ACCT5021 Accounting for Managers - GAAP VS NON-GAAP

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Question:

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This assignment requires you to consider whether non-GAAP reporting is in line with the conceptual framework. The Conceptual Framework states in part an objective for financial reporting and the qualitative characteristics of financial information. You need to obtain the financial reports of two companies from two different jurisdictions (e.g. listed in US and Australia) and document the non-GAAP earnings metrics presented. Required (Marking weighting in brackets):

Explain what is meant by the term non-GAAP reporting making use of the two companies you selected (20%).
Given the objective of financial reporting, discuss how non-GAAP reporting supports or detracts from this objective
Considering qualitative characteristics and enhancing characteristics for financial information, consider how non-GAAP reporting contributes or detracts from the characteristics that support high quality financial reporting.
The quality of written communication (This will be assessed for clarity, presentation, grammar, spelling, sentence structure and correct referencing using Chicago style) (40%).

Be sure to support your analysis with a detailed literature review of relevant academic articles and other sources like the media.

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Solution:

Introduction

The term financial reporting means disclosure of financial information of a company to its managers and public. It is used to determine the financial performance of an organization. These reports are issued quarterly and annually. The main purposes of these reporting are, it enables the management to understand the performance of the organization and accordingly frame strategies and understand the strength and weaknesses of the organization. On the basis of financial reporting this report stresses on the concept of non-GAAP measures used in businesses now-a-days as a vital element in their accounting methods. In general the financial statements are prepared following GAAP rules. But the reason why non-GAAP measures have emerged as a vital element in accounting practices is that they provide additional insight into the financial performance of the company and or cash flow.

Non-GAAP Reporting

A company reports its non statutory performance measures in the audited financial statements in press releases and several documents. These measures are termed as non-GAAP measures and refer to “proforma earnings”, “street earnings”, “core earnings”, “underlying profits”, “normalized profits” or “non-GAAP earnings”. The figures of non-GAAP earnings exclude the ones reported under IFRS. The measures in non-GAAP earnings include EBIT (Earnings Before Interest and Taxes) or EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). Hence, companies use non-GAAP earnings in order to emphasize the cash flow of the company (Henry, Lin and Yang). Tesla Just like several other companies Tesla also reports standard and non-standard financial metrics in its accounting methods. The standard financial metrics comprises of the one which is required by law, i.e. GAAP, whereas the non-standard financial metrics comprises of non-GAAP. According to several companies the usefulness of non-GAAP reporting is to impress the investors.

Figure 1: Tesla – GAAP vs. non-GAAP earnings Source: (Tesla 2013) The above graph shows Tesla’s GAAP vs. non-GAAP earnings. The non-GAAP earnings of the company is little higher than the GAAP earnings. As per report by Fox Business News, the earnings of the company on 5th November stood at $60.3 million as compared to the GAAP based estimate of $524.64 million, as provided by Thomson Reuters analysts (Parker and Porter 2001). Tesla’s first GAAP and non-GAAP report in the first quarter of the fiscal year 2013.

Figure 2: GAAP and non-GAAP net profit Source: (IBTIMES 2013) It is visible that Tesla improved its profit by addition of $14.9 million of stock-based compensation. Tesla’s GAAP and non-GAAP report in the second quarter of 2013.

Figure 3: GAAP and non-GAAP net profit Source: (IBTIMES 2013) Here, it is visible that in the second quarter, Tesla is adding its non-GAAP lease accounting, which makes the Net Loss as per GAAP to Net Profit as per non-GAAP. Woolsworth Australian companies follow GAAP in their accounting method such as net profit. What is seen now-a-days is that companies are using alternative profit measures which include cash profit, underlying profit and recurring earnings. The reason behind companies like Woolsworth using non-GAAP measures is to make their earnings look better. Woolsworth faced a net loss of A$1.2 billion after its value of improvements and general merchandize slashed resulting to weaker earnings. On excluding charges for net impairment and restructuring cost of A$2.6b, the underlying profit fell to A$803.5m, which is far better than the loss.

Figure 4: Income from GAAP and Non-GAAP Source: (Reuters 2016)

2. Non GAAP reporting and Objectives of Financial Reporting

The main objective of financial reporting is to deliver required information for the purpose of decision making. This induces the potential investors and creditors to make decisions regarding rational investment. It includes disclosure of financial information to the stakeholders of a company in order to make them understand the performance of the company. While carrying out the research on the earnings reports of 500 largest listed companies in Australia it was found that in the year 2000 about 20% of the companies reported non-GAAP after tax earnings measures. This data increased to 40% by the year 2014. Many are of the view that non-GAAP measures followed by the companies mislead investors. In contrary to this many says that non-GAAP measures help investors understand to performance of the company better (Reuters 2016). In order to convey the characteristics of a measure it is important for the companies to consider the way they will title non-GAAP financial measure. While calculating under non-GAAP financial measure it includes certain additional adjustments which are commonly not used while calculating EBITDA. When non-GAAP financial measures are presented they must be done in such a way that they do not have much difference with that of the GAAP measures. They are expected to be in greater prominence when directly compared with GAAP. During research it was found that few respondents were not in favour of the expected prominence. They stated that non-GAAP measures are more likely and useful to be followed by some industries compared to that of the GAAP measures. Other respondents specified that it is important to have prominence expectation as this will create a ceiling upon the voluntary information disclosed by an entity irrespective of the fact whether they have any importance to the investors or not. Again there were some other respondents according to whom the prominence expectation may deter effective communication with the stakeholders. It was decided by the Board to continue inclusion of disclosure element on the basis of the experience of the members of IOSCO as this will ensure greater emphasis on financial measures which are compared and calculated in a way approved by recognized framework. The Board expects the entities to provide meaningful discussion to the non-GAAP financial measures which will help stakeholders and equal and greater prominence must be provided to the measures which are reflected in the financial statements of an entity. Later on the Board decided for amending the provision by stating that there is no need to present non-GAAP financial measures with equal or greater prominence than the directly comparable measures calculated under GAAP (Parker and Porter 2004). It is accepted by Delloite analysts that non-GAAP measures must be in less prominence than the ones directly comparable to the GAAP measures. Hence, the presentation of non-GAAP financial measures will not detract from the ones presented under GAAP measures.

3. Non-GAAP reporting contributes or detracts from characteristics supporting high quality financial accounting

Non-GAAP financial measures have emerged as an important element in accounting methods followed by companies. The non-GAAP financial measures helps conveying information to the investors which the company assumes is relevant and helpful for understanding the performance of the company. As per several analysts and press comments, the use of non-GAAP financial measures are increasing now-a-days and are resulting in confusion. The preparers are the ones who are responsible for following good practices for the use of non-GAAP measures to comply with fairness in financial reporting (Parker and Porter 2004). It might be that the CFO and members of the investors relation team is quite impressed with the non-GAAP measures as a useful device for communication purpose in the market, but the members of the audit committee and the finance and legal team must be very careful while using these measures. The questions which they need to be confirmed about are;

the reason why the company is using non-GAAP measures?
how much reliable is the measure in providing reliable information to the investors?
are the non-GAAP measures providing less prominence compared to the GAAP measures, as mentioned under the rule?
is the reason behind use of non-GAAP is proven and whether they are capable of providing required information to the investors and are drafted without boilerplate?
is there adequate control on non-GAAP measures calculation?

The responsibility of maintaining strong financial reporting is not solely upon the preparers. The auditors must be very keen and sincere while reviewing the reports. Preparers are considered as lynchpin of high quality financial reports, whereas the auditors are considered to be the main gatekeepers of those reports, who are responsible for protection of the interest of the shareholders. The auditors are the ones who keep an insight of the financial reporting. They have the responsibility of reviewing the way management is designing ICFR and implementing the same at the same time how the management is making use of the non-GAAP measures in order to ensure they are complying with the high quality management reporting.

Figure 5: GAAP vs. Non-GAAP results Source: (Pega 2016) The figure above shows how financial plan is presented on the basis of GAAP and non-GAAP. The non-GAAP financial measures cannot be considered as a substitute of the GAAP measures. Hence, it is the responsibility of the senior management including the auditors to ensure that non-GAAP measures support high quality financial reporting.

Conclusion

The report highlights on the non-GAAP measures followed in accounting practices by many companies. Through this report the researcher tries to focus on the ways which confirm how non-GAAP measures comply with financial reporting standards. The non-GAAP measures although reflect a better position of a company compared to that of the GAAP measures are useful to investors. Many companies follow reconciliation of GAAP and non-GAAP measures which they include in financial schedules. The presentation of non-GAAP performance measures varies with users. Some are presented both inside and outside financial statements and some present only outside financial statements.

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