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The Pitfalls of Non-GAAP Metrics

Book Description

For decades, companies have used custom metrics that don't conform to generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS) as supplements to their official financial statements. Some common non-GAAP measures include adjusted earnings before interest, taxes, depreciation, and amortization (known as adjusted EBITDA), free cash flow, funds from operations, adjusted revenues, adjusted earnings, adjusted earnings per share, and net debt. However, as the authors point out, it's not unusual for these alternative measures to lead to problems. Since companies devise their own methods of calculation, it's difficult to compare the metrics from company to company — or, in many cases, from year to year within the same company. According to the authors, alternative measures, once used fairly sparingly and shared mostly with a small group of professional investors, have become more ubiquitous and further and further disconnected from reality. In 2013, McKinsey & Co. found that all of the 25 largest U.S.-based nonfinancial companies reported some form of non-GAAP earnings. Press releases and earnings-call summaries often present non-GAAP measures that are increasingly detached from their GAAP-based equivalents. In addition to creating potential problems for investors, the authors argue, alternative metrics can harm companies themselves by obscuring their financial health, overstating their growth prospects beyond what standard GAAP measures would support, and rewarding executives beyond what is justified. Board members, top executives, compliance officers, and corporate strategists need to make sure that whatever alternative measures companies use improve transparency and reduce bias in financial reports. Although no standard is perfect, the authors note that GAAP and IFRS standards provide a foundation for consistent measurement of corporate performance over time and across businesses.