In the first of a two-part article, originally published by Wiley Insight IFRS, Paul Rhodes, partner at Crowe Soberman, Ontario, examines the use of non-GAAP and additional GAAP measures in Canada and highlights how the relevance, comparability and understandability of a company’s financial statements can be compromised.
Since the adoption of IFRS by Canadian publicly accountable entities with effect from 2011, there has been an increase in the use of non-GAAP and additional GAAP measures. In some cases this is a necessary side effect of the IFRS financial reporting framework objective of ‘general purpose’ financial statements, as a one-size-fits-all approach is unlikely to do just that.
Non-GAAP financial measures
These have been defined by the Ontario Securities Commission (OSC) in Staff Notice 52-722 as a “numerical measure of an issuer’s historical or future financial performance, financial position or cash flow, that does not meet one or more of the criteria of an issuer’s GAAP for presentation in financial statements, and either:
- excludes amounts that are included in the most directly comparable measure calculated and presented in accordance with the issuer’s GAAP, or
- includes amounts that are excluded from the most directly comparable measure calculated and presented in accordance with the issuer’s GAAP.”
In some jurisdictions, non-GAAP financial measures are also referred to as alternative performance measures.
Additional GAAP measures
IAS 1 defines additional GAAP measures presented in financial statements as:
- a line item, heading or subtotal that is relevant to an understanding of the financial statements and is not a minimum line item mandated by IFRS (paragraphs 55 & 85), or
- a financial measure provided in the notes to the financial statements that is relevant to an understanding of the financial statements and is a measure not presented elsewhere in the financial statements (paragraph 112c).
Qualities desirable of the MD&ANeutrality is required for a faithful representation of economic events in financial statements. Management’s Discussion & Analysis (MD&A) should complement and supplement financial statements. The objective of MD&A is to provide a narrative explanation, through the eyes of management, of how an entity has performed in the past, its financial condition, and its future prospects. Therefore some qualities desirable of the MD&A are the same as those for financial statements. These include, in particular, the requirements that the financial and narrative information presented should be fair, balanced, understandable, relevant and comparable.
The risk posed by the increasing use of non-GAAP and additional GAAP financial measures is that these desirable qualities may be jeopardised. For example, there may be a lack of comparability of financial information between entities, or for the same entity for different periods, meaning that users are potentially unable to identify and understand similarities in, and differences between, items. In a worst case scenario information may not be neutral due to a biased presentation.
To put the issue into context: a study was conducted by the OSC, the results of which were published in 2013, in which the disclosures made by 50 reporting issuers with head offices in Ontario were reviewed. The study revealed that 82 per cent of those reviewed committed to enhancing their disclosures.
Problems with additional GAAP measures
The 1997 vintage of IAS 1 required the income statement to present the results of operating activities as a line item in the income statement. Even though that requirement was subsequently dropped because operating income is not a defined concept in IFRS, it still has a well understood meaning. Some issuers present operating income as an additional GAAP measure but exclude components that would be considered part of operating results. Examples include the exclusion of amortization of acquired intangible assets that are used in operating activities and the exclusion of inventory write-downs.
Other financial statement line items with well understood meanings can also be incorrectly reported (a common example being gross profit), by excluding components that are typically a part of the measure, and conversely, including components that are not part of the measure.
“Income before the undernoted”
Using terminology that is neither descriptive nor relevant to understanding the financial performance or position, such as ”income before the undernoted” or “income before operating expenses”. Similarly, the inclusion of unlabeled subtotals in the financial statements is unlikely to contribute to an investors’ understanding.
The use of boilerplate language, instead of explaining why the additional GAAP or non-GAAP measure is relevant to investors’ understanding of the financial statements, is problematic. A reporting issuer often makes no reference to the measure in either the notes to the financial statements or in MD&A, which casts doubt on the relevance of the measure to understanding financial position and performance.
Problems with non-GAAP measures
”Weighted average yield”
The use of undefined or ambiguous performance measures can be confusing and potentially misleading to investors. For example, disclosing, in MD&A or press release, undefined measures of performance, such as a “weighted average yield” applied to financial instrument receivables accounted for as loans and receivables at amortized cost using the effective interest method.
Furthermore, the inclusion of such a measure in the financial statements may reasonably lead investors to conclude that the measure is a standard GAAP measure that is required to be disclosed, especially in other public documents when there is inadequate disclosure and no reconciliation is provided between the measure and the entity’s GAAP financial statements.
Not providing a clear quantitative reconciliation between the non-GAAP financial measure and the most directly comparable GAAP measure. Such omissions leave investors having to make assumptions about the composition of the non-GAAP measure.
Clear management bias in presenting non-GAAP measures, such as including one-time gains but excluding one-time losses in other periods, or by describing measures as excluding non-recurring items when those items are seen to recur within a short timeframe. When items are removed from the GAAP measure of performance to arrive at the non-GAAP measure the nature of the item removed and why it is not expected to recur is rarely provided.
Management bias can also occur where the non-GAAP earnings measure is presented more prominently than the equivalent GAAP measure, or where the GAAP measure is excluded entirely. Earnings releases often include a level of analysis applied to non-GAAP measures that is not applied to the equivalent GAAP measure.
Investor confusion may be increased by issuers including many non-GAAP measures of performance in a public document with only slight differences between each.
The problems identified above are not new to the IFRS world in Canada. Clearly, there is a need for reporting issuers to be allowed to present measures of financial performance or position suitable to their respective business. However, the Canadian market regulators have had issues with the use of non-GAAP and additional GAAP measures for many years. A subsequent white paper will review in detail the IFRS and Canadian regulatory rules on the use of these measures, and also position that guidance within the global context.