally Accepted Accounting Principles). Non-GAAP reporting helps in providing useful information about individual companies and also includes operate earnings, core earnings, pro forma earnings, free cash flow etc. In simple words, non-GAAP reporting is an alternative way to measure the past or future financial performance, cash flows or financial position which excludes or includes amounts from the most comparable GAAP measures to bridge the gap between corporate reporting that is standardized under GAAP and reporting which is tailored to a specific circumstance or industry. There are several companies which adopt such reporting in addition to GAAP reporting. The reason behind the adoption of such reporting is that management believes that these alternative figures help in providing a much accurate report of the company’s overall financial performance. From the annual report of AK Steel Holding Corporation, it can be seen that the company reports financial outcomes with GAAP but at regular intervals, it discloses non-GAAP financial measures. For instance, it reports adjusted EBITDA of $55 per ton or $393.3 that depicts 40% increment in the EBITDA which was $46 per ton or $280.2 in 2014. The company discloses net income or loss and adjusted EBITDA as non-GAAP measures that exclude the impact of pension, non-controlling interests, impairment expenses for investment in magnetation, acquisition-associated charges of Dearborn, expenses for temporary facilities associated to idling etc. The company believes that such non-GAAP financial measures can provide investors a better understanding of its financial performance. In the same way, Radian Group Inc also uses non-GAAP financial measures that are excluded from the operating outcomes of the company’s operating segments. The key indicator for performance of the company for evaluating its performance is adjusted pretax operating income or loss. Such adjusted pretax operating income (loss) helps in balancing the GAAP pretax income or loss to remove the impacts of net gain or loss on financial instruments and investments, impairment and amortization of intangibles, acquisition associated expenses etc (Williams, 2012). It further excludes gains and losses associated with estimates of fair value on insured credit derivatives instead of including the effect of variations in the present value of recoveries and claims related to insurance on such insured credit derivatives. The company believes that such measures help in advocating about the underlying operations of its segments. The provisions of such measures are made in such a way so that it can align with the methods of evaluation of the company’s performance both by the Board and management.
Additional measures provide consistency and efficiency to the financial statements and it can benefit the market by providing investors a greater insight into the operations of companies. Non-GAAP measures are disclosed in the annual reports of companies because it adjusts the reported GAAP outcomes prepared according to the IASB framework of financial reporting (IASB, 2010). This helps in facilitating a user’s understanding of the underlying operational performance of a company, financial position or liquidity. For example, Radian Group Inc employs non-GAAP financial measures (adjusted pretax income or loss) in addition to the GAAP measures for a better understanding of the company’s performance. Similarly, AK Steel Holding Corporation discloses adjusted EBITDA and adjusted net income or loss in addition to the GAAP measures for the same purpose. There is some flexibility around what companies adopting non-GAAP measures can present because IFRS does not restrict additional measures in the financial statements. It is indeed the IASB which acknowledges that additional measures can prove to be very useful to users. Studies suggest that the exclusion of transitory items in non-GAAP disclosures provides information when consensus incomes can be obtained but are also linked to strategic purposes when GAAP measures fall below expectations (IASB, 2010). However, some studies also believe non-GAAP financial measures to be noisy and difficult to be interpreted but companies with high quality financial statements are not prone to such criticisms. Several companies believe that the exclusion of certain balance sheet and income statement items in non-GAAP reporting provides a more significant basis for measuring the performance of a company during a specific period. Hence, the earnings depicted by non-GAAP measures tend to be greater than GAAP measures and thus highly criticized by investors and accountants. Therefore, the Sarbanes Oxley Act, 2000 have added certain prohibitions regarding the use of non-GAAP measures that requires companies adopting non-GAAP reporting to disclose GAAP figures also. But, despite such abuse, it is seen that few non-GAAP measures have higher quality content than GAAP measures. Non-GAAP earnings are viewed as more permanent than the GAAP earnings because they remove one-time expenses that are unlikely to reoccur. Hence, a better indication of the company’s earnings is provided and this becomes a major reason why investors opt for such reporting. Even the analysts of Wall Street opt for non-GAAP measures to forecast their estimates of income (Seilber, 2015). Furthermore, such non-GAAP financial measures also help either by disaggregating various prospects of the company’s operations or removing the impacts of unusual, unique or large transactions like dispositions or acquisitions. Companies thus get an option to exclude the effects of these transactions if they have a reason to believe that this can provide information that benefits a user’s evaluation of long-term aspects, impacts of business decisions and past results of a company (FASB vs. GAAP , 2010). Debt covenants may specify the maintenance of a specified EBITDA in excess of a specified amount. Executive compensation policies may accommodate several measures of corporate performance to determine compensation levels. Sale and purchase agreements may specify a further contingent consideration or an initial buying price related with an EBITDA measure. The accommodation of these measures in private contracts assists the conclusion from interviews with potential investors and shareholders that non-GAAP reporting assist in providing value of incremental information beyond that found in GAAP reporting as defined in the IASB conceptual framework (FASB vs. GAAP , 2010).
With regard to the qualitative characteristics of IASB conceptual framework and the above-mentioned discussion, it can be concluded that despite several limitations and criticisms, non-GAAP measures contribute to high quality financial reporting. Despite various attempts by regulatory bodies to outline the use and reoccurring disadvantages as to the relevance and reliability of non-GAAP reporting, many companies still opt for EBITDA numbers like AK Steel Holding Corporation which relies on adjusted EBITDA numbers (Whittington, 2008). Research stated that as financial statements are complex to be interpreted by investors, companies employ few forms of non-GAAP earnings in their reporting in order to facilitate evaluation of the underlying performance of investors (Lang et. al, 2006). The prime difficulty with GAAP reporting, as described by studies is its importance to net earnings which is useful to creditors, investors and firms but potential investors seek details beyond these net earnings like distinguishing non-operating items from operating ones (Davies & Crawford, 2012). They also seek information on items which are non-recurring or recurring in nature. Lastly, they also want to know which items are not real or real like amortization of intangible assets which merely portrays applicability of accounting policies. Therefore, non-GAAP metrics depict performance more effectively than the GAAP financial measures. Thus, it is not only relevant for users but also sophisticated investors rely on such reporting to make economic decisions on the basis of financial health and performance of a company. For instance, disclosure of adjusted net income or loss at per share and total basis, current operating outcomes of AK Steel can more efficiently be reflected and hence, these are not only relevant for investors but they also rely on such measures for taking economic decisions (Whittington, 2008). The non-GAAP measures of Radian Group are also relevant for evaluating their financial performance, thus also makes it reliable. Non-GAAP reporting also facilitates comparability between entities but if the report is not standardized and there is an absence of enhanced disclosure and transparency, then such qualitative characteristic gets hampered. For example, Radian Group discloses non-GAAP measures on a consistent basis with presentation of current year for comparison purpose. Reorganization of financial measures as non-standardized or non-standardized or entity specific components like non-recurring or recurring, enhances the comparability and communication process of such reporting (Davies & Crawford, 2012). Furthermore, non-GAAP reporting facilitates the understandability qualitative characteristic where it advocates the employment of entity specific and standardized measures and disclosure of complementary and contextual details to the users so that their understanding of these measures can be enhanced. Information on these measures also helps the investors to appreciate why companies believes that entity specific adjustments are significant for understanding its performance, how these are calculated, how these are reported in the financial statements etc (Graham & Smart, 2012). The presence of complementary information also provides a context that assists users in understanding the measures and its limitations. For instance, current operating outcomes of AK Steel provide investors with an enhanced understanding of its overall financial performance. IFRS necessitates faithful representation in the financial statements, which can be possible if such statements are reliable, relevant, comparable and understandable. Thus, non-GAAP reporting also facilitates faithful representation where users can take economic decisions on the basis of information presented through such reporting.
Although non-GAAP measures are widely used in financial reporting, it is necessary for investors and other users to understand whether it is really effective or not. For this purpose, a careful consideration of both sides of the argument is required. Firstly, it has been studied that the comparability of non-GAAP measures vary between companies and the lack of inconsistencies for determining how these measures are calculated, limits their efficacies. But studies suggest that when greater or equal prominence is provided to GAAP measures, together with an expansive disclosure and transparency, then such limitation cannot impact the usefulness of information in annual reports. Secondly, it has been observed that management of several companies view non-GAAP reporting to be complex and misleading for investors but many companies still opt for such measures as these provide meaningful information regarding their financial performance. Thirdly, as non-GAAP measures are derived from items in the financial statements prepared according to the GAAP measures, thereby inheriting even the limitations of GAAP. This means that variations in GAAP measures between companies also affects the usefulness of non-GAAP measures. In contrast to this, several companies rely on non-GAAP measures for taking relevant decisions despite the limitations derived from GAAP measures together with its own limitations. Considering the example of AK Steel Holding Corporation, it can be seen that firstly the company believes that adjusted EBITDA and adjusted income or loss assists the investors in understanding its performance and on the other hand, it also advises investors and shareholders to not rely on such measures as an alternative for GAAP measures. Similarly, Radian Group Inc also states that the total of adjusted pretax income or loss is not a total profitability measure and hence must not be viewed as an alternate to GAAP pretax income or loss. This proves that there has been a lot of confusion regarding the effectiveness of non-GAAP financial reporting. It has its importance but also has several limitations. Companies like Radian and AK Steel disclose non-GAAP measures to increase the investor’s understanding on the company’s performance but they advise investors to rely on both GAAP and non-GAAP measures for better understanding. On a whole, these limitations cannot the usefulness of any information and observing non-GAAP measures as complex is because of non-standardized measures (Watts, 2003). For example, as non-GAAP measures cover the same term as the financial statements related to it. If companies disclose any measure on a 12-month trailing basis, then inclusion of cumulative term provided by financial statements in this 12-month period helps in providing relevant information. It is also recommended that companies must be balanced and thoughtful to prohibit removal of an item’s impact that minimizes income in one term while not removing a same item in a distinct term. Therefore, consistency in disclosing information must be done by companies so that if there are complexities, it becomes easy from the next period. Companies must arrange means for consultation with counsel regarding ways especially on matters relating to disclosure and transparency to enhance the effectiveness of non-GAAP disclosures (Christensen et. al, 2008). For example, if EBITDA measures accommodate additional adjustment, then companies must recognize the measure as adjusted EBITDA (Horngren, 2013). This kind of transparency has been followed by AK Steel and Radian Group in their annual report respectively. Companies are advised to give more or equal significance to GAAP measures and must confirm that each non-GAAP measure is provided with the comparable GAAP measures (Beattie & Dhanani, 2008). Also, disclosure regarding inability in providing a quantitative reconciliation of non-GAAP measure must be revised to accommodate specific disclosures. The disclosure of non-GAAP per share measures of liquidity must not be disclosed by companies so long till they prove to be measures of performance. Therefore, non-GAAP reporting is effective but standardization in reporting is required by companies together with GAAP measures. Material information must only be considered by companies and irrelevant information must be cast away (Deegan, 2011).
As with the observation of Soderstrom and Sun (2007), the socio-political system of a country, legal parameters, financial reporting systems and the accounting standards of the firms directly influence the accounting quality. Accounting standards, as referred commonly as General Accepted Accounting Principles (GAA/P) are standards and procedures that companies implement to the financial statement in commonly accepted norms and regulations. GAAP are essential so that financial reports consistently and fairly describe the economic performance of the company to the stakeholders and other inclusive parties (Needles & Powers, 2013).
On the contrary, However, Paredes (2003) rightfully observed that people can become overloaded with information, hence contribute to making worse decisions since the extent of information is large and includes more disclosures. But as with the CEO of the company Dave Richards is the not the sole contributor to the finance of the company and hence there can readily adjustments made to imbibe the needed improvisations in the Accounting reports, provided the basic standards are necessitated as per the GAAP framework that is understood by the larger community and the stakeholders. The IASB is responsible conceptual international framework IFRS are Board (IASB) that functions as an independent statutory body of the IFRS Foundation (Choi & Meek, 2011). And as a general consideration of the Finance reports is to highlight the economic performance to the stakeholders, even on an an international arena, non-GAAP framework provides fewer attributes that included in the diverse and different frameworks that are based on political, geographical or organizational parameters rather that the deliverance of efficiency in the quality of the information being passed on to the stakeholders and the parties of the organization. For instance, including the base financial tools and parameters such as the Leverage Ratios, Interest coverage and Net Worth of an Organization is one of the basic attributes that highlight an organization (Deegan, 2011). Hence, evolving a framework on the basis of the tools and parameters that convey the information to the stakeholders should be an optimal mode of developing an acceptable common framework around the world. However, with the reserves of IASB, it can presume that mandatory adoption of IFRS in more relevant and useful disclosure requirements to facilitate in decision-making parameters for stakeholder would, therefore, eliminate the concerns of information overload. (Matt, 2016).
Moreover, Explanations for the existence of conservatism speculate the benefits of financial reports to the audience as stakeholders , as GAAP-based structure increases firm value by constraining management’s opportunistic and liable payments to a business or other the inclusive parties. Such an increase in value is eventually shared among the inclusive parties to the firm, increasing the welfare and prospects of an organization (Watts,2003).Hence, Dave Richards has a more important observation that practically establishes the larger interest of the organization to sustain and continue with a managed infrastructure for the organization
Hence, the framework can be considered as the attributes relative to the Accounting quality. One of the earliest citations from Siegel (1982), Quality has been an important attribute of accounting information. However, with the current context of distinct sources in finance reports, accounting quality can neither be readily measurable nor generally agreed upon the characteristic and prospects of a firm (Northington, 2011). In the later years as the developments in the framework of Financial reports were being negotiated, Imhoff (1992) speculated on the importance of the observation of Siegel and concluded that accounting quality as a term is used to suggest that accounting signals may not be equally free of contradictions since these are bound to influence by bias or measurement error or, a combination of both. Hence it could be observed that limiting the external influences on financial reports, including a base framework for provision of an unhindered and consistent conveyance of the financial state of an organization, the stakeholders and the inclusive members of an organization including the employees has better transparency and reserves to deal the operative and decisive parameters of an organization (Guerard, 2013).
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