Bridging the GAAP: non-GAAP financial measures must have a prominent place on the audit committee agenda.

• Author: Whalen, Dennis T.
• Position: ON THE GOVERNANCE AGENDA

Financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP) don't always tell the whole story of a company's performance. To bridge the gap, your company--like many companies today--probably supplements reported earnings under GAAP with "non-GAAP financial measures" (such as EBITDA, adjusted earnings, and free cash flows) that the company believes more accurately reflect the results of operations and are better indicators of future performance.

While many investors find non-GAAP financial measures helpful (and have come to expect them), news headlines and regulatory scrutiny continue to highlight concerns about the overuse and the expanding variety of non-GAAP financial measures. (See such articles as "Tailored Accounting at IPOs Raises Flags," The Wall Street Journal, Jan. 7, 2015, and "How Much Do Silicon Valley Firms Really Earn?" Barron's, June 27, 2015.) And in 2014, non-GAAP financial measures continued to be a common topic of SEC Staff comment letters.

Indeed, the SEC Staff continues to scrutinize non-GAAP financial measures --particularly the consistency of the information --that companies disclose in their SEC filings, earnings releases, conference calls, and other public statements, and challenge the use of non-GAAP financial measures in any context when considered to be materially misleading. Is management presenting an overly optimistic view of the company? Do the non-GAAP financial measures help investors understand the company's performance and prospects? (The SEC has detailed regulations regarding disclosure of non GAAP financial measures to ensure that investors are provided with information that is fulsome and not misleading.)

In this environment, it is critical that non-GAAP financial measures have a prominent place on the audit committee agenda, and that the committee have a robust dialogue with management about the process by which management develops non-GAAP financial measures, and their correlation to the actual state of the business and results. We recommend the following areas for the committee's consideration:

* Remember that non-GAAP financial measures are not audited by the external auditor. Non-GAAP financial measures are included in the MD&A--not in the audited financial statements. As a result, the auditor's responsibility is limited to consideration of whether the information is materially inconsistent with information appearing in the financial statements. Of course, the...