Hi everyone. There are four parts to financial statement analysis and valuation: introduction to financial statements and SEC filings, going beyond the financials, forecasting, and valuation. It all starts by building a solid foundation and understanding the basics of financial statements and SEC filings. We then gather additional insights by analyzing information beyond the financials to understand a company's strategy, its competitive environment, and other external factors. Investors use both sets of information to build a forecast that ultimately leads to the firm's valuation. Forecasting starts with analyzing historical financials to identify trends and to reveal any risk and opportunities that should be taken into consideration. However, sometimes historical financial information contains one-time or unusual events that can distort your analysis. As such, many companies, investors, and analysts, make non-GAAP adjustments to remove the noise into numbers and provide a clearer picture of the firm's core business results. Today, we will discuss non-GAAP adjustments, specifically the what, the why, and the how behind these adjustments, and issues that an investor should be on the lookout for as they perform their financial statement analysis. Now let's define what a non-GAAP metric is. A non-GAAP metric is a measured at adjusts a firm's historical or future performance, its financial position, or its cash flow. Non-GAAP adjustments can include or exclude amounts from the most directly comparable GAAP measure, such as the removal of restructuring charges, stock compensation, or add-backs of deferred revenue. Specifically, some companies state that restructuring charges are one-time in nature and do not represent their core operations. As such, they remove the impacts of these charges from the GAAP measure to give investors a clearer picture of the trends within their core business. In addition, some firms add back deferred revenue to the current revenue number to say, well, if we had met all of our performance obligations, this is the amount of revenue we would've had. Typically, the SEC allows a firm to break apart and remove certain items as part of their non-GAAP adjustments to allow them to tell their story in a reasonable way. However, anytime a company tries to alter or apply a different accounting principle, then the SEC tends to push back in the firms use of such adjustments. My question is, how would you know where the line is as to what is allowed versus not allowed? To be honest, the line is often a little blurry. The SEC has increased their attention on non-GAAP adjustments and you can see that trend in he high number of SEC comment letters on non-GAAP metrics. The guiding principle that regulators often apply or rely on is whether the non-GAAP metric provides additional clarity to investors and helps them to make better informed investment decisions. Now, there are many examples of non-GAAP adjustments that are commonly used by companies, such as organic revenue, which presents a firm's revenue performance after excluding the impact of foreign currency fluctuations, acquisitions, and divestitures. We also have EBITDA, which means earnings before interest, taxes, depreciation, and amortization. Now this is a commonly used metric that adjusts for interest expenses, income taxes, depreciation expenses, and amortization charges. Firms can also adjust this EBITDA number even further by excluding the impact of unusual earnings charges such as coronavirus-related costs and costs related to social justice disruptions. You will come across many other alternative earnings measures using labels such as proforma, adjusted, or street earnings. All these measures exclude earnings items that management views as distorting the company's core income performance. Companies frequently use non-GAAP measures in various venues, such as: quarterly earnings press releases, earnings conference calls, investor presentations, and compensation targets set in executive management contracts. You'll also see non-GAAP metrics in the Proxy filings, the MD&A section of quarterly 10Q and annual 10K filings, and in internal reports and budgets. It's important to know that while the use of non-GAAP measures is common and permitted by the SEC, companies should not use non-GAAP metrics on the face of the financial statements and in the footnotes. The sections of the 10Q or 10K should only include audited gap results. As we mentioned, the SEC does permit the use of certain non-GAAP measures if they provide investors with better visibility and clarity into the company's core operations. However, companies must give equal or greater prominence to the most directly comparable GAAP financial metric whenever they report a non-GAAP measure. Equal or greater prominence is monitored very closely by the SEC. For example, companies are not allowed to omit the comparable GAAP measure from a press release headline or caption that includes a non-GAAP measure. They should also not present a non-GAAP measure using styles that emphasizes the non-GAAP measure over the comparable GAAP measure. For example, presenting a non-GAAP measure in bold or in larger fonts. Companies are also not allowed to discuss or analyze a non-GAAP metric without providing a similar discussion or analysis of the comparable GAAP metric in a location with equal or greater prominence. For example, firms cannot discuss the non-GAAP metric in the first paragraph of an earnings press release while relegating the discussion of the gap metric to say, the third or fourth paragraph. Lastly, companies must not present a non-GAAP measure that precedes the most directly comparable gap measure. In addition, companies must reconcile non-GAAP metrics to their GAAP equivalence. Surprisingly, the rules around reconciling a historical non-GAAP metric are very different from the requirements for reconciling a future or forecasted non-GAAP measure. The SEC does not require firms to reconcile a forecasted non-GAAP metric if management deems the effort to do so as very high. We actually find in practice that many firms opt out, meaning they do not reconcile forecasted non-GAAP metrics because they say it takes an unreasonable effort. Companies typically state that the adjustments to forecasted amounts are often transitory and thus are difficult to predict when preparing a detailed reconciliation. To wrap up, non-GAAP metrics are useful for investors as they evaluate and analyze a company and build out forecasts. Many companies use non-GAAP adjustments correctly to help inform, provide clarity, and to supplement the GAAP information provided to investors. However, regulatory oversight by the SEC is important as a misuse of non-GAAP adjustments can certainly be misleading to investors.
