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Financial Reporting Brief
Our featured article for July is 'Non-GAAP Measures – Focus of Attention' with Brendan Sheridan commenting on the need to manage and control such disclosures given they are of high interest to analysts, stakeholders and the media.
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Non-GAAP Measures – Focus of Attention
Many stakeholders, analysts and others have concerns that companies may have a tendency to highlight in their financial reporting what they describe as ‘earnings before bad stuff’. Reports and comments to that effect are frequent including those that for 2015, GAAP earnings of S&P 500 companies were 25% less than their proforma adjusted results. The gap was the widest on record since 2008, a year when companies recorded exceptionally high charges primarily arising from the commencement of the severe downturn.
In the past year or so there has been considerable activity by the supervisors and regulators in relation to developing and imposing a framework and discipline for such reporting, including the use of non-GAAP measures. These include inter alia reports by IOSCO and ESMA, and the continuing processes of the SEC in the USA.
In a recent speech, the IASB chairman commented on non-GAAP measures and whether IFRS standards provide sufficient criteria by which performance can be judged by users of financial statements. In his comments he admitted that the IASB provides too little guidance in formatting the income statement and defining its component elements, leading to potential lack of comparability above the bottom line, making it difficult for users to judge performance.
The IASB Chairman suggested some ‘potential remedies’ to these difficulties and emphasised that ultimately the number that counts most is the unadjusted bottom line, where all elements of income come together, both recurring items and exceptional items, whatever those may be. It is important that it shows everything, ‘warts and all’.
What are non-GAAP Measures?
A non-GAAP financial measure is a numerical measure of an issuer’s current, historical or future financial performance, financial position or cash flow that is not measured in accordance with GAAP, a recognised reporting framework under which the entity’s financial statements are prepared.
Common terms used to identify non-GAAP financial measures include, among others, ‘underlying earnings’, ‘normalised profit’, ‘pro forma earnings’, ‘cash earnings’, ‘adjusted earnings’ and ‘earnings before non-recurring items’, One of the more common measures is EBITDA – Earnings Before Interest, Taxation, Depreciation and Amortisation. Although EBITDA is a key part of the financial information many companies present, it is a non-GAAP measure and different companies approach calculating it differently, which skews comparability.
Typically, although not exclusively, these measures, otherwise known as alternative performance measures (APMs) are to be found in sections of the annual report outside of the financial statements. APMs are often quoted in preliminary results and other market and press announcements, and attract significant attention from analysts and other users.
IOSCO (The International Organisation of Securities Commissions) has in its June report ‘Statement of Non-GAAP Financial Measures’ set out its expectations for the presentation of non-GAAP financial measures by issuers. These include that sufficient information should accompany the measures to aid in their understanding and that the measures should be presented transparently and with disclosure of how they are calculated. The report provides specific expectations in the following broad categories:
• Defining the non-GAAP financial measure
• Unbiased purpose
• Prominence of GAAP measures versus non-GAAP financial measures
• Reconciliation to comparable GAAP measures
• Preservation of non-GAAP financial measures consistently over time
• Recurring items
• Access to associated information
These elements if attended to and present would contribute to the reliability and comparability over time of non-GAAP financial measures and reduce the potential for misleading disclosure.
The European Securities and Markets Authority (ESMA) published in June 2015 its final guidelines on APMs for listed issuers traded on regulated markets and persons responsible for drawing up a prospectus. The main points of the guidelines are generally similar to those in the IOSCO report. In May 2016 the UK Financial Reporting Council (FRC) published a summary of frequently asked questions and responses on the Guidelines.
Managing the Expectation
Non-GAAP measures are clearly a focus of attention for many. While these measures can be a source of confusion, when handled appropriately they can help convey information that is useful to enable investors and stakeholders generally to understand the company’s performance not otherwise provided by GAAP measures. To enhance the usefulness of disclosure the use of such measures should be controlled and managed appropriately and on a consistent basis.
It is essential that non-GAAP measures are determined and presented with the same analytical rigour and quality assurance process as audited results, and they must be on a basis consistent with the audited financial statements.
To achieve this, and to mitigate or avoid unnecessary negative scrutiny, a company should adopt an approach which is well managed and controlled along the following or similar lines:
- Ensure Audit Committee (or equivalent governance) Oversight – the company’s disclosure controls and procedures should address Non-GAAP measures and the audit committee should understand the process by which the company decides to present Non-GAAP measures and any changes to approach from period to period. These measures are generally outside the direct scope of the external auditor reporting on the financial statements.
- Use non-GAAP Measures Consistently – a company should address non-GAAP measures as part of its overall financial disclosure policy, consistent with its disclosure goals and results of operations, with the reasons for any new measure introduced or change in measure clearly explained.
- Conduct a Peer Analysis – a company should be knowledgeable about the financial metrics used by its peers and, unless there is a reason to depart from standard industry practice, should consider presenting its measures on that basis.
- Remain Focused on the Disclosure Purposes – do not lose sight of the purpose for providing disclosure, which should be to help investors understand the company’s performance. Every effort should be made to provide plain English, non-boilerplate discussion and analysis and consideration should be given to whether non-GAAP measures help the company achieve those goals.
The SEC recently escalated its efforts to curb perceived misuse of non-GAAP financial measures with the issuance of a revised set of Compliance and Disclosure Interpretations. A central theme of the new Interpretations is the more prescriptive approach taken to the ‘equal or greater prominence’ requirement, with the requirement that GAAP measures must be presented first, and must also be discussed and analysed in the narrative sections of the report. IOSCO, and others, have expressed the expectation of equal prominence for GAAP and non-GAAP measures and it is possible that this may be strengthened further.
The publication of earnings press releases and the financial information and earnings performance provided to analysts and ratings agencies need to be managed in an appropriate manner. Non-GAAP measures, where used, should be with the objective of improving transparency and providing insight into the indicators management uses to manage the business and analyse the results.
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