GAAP vs. Non-GAAP

GAAP is a set of rules and procedures that accountants typically follow to record and summarize business transactions. These guidelines provide the foundation for consistent, fair and accurate financial reporting. Private companies generally aren’t required to follow GAAP, but many do. Public companies don’t have a choice; they’re required by the Securities and Exchange Commission to follow GAAP.

Over the years, the use of non-GAAP measures has grown. Some investors and executives argue that certain unaudited figures provide a more meaningful proxy of financial performance than customary earnings figures reported under GAAP. Before relying on non-GAAP metrics, however, it’s important to understand what’s included and excluded to avoid making misinformed investment decisions.

Spotlight on EBITDA

One popular example of a non-GAAP metric is earnings before interest, taxes, depreciation and amortization (EBITDA). It was developed in the 1970s to help investors project a company’s long-term profitability and cash flow. The figure is said to be one of the most valuable yardsticks that investors consider when a company is being bought or sold. However, some companies manipulate EBITDA figures by excluding certain costs, such as stock- or options-based compensation, that are plainly a cost of doing business. This trend has made it difficult for investors and lenders to make fair comparisons and understand the items taken out.

Last year, the Financial Accounting Standards Board added a project to its research agenda to consider the interaction with standardizing key performance indicators (KPIs) within the current regulatory framework, including whether to develop a standard definition of EBITDA. During a March meeting of the Financial Accounting Standards Advisory Council, senior accountants evaluated whether it makes sense to have a GAAP definition of EBITDA, to use either as a one-size-fits-all formula or as a starting point from which companies could make adjustments based on their business needs. For example, a company might tailor its EBITDA calculation to sync with the definition found in its loan agreements. Adjustments to EBITDA would then need to be clearly disclosed in the company’s footnotes.

Adopt a balanced approach

Many organizations decide to report EBITDA and other non-GAAP metrics to help investors and other stakeholders make better-informed decisions. However, these entities should also avoid making claims that could potentially mislead investors and lenders. Contact us to responsibly and transparently report non-GAAP figures for your company.

Are you thinking about merging with or acquiring a business? CPA-prepared financial statements can provide valuable insight into historical financial results. But an independent quality of earnings (QOE) report can be another valuable tool in the due diligence process. It looks beyond the quantitative information provided by the seller’s financial statements.

These reports can help buyers who want more detailed information — and help justify a discounted offer price for acquisition targets that face excessive threats and risks. Conversely, when these reports are included in the offer package, it can add credibility to the seller’s historical and prospective financial statements. They may also help justify a premium asking price for businesses that are positioned to leverage emerging opportunities and key strengths.

Deep dive

QOE analyses can be performed on financial statements that have been prepared in-house, as well as those that have been compiled, reviewed or audited by a CPA firm. Rather than focus on historical results and compliance with U.S. Generally Accepted Accounting Principles (GAAP), QOE reports focus on how much cash flow the company is likely to generate for investors in the future.

Examples of issues that a QOE report might uncover:

• Deficient accounting policies and procedures,
• Excessive concentration of revenue with one customer,
• Transactions with undisclosed related parties,
• Inaccurate period-end adjustments,
• Unusual revenue or expense items,
• Insufficient loss reserves, and
• Overly optimistic prospective financial statements.

A QOE report typically analyzes the individual components of earnings (that is, revenue and expenses) on a month-to-month basis. This helps determine whether earnings are sustainable. It also can identify potential risks and opportunities, both internal and external, that could affect the company’s ability to operate as a going concern.

EBITDA vs. QOE

It’s common in M&A due diligence for buyers to focus on earnings before interest, taxes, depreciation and amortization (EBITDA) for the trailing 12 months. Though EBITDA is often a good starting point for assessing earnings quality, it may need to be adjusted for such items as nonrecurring items, above- or below-market owners’ compensation, discretionary expenses, and differences in accounting methods used by the company compared to industry peers.

In addition, QOE reports usually entail detailed ratio and trend analysis to identify unusual activity. Additional procedures can help determine whether changes are positive or negative.

For example, an increase in accounts receivable could result from revenue growth (a positive indicator) or a buildup of uncollectible accounts (a negative indicator). If it’s the former, the gross margin on incremental revenue should be analyzed to determine if the new business is profitable — or if the revenue growth results from aggressive price cuts or a temporary change in market conditions.

Flexible tool

Fortunately, the scope and format of QOE reports can be customized, because they’re not bound by prescriptive guidance from the American Institute of Certified Public Accountants. Contact us for more information about how you can use an independent QOE report in the M&A process.