FINANCIAL REPORTING AND IR

Communicating financial performance to the market is no easy task. One way companies do this is through financial statements prepared in accordance with generally accepted accounting principles (GAAP), which present the historical performance of the company using a set of consistent standards. These standards aim to enhance comparability among financial statements between companies, allowing users to appropriately assess performance and draw conclusions.

However, GAAP rarely tells the whole story of a company’s performance. In addition to GAAP financial statements, many companies view non-GAAP measures (NGMs) in other accompanying documentation (e.g. earnings releases, prospectuses) as a useful tool to bridge the information gap with investors and analysts.

The Canadian Securities Administrators (CSA) has defined a NGM as “a numerical measure of an issuer's historical or future financial performance, financial position or cash flow that is not specified, defined or determined under the issuer's GAAP and is not presented in an issuer's financial statements.” Common NGMs presented in press releases and management’s discussion and analysis (MD&A) include: earnings before interest, taxes, depreciation and amortization (EBITDA); adjusted EBITDA; and adjusted earnings. However, companies are free to create their own measures that best reflect their individual performance.

Globally, the use of NGMs outside of GAAP financial statements is widespread. More than 88% of the S&P 500 currently disclose NGMs in their earnings release[i]. As the use of NGMs has grown, so too have concerns about their use. Without a consistent set of standards or principles underlying the presentation of NGMs, the ability of users to appropriately understand, interpret and compare NGMs between companies may be significantly limited. With the risk that NGMs may be misleading investors, consensus is building globally suggesting improvements are needed.

The arguments both for and against NGMs have merit. NGMs are as varied as the companies that present them. These measures provide management the flexibility to communicate a company’s performance in a way it believes is best understood and allows investors to see performance through the lens of management. On the other hand, the lack of globally consistent guidance and enforcement should cause investors and other users to pause. The most common grievances regulators have with the application of NGMs include:

• Presentation of NGMs with greater prominence than the comparable GAAP measures;
• Inconsistent calculation of NGMs between periods presented;
• Use of measures with biased purpose – i.e. exclude charges and include gains;
• Exclusion of normal and recurring expenses that could make earnings measures misleading; and
• Inadequate definitions of NGMs and insufficient explanation of why the measure is useful to investors and the purpose, if any, for which management uses the measure.

Global attention

The U.S. Securities and Exchange Commission (SEC) staff recently updated its guidance on how companies are allowed to use NGMs, and specifically listed prohibited practices[ii]. The revised guidance follows warnings earlier this year by the SEC chair and SEC staff that enforcement action will be taken against companies that do not comply with guidance outlining how a company must present NGMs.

The SEC will not hesitate to bring enforcement action against a company if it uncovers an “actionable violation,” said SEC Chair Mary Jo White in May 2016[iii].

Warnings were quickly followed by actions. Since updating its guidance, the SEC has sent more than 30 comment letters to companies regarding their use of NGMs[iv].

It is not only U.S. regulators who are raising the alarm. The International Organization of Securities Commissions (IOSCO) and the European Securities and Markets Authority (ESMA) have recognized the potential issues created by inconsistent use, inadequate definitions and undue prominence of NGMs; they, too, have issued guidelines aimed at improving transparency and comparability of NGMs presented outside of the financial statements.

Beyond regulators, accounting standard setters are also monitoring the situation. Hans Hoogervorst, International Accounting Standards Board (IASB) Chairman, noted accounting standard setters should assess what role current GAAP played in the proliferation of NGMs outside the financial statements and whether changes to the definition of performance within the financial statements would improve the reporting environment. Describing the current state of NGMs as “the sugar-coated realm of non-GAAP,” Hoogervorst is clearly not alone in his concern that investors may be misled[v].

Canada is not being spared

Closer to home, regulators in Canada are taking note. Recent comments from the Ontario Securities Commission (OSC) echo concerns expressed by the SEC and others. In Canada, reporting issuers are required to follow the guidance provided by CSA Staff Notice 52-306. The CSA notes that companies continue to fail to disclose or discuss the most directly comparable GAAP measure and fail to present the GAAP measure at equal or greater prominence as the NGM[vi]. Examples of behaviour that might run afoul of the equal or greater prominence requirement include omitting the comparable GAAP measure from the earnings release headline or emphasizing the NGM with bolded font.

What more is needed?

With all the activity globally related to NGMs, two things are clear. First, regulators and investors are concerned about being misled. Second, unless regulators decide on a wholesale prohibition on the use of NGMs, these measures are unlikely to go away. Further action is needed from all stakeholders to move forward on this issue.

It seems clear management in many cases does not believe GAAP measures alone tell the whole story of the company’s performance, which is driving the increased use of NGMs. Accounting standard setters should consider their contribution to a solution. What improvements can be made to the relevance and understandability of GAAP measures in order to decrease the perceived need for alternative measures?

Investors may consider whether they currently accept NGMs that are not clearly defined, consistent or appear rose-coloured. If so, they may look to other measures to assess performance.

Executives and IR professionals could focus on ensuring NGMs are clearly defined and presented in an unbiased and transparent way. Audit committees might take a renewed look at their company’s presentation of NGMs and ask whether NGMs are subject to sufficiently robust oversight and controls.

 

Andy Brown, CPA, CA is a Senior Manager, and Rob Brouwer, FCPA, CPA is Canadian Managing Partner, Clients and Markets, for KPMG LLP in Canada.