S. David Young
Professor of Accounting and Control
Journal Article | MIT Sloan Management Review | 59 | January 2018
The Pitfalls of Non-GAAP Metrics
Companies have used custom metrics that don’t conform to the standards of the U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) for decades as supplements to their official financial statements. Some common non-GAAP measures[i] include earnings before interest, taxes, depreciation, and amortization (known as EBITDA), free cash flow, funds from operations, adjusted revenues, adjusted earnings, adjusted earnings per share, and net debt. However, these alternative measures can lead to serious problems.Since companies devise their own methods of calculation, there's no way to compare the metrics from company to company -- or, in many cases, even from year to year within the same company. Lately, in the course of examining the financial statements and communications of thousands of public companies in at least a dozen countries, we’ve seen a troubling trend. 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.Not only does the proliferation of alternative metrics of pose a problem for investors. It can also harm the companies themselves by obscuring their financial health, overstating their growth prospects beyond what standard GAAP measures would support and rewarding executives beyond what can be 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, instead of injecting more bias in financial reports.