Non-GAAP measures and reconciliations

Key takeaways

• A non-GAAP measure adjusts or combines amounts from the financial statements in a way the accounting standards do not define.
• SEC rules require US registrants to present the most directly comparable GAAP measure and a quantitative reconciliation, and in filings to give the GAAP measure equal or greater prominence.
• Organic growth removes acquisitions, disposals and currency effects from reported growth; constant currency growth removes only currency, by translating both periods at the same rates.
• Free cash flow has no standard definition, so the reconciliation from cash from operations is what tells you which one a company uses.
• Read non-GAAP measures by the reconciliation, not the headline: check whether excluded costs recur, whether adjustments run in both directions and whether definitions change over time.
• IFRS 18 brings management-defined performance measures into the audited notes, with a reconciliation and the tax and non-controlling interest effect of each adjustment.

What counts as a non-GAAP measure

The SEC defines a non-GAAP financial measure, in substance, as a numerical measure of historical or future financial performance, financial position or cash flows that excludes amounts included in, or includes amounts excluded from, the most directly comparable measure calculated under GAAP. Adjusted net income excludes amounts included in GAAP net income. Free cash flow subtracts capital expenditure from a GAAP cash flow subtotal. Both qualify.

Some numbers are not non-GAAP measures even though they are not in the financial statements. Operating metrics such as store count, units shipped, subscribers or backlog are not financial measures. Ratios computed entirely from GAAP amounts, such as a GAAP operating margin, are not non-GAAP. And measures required by law or a regulator, such as a bank's regulatory capital ratios, are excluded from the definition.

It helps to separate performance measures, which adjust profit (adjusted EBITDA, adjusted EPS), from liquidity measures, which adjust cash flow or leverage (free cash flow, net debt). The SEC rules treat the two differently, and a single number can be presented as either depending on the reconciliation, which matters for what adjustments are allowed.

The SEC rules in plain terms

Two sets of SEC rules apply to US registrants. Regulation G covers any public disclosure of a non-GAAP measure, including press releases, earnings calls and investor presentations. It requires the company to present the most directly comparable GAAP measure and a quantitative reconciliation between the two, and it prohibits presenting a non-GAAP measure in a way that is misleading. Regulation S-K adds stricter requirements for measures included in documents filed with the SEC, such as annual reports and registration statements.

Under the filed-document rules, the GAAP measure must be presented with equal or greater prominence than the non-GAAP one. The company must explain why management believes the measure is useful to investors and, to the extent material, how management uses it. Certain practices are prohibited: excluding charges or liabilities that required or will require cash settlement from a non-GAAP liquidity measure (EBIT and EBITDA are specifically allowed); presenting non-GAAP measures on the face of the financial statements or in the notes; using titles confusingly similar to GAAP titles; and labeling an adjustment non-recurring, infrequent or unusual when a similar charge is reasonably likely to recur within two years or occurred within the prior two years.

SEC staff interpretations go further. A measure can be misleading even with a reconciliation if it excludes normal, recurring cash operating expenses necessary to run the business, if it adjusts only for charges and not for similar gains, if its definition changes between periods without explanation, or if it substitutes an individually tailored accounting method for GAAP, such as recognizing revenue on billing when GAAP requires it over time. Non-GAAP liquidity measures may not be presented on a per-share basis.

Adjusted earnings and adjusted EPS

Adjusted EPS starts from GAAP net income attributable to shareholders, removes items the company considers outside its ongoing performance, adjusts for the income tax effect of those items and divides by diluted shares. The tax step is essential. Removing a pretax cost without removing the tax deduction it generated overstates adjusted earnings, and SEC staff expect the tax effect to be shown as a separate adjustment.

The most common adjustments are amortization of acquired intangible assets, restructuring and integration costs, impairments, gains and losses on disposals and investments, and stock-based compensation. Their quality varies. Amortization of acquired intangibles is non-cash and relates to past acquisitions, and it is widely excluded. Stock-based compensation is a recurring cost of employing people, and excluding it flatters every year. Restructuring is defensible once and questionable if it appears every year.

Organic growth and constant currency

Reported revenue growth mixes three things: growth in the existing business, revenue bought or sold through acquisitions and disposals, and the translation effect of exchange rates on revenue earned in other currencies. Organic growth, also called like-for-like or underlying growth, strips out the second and third to isolate the first. Companies define it differently; the common approach removes the revenue of businesses acquired from the current period until they have been owned for a full comparable period, removes revenue of businesses sold from the prior period, and removes the currency effect.

Constant currency growth removes only the currency effect. It restates the current period's foreign-currency revenue at the prior period's exchange rates (or both periods at a fixed set of rates) so that the growth rate reflects local-currency performance. It is especially important for companies reporting in US dollars with large operations elsewhere, because a strong dollar can turn solid local growth into reported decline.

Free cash flow

Free cash flow is the non-GAAP measure most often presented as a liquidity measure. The simplest and most common definition is cash from operating activities less capital expenditure. Because it starts from a GAAP subtotal and deducts a GAAP line, it is easy to reconcile, but companies vary it: some deduct capitalized software and development costs, some add back proceeds from asset sales, and IFRS reporters may or may not deduct lease principal payments, which IFRS 16 places in financing activities.

Adjusted free cash flow goes a step further by adding back cash costs management considers non-recurring, such as restructuring payments or acquisition fees. Those items are cash that left the business, and under the SEC rules a liquidity measure may not exclude charges that required cash settlement, so such figures need particular care in filings. For an investor, the question is simply whether the company will keep spending that cash.

ARR and other key performance indicators

Annual recurring revenue (ARR) is the annualized value of recurring subscription contracts in force at a point in time. It is not a GAAP measure and is not directly reconcilable to revenue, because revenue is recognized over a period while ARR is a snapshot, and because ARR typically excludes one-off services, usage above contracted minimums and implementation fees. It is, however, the metric by which most software businesses are valued and financed in private markets, including recurring revenue loans sized as a multiple of ARR rather than EBITDA.

Definitions vary on almost every point: whether signed but not yet live contracts count, whether free trials or heavily discounted first years are annualized at list or actual price, whether multi-year ramped contracts use the current or final year's value, and how month-to-month customers are treated. A company should state its definition and keep it consistent, and a diligence team should rebuild ARR from the contract list and tie the total to invoices and recognized revenue.

The ARR bridge, from opening to closing ARR, is where the quality shows. It separates new customers from expansion of existing ones, and contraction and churn from both. Net revenue retention (NRR) and gross revenue retention (GRR) are computed from it.

Reading non-GAAP measures skeptically

Start from the reconciliation, not the headline. List each adjustment, its size and whether it appeared last year. Adjustments that recur every year are part of the cost of running the business, whatever they are called. Check the direction: a company that removes losses on disposals should also remove gains, and one that adds back litigation costs should deduct insurance recoveries.

Track the gap over time. A widening difference between GAAP and adjusted earnings means an increasing share of reported costs is being declared irrelevant. Check the definitions against prior years for quiet changes. Compare the measure with the one a peer uses before comparing the numbers. And remember that compensation plans are often tied to adjusted metrics, which gives management a direct interest in their definition.

IFRS 18 and management-defined performance measures

IFRS 18, Presentation and Disclosure in Financial Statements, replaces IAS 1 for annual reporting periods beginning on or after 1 January 2027. Besides requiring new defined subtotals in the income statement, including operating profit, it creates a category called management-defined performance measures (MPMs). An MPM is a subtotal of income and expenses that a company uses in public communications outside its financial statements to communicate management's view of an aspect of its financial performance. Certain common subtotals, such as gross profit and the new IFRS-defined subtotals, are excluded from the definition.

For each MPM, the company must disclose in a single note of its financial statements why the measure is useful, how it is calculated, and a reconciliation to the most similar subtotal specified by IFRS, including the income tax effect and the effect on non-controlling interests of each reconciling item. Because the disclosure sits in the notes, it falls within the scope of the audit, which the SEC rules do not require for US non-GAAP measures.

Not every non-GAAP measure is an MPM. Measures that are not subtotals of income and expenses, such as free cash flow, net debt or ARR, fall outside the definition. Those remain governed in the European Union by the ESMA Guidelines on Alternative Performance Measures and elsewhere by local regulators.