Is EBITDAC a thing? Yes, according to the FT. This article describes the use of a new non-GAAP metric: “earnings before interest, tax, depreciation, amortisation—and coronavirus.” Applying the new metric, a few companies have actually added back profits they contend they would have earned but for the mandatory lockdowns resulting from COVID-19. Hmmm. While, according to the article, the add-back has “bemused some observers,” it does raise the question: how should companies employ non-GAAP financial measures (NGFMs) in the context of COVID-19? How should audit committees conduct oversight of the use of NGFMs that have been adjusted for coronavirus-related effects? Auditors weigh in.
First, the Center for Audit Quality has posted “COVID-19 Considerations for Non-GAAP Financial Measures and Performance Metrics,” which, as the title suggests, looks at NGFMs in the context of COVID-19 and provides some suggestions to help audit committees navigate the rocky terrain. Through roundtable discussions, the CAQ found that NGFMs were generally viewed by companies and investors to be useful “when they are calculated and presented consistently, transparently disclosed, and comparable to measures disclosed by other companies.” Adjustments made to reflect coronavirus-related factors may affect consistency and comparability initially and, to help investors understand the impact of COVID-19 on the company, will require transparent disclosure regarding the calculation and the reasons why management finds these metrics meaningful.
In particular, the CAQ focuses its discussion on the responsibilities of the audit committee to oversee the financial reporting process on behalf of company shareholders. The CAQ advises that the audit committee can
“act as a bridge between management and investors by:
- assessing management’s reasons for presenting non-GAAP financial measures and performance metrics;
- considering the sufficiency of management’s related disclosures; and
- evaluating whether the measures present a fair and balanced view of the company’s performance.”
In evaluating NGFMs and performance metrics, such as KPIs, used to reflect the impact of COVID-19, the CAQ suggests that audit committees:
- Try to evaluate the NGFMs, metrics and related disclosure from the perspective of the investors to gauge whether the NGFMs, metrics and disclosure will actually help investors understand how management and the audit committee see the business.
- Discuss with management the coronavirus-related changes made to the NGFMs and metrics, particularly why the changes were made and whether the disclosure adequately captures the changes and the rationale for them.
- Discuss with management their compliance with the SEC’s rules and guidance regarding NGFMs and other metrics, particularly the guidance related to adjustments for COVID-19.
- Discuss with the outside auditors their responsibilities regarding NGFMs and performance metrics.
Audit firm EY has also provided its views on appropriate use of NGFMs to present the effects of the COVID-19, offering advice on which types of coronavirus-related adjustments are appropriate. EY indicates that the SEC staff’s prior guidance and comment letters on the use of NGFMs are instructive in offering a framework to help companies evaluate the acceptability of coronavirus-related adjustments. Looking to that framework as a guide, EY advises that adjustment to NGFMs for the effects of COVID-19 should be limited to items directly attributable to COVID-19 and that are both:
- “Incremental to charges incurred prior to the outbreak and not expected to recur once the crisis has subsided and operations return to normal
- Clearly separable from normal operations.”
EY also advises that, to the extent that common adjustments, such as asset impairments or restructuring charges, are made for the first time, companies should retrospectively adjust their NGFMs for prior periods if the item also materially affected those periods. In addition, companies are cautioned to keep in mind the SEC staff’s guidance that an NGFM “can be misleading if it excludes nonrecurring charges but does not exclude nonrecurring gains.”
Assuming that charges or gains are attributable to COVID-19 and are incremental to and separable from normal operations, as noted above, EY believes that the following types of adjustments may be acceptable:
- “Temporarily paying a premium to compensate employees for performing their normal duties at increased personal risk (e.g., hazard pay)
- Cleaning and disinfecting facilities more thoroughly and/or more frequently
- Terminating contracts or complying with contractual provisions invoked directly due to the events of the pandemic (e.g., contract termination fees or penalties)
- Insurance recoveries”
In the absence of further guidance from the staff, EY advises that companies avoid COVID-19-related adjustments regarding the following items, as inconsistent with the framework above:
- “Paying idled employees
- Rent and other recurring expenses (e.g., security, utilities, insurance, maintenance) related to temporarily idled facilities
- Excess capacity costs expensed in the period due to lower production
- Paying employees for increased hours required to perform their normal duties
- Paying more for routine inventory costs (e.g., shipping costs)”
Moreover, EY cautions not to “use a non-GAAP measure that includes adjustments to normalize operations, such as including estimates of lost revenue to show what results would have been without the effects of the pandemic.”
However, even if it is inadvisable to adjust NGFMs to reflect certain items, companies can still convey the information about the impact of coronavirus-related items just by providing additional disclosure about the unusual expense or other item. For example, EY suggests, companies can show the effect of payroll expenses related to employees idled during the pandemic simply by disclosing that “payroll paid to employees idled due to the COVID-19 pandemic of approximately $xx million are included within cost of revenue, selling, general and administrative and research and development expenses.” Disclosure of that nature is not considered an NGFM.
Although slightly more tentative, audit firm Deloitte appears to take similar positions. According to Deloitte, companies may present NGFMs that adjust for “unusual, direct, and incremental costs due to COVID-19 as well as any related economic uncertainty, such as asset or goodwill impairments.” However, adjusting for “estimated lost revenues or profits is likely to be inappropriate because the SEC may view it to be a tailored accounting principle.” Similarly, adjusting for unusual items, such as restructuring charges, may be acceptable but adjusting “revenues or eliminate recurring cash operating expenses may be viewed as potentially misleading and therefore may be prohibited.”
With regard to adjustments for salary continuation while operations are suspended or closed (referred to as idled employees by EY above), even though salary continuation would be unusual, those expenses would be recurring cash operating expenses, with the result that NGFMs reflecting those adjustments could be subject to challenge by the SEC. Addressing KPIs and similar metrics, Deloitte advises that, if they change as a result of COVID-19 or for any reason, companies should provide “clear and transparent disclosure of the change” and update definitions of the affected metrics. Companies should also consider whether they will need to “recast prior periods to conform to the current presentation if the changes are significant.”