HOW TO MAKE YOUR NON-GAAP MEASURES COMPLY WITH GAAP

It’s that time of the year again for closing the books and, very likely, a ritual discussion will take place at many corporate headquarters over the next weeks.

Reporting of performance measures

This debate between management and external audit firm will be around the presentation of the annual results, and it’s one that will not easily be settled. Simply because there’s an implicit conflict of interest: management wants to explain its operational performance and often has to use non-GAAP measures to do so, whilst external auditors need to validate the presentation of financial statements against GAAP Standards such as IFRS®.

As a consequence of this status quo, primary income statements in GAAP financial statements often are a mix of both worlds, confusing investors when they try to compare performance with other companies, and frustrating both management and auditors.

One solution can be to completely disconnect the presentation of formal, GAAP-compliant financial statements from other expressions made by the company around its earnings in its press release. 

That however does not help investors to make the connection between management’s comments in press release, and the annual financial statements.

Which complicates the understanding of the company’s performance significantly.

Regulators’ view

ESMA performed a desktop research on 2018 annual financial statements (Management Reports or MR) and ad-hoc reporting (mostly earnings press releases) by 123 issuers to see how companies comply with the rules regarding reporting of “Alternative Performance Measures” (APMs).

Not surprisingly, ESMA concluded that companies use a wide variety of APMs in their financial statements and other reporting.  For the most part (around 80%) companies do not sufficiently explain, disclose or reconcile APMs in their financial statements, and ESMA strongly encourages issuers to improve.

One area of attention flagged by ESMA for FY19 reporting is that issuers should properly disclose the impact of changes to the APM used. More specifically the impact of IFRS 16 on APMs such as EBITDA, EBITDAR, CAPEX, net debt or free-cash flow should be clarified by companies!

Standard setters

To address concerns raised by investors, the International Accounting Standards Board (IASB) launched an initiative called ‘Better Communication in Financial Reporting’ some years ago. 

As part of that initiative, IASB is looking to replace the existing IAS 1 ‘Presentation of Financial Statements’ with a new IFRS Standard “General Presentation and Disclosures”. The Exposure Draft of this new standard was issued in 2019, with the comment period ending in June 2020 (extended to 30 September 2020 due to COVID-19). The most important elements from the draft Standard are the following:

A. Introduction of 3 subtotals in the income statement to improve the comparability of financial statements: 

 i. Operating profit or loss;

 ii. Operating profit or loss and income and expenses from integral associates and joint ventures (effectively splitting results derived from integral- and from   non-integral associates and joint ventures!);

 iii. Profit or loss before financing and income tax (EBIT).

B. Introduction of specific footnote disclosure to identify and describe non-GAAP Management Performance Measures. It should include a reconciliation to IFRS sub-totals to help the readers make the bridge between press release and financial statements. Management Performance Measures:

i. are used in public communications outside financial statements;

ii. complement totals or subtotals specified by IFRS Standards; and

iii. communicate to users of financial statements management’s view of an aspect of an entity’s financial performance.

C. Introduction of specific footnote disclosure that identifies and explains certain ‘unusual items of income and expense’ (basically these are non-recurring items) within the primary income statement. 

Unusual items have limited predictive value and this disclosure will facilitate building more reliable future expectations by readers.  From ESMA’s desktop review, the most commonly adjusted items by companies are the following:

Investors will be able to better understand how- and why management excludes certain one-off elements when it presents its performance measures, and tie them back to the primary GAAP income statement by using the specific footnote disclosures.

What to do for your annual financial statements?

There is a lot of good sense in the IASB proposal. It will allow companies to use relevant performance measures in their financial communication even if those are non-GAAP and exclude certain one-off items.

So even if just a proposal for the moment, you may want to consider organizing your disclosures and communications for FY19 along the lines of IASB’s draft Standard. It will probably avoid painful discussions and certainly help the readers of your financial statements. And that includes your local regulator!

For now I am wishing you a very good and transparent FY reporting!