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Non-GAAP measures of financial performance can be enormously helpful and insightful in assessing the true financial condition and performance of a company. However, non-GAAP measures can also be used in a way that obfuscates or even conceals the true financial condition and performance of a company. With the passage of Sarbanes-Oxley reforms, the Securities and Exchange Commission (SEC) was directed to promulgate rules to correct the latter types of uses of non-GAAP measures that had become common practice over the past 30 years.1 There was flexibility in both the rules of the profession and federal regulation to allow the use of these non-traditional measures. However, it was clear from Congressional hearings preceding the passage of Sarbanes-Oxley that there had been abuses of these measurements.
This discussion explains the backdrop of the pervasive, and often misleading, use of non-GAAP measures in financial reports that led to the present statutory and regulatory reforms. Following a brief review of the current standards for using non-GAAP measures are thoughts on the ethical issues in the use of these measurements beyond these regulatory requirements and interpretations.
The backdrop: the types of non-GAAP measurements and their use
EBIT (earnings before interest and taxes) and EBITDA (earnings before interest taxes, depreciation, and amortization) are not as much accounting tools as financial analysis tools. They were developed because of concerns on the part of those who evaluated financial performance and worth that the rigidity of generally accepted accounting principles (GAAP) necessarily resulted in the omission of information that was relevant for determining the true value of a company and the richness of its earnings. EBIT and EBITDA were means of factoring out the oranges so that the apples of real earnings growth in a company could be determined.
While the dot coms and other firms of the new economy are often viewed as popularizing EBITDA as the measure of valuation for companies, its origins actually go back to the time of Michael Milken and the junk bond era. The takeovers of the Milken era, which were characterized by companies with very little cash, were actually accomplished through the magic of the EBITDA measurement. If an acquirer could reflect an EBITDA of just $100 million per year, that amount was sufficient to attract...