Between mid-September and mid-October of 2016, the Securities and Exchange Commi
ID: 2530499 • Letter: B
Question
Between mid-September and mid-October of 2016, the Securities and Exchange Commission (SEC) put Tesla Inc. under fire after the latter added back certain costs to revenue using non-GAAP earnings. While the use of non-GAAP earnings is allowed to some extent, Tesla violated the US GAAP. In four separate comment letters sent from the SEC to Tesla, the regulatory body inquired about “….a statement disclosing the reason why you believe that the presentation of a non-GAAP financial measure provides useful information to investors...not how your management uses the information”.
2. What does non-GAAP earnings mean? Why it is violation of US GAAP in some situations?
Explanation / Answer
Non-GAAP earnings are an alternative method used to calculate earnings of a company and many companies report Non-GAAP earnings in addition to their earnings as calculated adopting generally accepted accounting principles(GAAP). Some financial expert believe that alternative methods to calculate earnings provida a more accurate company's financial performance.
Examples of Non-GAAP earnings are cash earnings, operating earnings and earnings before interest, taxes, depreciation and amortization(EBITDA)
There are instances in which GAAP reporting fails to accurately portray the operations of a business. Companies are allowed to display their own accounting figures, as long as they are disclosed as non-GAAP and provide reconciliation between the adjusted and regular results. Non-GAAP figures usually exclude irregular or noncash expenses, such as those related to acquisitions, restructuring or one-time balance sheet adjustments. This smooths out high earnings volatility that can result from temporary conditions, providing a clearer picture of the ongoing business. Forward-looking statements are important because valuations are largely based on anticipated cash flows. However, non-GAAP figures are developed by the reporting company, so they may be subject to situations in which the incentives of shareholders and corporate management are not aligned.
Several principles serve as the basis for GAAP accounting, including accrual basis accounting and revenue recognition policies. The accrual basis of accounting matches revenue earned with the expenses incurred to produce the revenue, and the accrual basis method does not post revenue and expenses based on the movement of cash. GAAP insists on the accrual method, because the financial statements are a better indicator of the true earnings of a company if revenue and expenses are not based on cash movements.
GAAP also requires businesses to create policies for recognizing revenue in financial statements, and that the policies must be consistently applied. Companies can recognize revenue when a product is shipped, when a customer receives an invoice or not until the client’s payment is received. To avoid financial manipulation, a business should apply the revenue recognition policy consistently from one month to the next, and it should disclose the policy in the footnotes to the financial statements. Using a consistent policy means that the earnings reported each month are more reliable.
A company uses non-GAAP earnings to emphasize the firm’s cash flow, which is why (EBITDA) is presented in the financials. Depreciation and amortization do not affect cash, so using EBITDA provides an earnings number that excludes these non-cash expenses.
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