Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
Module 3: Non-GAAP Adjustments
Table of Contents
Non-GAAP Adjustments ................................................................................................................... 2
Introduction to Non-GAAP Measures .................................................................................................................. 2
History and trends in Non-GAAP Reporting ....................................................................................................... 11
To GAAP or Non-GAAP ....................................................................................................................................... 16
Good examples of Non-GAAP adjustments ....................................................................................................... 20
Bad examples of Non-GAAP adjustments .......................................................................................................... 23
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
Non-GAAP Adjustments
Introduction to Non-GAAP Measures
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
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
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.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
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.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
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.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
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.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
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.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
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
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
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.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
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.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
History and trends in Non-GAAP Reporting
Hi everyone, the use of non-GAAP adjustments can be very helpful for investors.
They can aid with evaluating past results, analysing trends and identifying risks and
opportunities as a starting point for building out a forecasts. The SEC's oversight and permitted
use of non-GAAP measures, dates back several years, however. Recently the SEC has
increased their focus and scrutiny of these adjustments.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
Now, let's look briefly at this history and discuss some major turning points. Beginning in 2001,
the SEC increase its focus on the use of non-GAAP metrics and issued a clear warning about
certain misuses it saw across firms. Then in 2003, regulation G or Reg G, was instituted as part
of the 2002 Sarbanes-Oxley Act to increase SEC's oversight and provide rules on the proper
use of non-GAAP measures. Also, in 2010, and again in 2016, the SEC issued new compliance
and disclosure interpretations, which we dub As CMD eyes to accompany regulation G. These
interpretations provide guidance to firms on how to properly apply reg G. This guidance was
important, as the SEC found that some firms stretch the limits on how they use non-GAAP
metrics. Admittedly the improper use of non-GAAP metrics remains a fluid situation. But the
SEC remains focused on this issue, as strong oversight has led to better quality non-GAAP
disclosures over time.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
With respect to trends, studies find that the use of non-GAAP adjustments Is very common in
the US and internationally. Evidence shows that 97% of S&P 500 firms, disclose at least
one non GAAP metric in an earnings release. 95% of the companies listed on the UK footsie
100 report non GAAP metrics. And if we take the entire set of firms listed in the US 50% provide
at least one non-GAAP metric in an earnings release. Now those are some high percentages.
Typically, the use of non- GAAP adjustments result in an improvement in a company's reported
results. On average adjustments have added 26 cents per share to earnings, or 15% versus the
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
reported gap earnings results. Also, we find that the increased use of Non-GAAP adjustments is
not limited to only firms, but also to analysts that provide forecasts for these firms.
Finally, companies who plan to conduct an initial public offering Or IPO? Also use non GAAP
metrics and they are doing so at an increase in rate. Companies who are coming to market
know that telling their story is very important to inform investors about their business in an effort
to obtain the valuation they desire. Many IPOs are not profitable because they're young and still
in the investment phase. The revenue potential may look great, but current earnings have not
yet been realised because of heavy spending in areas such as marketing R&d. These firms
often use non-GAAP adjustments to remove expenses that they feel are heavy now, but believe
will taper off in the future. In doing so, the firm is trying to illustrate to potential investors. What
earnings would look like on a normal basis after the heavy investments are over.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
So to conclude, the use of non-GAAP adjustments is very prevalent. These metrics can be
useful for investors as they evaluate past results, analyze trends identify risks and opportunities
when starting to build forecasts. Most companies use non-GAAP adjustments correctly, to help
inform provide additional clarity and to supplement the gap information provided to investors.
Moreover, key regulatory reactions and SEC oversight have been important in tamping down
the misuse of non-GAAP adjustments.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
To GAAP or Non-GAAP
Hi everyone, many companies report Non-GAAP measures to better inform investors about the
company's core financial performance.
These measures are very useful in forecasting as companies often remove transitory, or one
time items that do not reflect recurring or sustainable business performance. However, some
companies can misuse Non-GAAP measures to paint a false picture of the company's
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
performance. SEC oversight and regulation are important to limiting the misuse of Non-GAAP
measures and ensuring the quality of the information disclosed to investors. In this video, we will
discuss the pros and cons of providing Non-GAAP metrics.
Now, there are several benefits of using Non-GAAP measures. Partly because gap accounting
does not fit the business model, or the business transactions of every firm. First, Non-GAAP
adjustments can help remove one time or transitory items that are recorded as part of gap
accounting. These one time items can distort a company's performance trends. So removing
them can help companies to show sustainable or repeatable earnings that is more reflective of
core business operations. Second, Non-GAAP measures can help provide a clearer long term
view of the business and make it easier for investors to forecast future business performance.
Third, investors can gain a better understanding of the company's core business based on the
adjustments that management chooses to make. Lastly, Non-GAAP measures can help
management to tell the firm's story and explain the core operating results of the business in a
clear way. So if used properly, non GAAP adjustments can be very useful to investors.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
Let's look at these benefits more closely in the context of forecasted earnings.
Not all line items on the income statement are equal. Some transactions are expected to recur
every period others are one-time items which do not speak to the firm's core or ongoing
operations. Non-GAAP measures can therefore improve forecasting by separating the ongoing
operations of the firm from the one-time events. More specifically, focusing on core business
trends, improves forecasting that is necessary for fundamental valuations and thereby helps
inform investment decision.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
Now despite the many benefits of Non-GAAP measures, there are also some risks of improperly
using these metrics. For example, Non-GAAP measures can be used as window dressing. If
management wants to report a higher earnings number, they can be tempted to strip out certain
expenses and claim that the expenses are one time, or simply claim that the items are not
important for assessing the firm's core performance. The overuse or improper use of Non-GAAP
measures can also confuse or mislead investors, that is, the disclosure of too many Non-GAAP
measures can make it harder for investors to understand the firm's overall performance. Also
Non-GAAP measures can portray a false picture of the firm's financial results. In addition Non-
GAAP measures can present an alternative reality by adding back items that actually occurred,
or by changing the basic principles of GAAP accounting. For example, adjustments to revenue
can boost the revenue figure, even though the revenue has yet to be earned. And finally, Non-
GAAP measures can reduce or lower compatibility across firms. The application of Non-GAAP
adjustments is not standard across firms. Also while the use of Non-GAAP measures is
prevalent not all companies disclose these types of metrics.
The debate on the benefits and risk of Non-GAAP adjustments continues. The intent of allowing
Non-GAAP adjustments is grounded in helping investors to understand a company's core
business, and to give them a better view of future performance. However, there are many
examples of overuse and misuse in Non-GAAP reporting. What is undeniable is that Non-GAAP
adjustments are used by almost all companies in several different situations, including an
executive compensation, and as a main focus of sell side analysis. What is important for
investors is for them to understand the limitations and risks and perform their own financial
statement analysis and valuation, that is key.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
Good examples of Non-GAAP adjustments
Hi, everyone.
Non-GAAP measures are useful for forecasting a company's future performance. Most
companies use non-GAAP adjustments correctly, but some companies can present non-GAAP
metrics that are misleading to investors. Today, we will review one example of how the proper
use of non-GAAP adjustments can aid investors.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
Let's look at a scenario where a company reported earnings results over a two-year period. The
gap earnings results show a slight improvement in net sales or revenue increasing by 0.2
percent and a significant decrease in SG&A expenses. This decrease is over 17 percent of
sales or revenue. Something doesn't appear right. It would be very difficult for an investor to
identify an earning's trend for building a forecast with this type of volatility.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
To determine the drivers of the sharp drop in SG&A expenses from 2015-2016, we analyze
a company's 10-K or annual report, the press release, as well as investor presentations. Now
we find out that in 2015 and 2016, there were significant spin-off charges recorded. In addition,
there were certain acquisition and integration costs and restructuring costs recorded over both
years. These expenses are deemed unusual in nature and are not expected to be repeated. As
such, it would be appropriate for an investor to exclude these items as non-GAAP adjustments
to gain a better understanding of the core business and trends.
By excluding the one-time items in both 2016 and 2015, we get a much clearer picture of the
trends within the core business. Instead of SG&A decreasing by over 17 percent, we now
see the SG&A actually increased by 1.7 percent from 2015-2016. In addition, SG&A
as a percentage of sales now appears to be much more consistent at around 20 percent.
Definitely a trend we can use as a starting point to build our forecast.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
Bad examples of Non-GAAP adjustments
Welcome.
Non-GAAP measures are useful for forecasting a company's future performance. Most
companies use non-GAAP adjustments correctly, but some companies can present non-GAAP
metrics that are misleading to investors. Today, we will review a couple examples of how non-
GAAP adjustments can be misleading.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
In our first example, Groupon issued an IPO or initial public offering in 2010. As part of their IPO
filing, they introduced a non-GAAP metric called adjusted consolidated segment operating
income or adjusted CSOI. They stated that adjusted CSOI gives investors a look at the
company's performance by excluding expenses that are non-cash or not reflective of future
operating expenses. The company is claiming that heavy investments in online marketing costs
should be considered as non-recurring, as these investments are only required in the startup
phase and this amount of advertising will not be required as part of their ongoing business. In
addition, Groupon decided to remove acquisition related costs and certain non-cash items such
as stock compensation as part of their adjusted CSOI calculation.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
Now these adjustments had a significant impact on loss or income from operations. Their GAAP
reported results in 2010 was a loss of 420 million. However, after removing amount spent on
online marketing, stock-based compensation, and acquisition related charges, the last of 420
million is adjusted to a profit of 61 million, a swing of over 480 million versus the GAAP reported
results.
The SEC actually question Groupon's use of adjusted CSOI. One of the concerns was removing
the online marketing costs. In fact, one investor actually noted that, in essence, Groupon is
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
asking investors to look at their profit before any expenses. Obviously decisable adjustment can
create confusion for investors and a lack of clarity as to cost that will be incurred in the
company's core operations.
Ulta Beauty is our second example of companies making confusing or potentially misleading
non-GAAP adjustments. As you are aware, COVID-19 created havoc for many companies in
2020, additional costs were incurred as they battled through the pandemic, ranging from
additional sanitary measures, temporary shutdowns, and some permanent closures. Many
companies attempted to isolate costs related to COVID-19 and tried to provide investors with a
picture of their results, excluding the impacts of this unusual event.
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
Ulta Beauty was one such company. They presented non-GAAP adjustments of over 85 million
for COVID-19 related expenses during the 39 weeks end date, October 31st, 2020. I believe
that it's important for investors to know the additional unusual costs incurred.
However, Ulta did not present a full picture of the total impact of COVID-19. In addition to the 85
million of COVID-19 related costs, Ulta also received over 51 million of federal tax credits or tax
savings related to governmental relief for the pandemic. The problem is that Ulta did not adjust
for these tax savings as one time or unusual in nature. As such, they excluded the cost but did
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Forecasting Financial Statements & Valuation for Accountants
Professor Nerissa Brown
not make a similar adjustment for the tax credit. This has the potential to mislead investors,
giving them a false sense of the core operating results and does not provide a full impact of the
COVID-19 pandemic on their business. It's important for companies when making non-GAAP
adjustments to give investors the full picture, both the good and the bad.
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