In this holiday season, while many are focused on how the Jedi will defeat the Dark Side of the Force, others appear to be focused on what they believe is the dark side of something else: non-GAAP measures. In her keynote address at the 2015 AICPA National Conference, Mary Jo White, chairwoman of the SEC, noted that the use of non-GAAP measures “deserves close attention.” She added that “non-GAAP measures are used extensively and in some instances may be a source of confusion.” Following up on Chairwoman White’s comments, a Wall Street Journal article (“U.S. Corporations Increasingly Adjust to Mind the GAAP,” December 15, 2015) criticized companies’ increased use of non-GAAP measures in earnings releases and SEC filings. The authors claimed that such use obfuscates corporate earnings. But does it?
Let’s examine one commonly used non-GAAP measure, adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization). Why calculate adjusted EBITDA? Generally, investors and other market participants are concerned with a company’s recurring cash earnings. Investors ultimately want cash. Non-cash earnings cannot result in cash, and investors perceive non-recurring earnings as temporary blips in a company’s ability to generate cash flows from its ongoing operations. But GAAP does not provide a measure of recurring cash earnings. To fill this void, companies and other interested parties, such as investors, M&A participants, investment bankers, and equity analysts, often calculate adjusted EBITDA as an estimation of a company’s recurring cash earnings. In addition to adding back to GAAP net income the impact of interest, taxes, depreciation, and amortization, calculations of adjusted EBITDA often include “one-time” addbacks such as restructuring charges, weather-related costs, and foreign currency gains and losses. These calculations of adjusted EBITDA, despite being labelled in the Wall Street Journal article as one form of “obfuscation,” can provide a useful, enhanced understanding of corporate earnings. The widespread use of adjusted EBITDA supports this notion.
So where’s the rub? GAAP defines interest, taxes, depreciation, and amortization, so the amount and nature of those addbacks are generally not controversial. GAAP, however, does not define other addbacks, which are then subject to subjective interpretation in their nature, type, and amount. For example, last winter’s "stormageddon" on the East Coast resulted in business interruption and other losses for many companies. Whether, and to what extent, an affected company adds back such losses in a calculation of adjusted EBITDA depends on the judgment of the company’s management. Moreover, even if the company does not modify adjusted EBITDA for such losses, an investor or other interested party might. Without uniform guidance such as GAAP, companies and others are left to their own devices to calculate such modifications to adjusted EBITDA on a case-by-case basis. Perhaps as a result of this lack of standardization and comparability across companies, some have criticized non-GAAP measures as being, in the words of Chairwoman White, “a source of confusion.”
Complaining about non-GAAP measures does not, however, change the fundamental reason as to why companies present them: Investors demand them. Companies will continue to present them so long as investors demand them. If companies want these measures to be helpful to investors rather than “a source of confusion” or worse, a possible source of litigation, clear disclosure of the nature and calculation of such measures would serve to both enhance investors’ understanding of corporate earnings and reduce criticisms of such measures.
Keywords: securities litigation, non-GAAP, SEC, Mary Jo White, EBITDA