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Mind the GAAP

19 July 2016

Mind the GAAP - read more

Performance reporting and the pitfalls of non-GAAP metrics

The International Accounting Standards Board (IASB) endeavours to make the world of financial reporting one where companies and their statements are comparable, consistent and transparent. However, over the past few years we have seen financial reports grow in length, and although investors do not complain about the amount of information they receive, they do sometimes raise concerns about the complexity and understandability of financial statements.

Part of this is tied to the growing inclusion of additional, non-IFRS (International Financial Reporting Standards) and non-GAAP (Generally Accepted Accounting Principles) information. In some cases, non-GAAP measures provide a useful way of illustrating a broader view of a company’s performance, or conveying other useful information that falls outside IFRS requirements.

However, they can also be used to represent a sugar coated, selective presentation or enhancement, of a company’s financial performance. Profit or loss should be the primary source of information and indicator of performance, and must contain consistent and comparable information that is relevant to investors.

Yet further discipline around the use and presentation of non-GAAP measures should be looked into, to ensure the bottom line of financial statements remains comparable and consistent. Tackling this problem requires coordinated action by standard setters, regulators, companies and auditors. The IASB can play a part and, as such, performance reporting is likely to form a major part of its future agenda.

Defining financial performance

The IASB has already done important work on profit or loss, but it does not provide the final answer on performance – it will most likely continue working on performance reporting in the coming years. Many investors ask the IASB to start by providing a definition of performance. However, trying to do so is as illusory as trying to define beauty. Beauty is a multifaceted quality, and as they say ‘is in the eyes of the beholder’. Giving the term a 100% objective definition is therefore next to impossible.

Financial performance is not that different; it is multifaceted, to some degree subjective, but at the same time most people recognise it when they see it. The question is whether IFRS provide sufficient criteria by which performance can be judged by users of financial statements.

Even if they look at profit or loss as the primary indicator of performance, users generally want to dig deeper so that they can better judge which components of income have a high degree of persistence or not. Drilling down to specific components of income is necessary in order to predict future cashflows.

The fact is that IFRS prescribes very little in the way of formatting the statement of profit or loss. Companies have considerable freedom in the way they present the components of income that make up profit or loss. As a result, there is little comparability above the bottom line, making it difficult for users to judge performance.

The IASB may also have to do more in terms of formatting requirements of the income statement because there is growing evidence that shows increasing use of non-GAAP measures and that these measures are misleading.

Problematic reporting

It is important to remember that non-GAAP measures represent a selective presentation of a company’s financial performance. Often, that selection is not free from bias. Non-GAAP inclusions can become problematic if there is not adequate discipline around their provision and if they lack consistency from year-to-year, are not comparable between different companies (even in the same industry), or are not transparent about what the measures truly consist of.

More than 88% of the S&P 500 currently disclose non-GAAP metrics in their earnings release. Of those releases, according to Audit Analytics, 82% show increased net income and are clearly designed to present results in a more favourable light.

A study from Citi Research showed that the popular metric ‘core earnings’ was on average 30% higher than GAAP earnings, although research from Morgan Stanley also shows that many investors believe they have no problem distinguishing GAAP from non-GAAP information when reading and making decisions based on financial statements.

Securities regulators are also concerned that non-GAAP numbers are becoming detached from reality. The International Organization of Securities Commissions (IOSCO) recently identified a frame of reference for the disclosure of non-GAAP financial measures. The intention was to contribute to the reliability and comparability over time of non-GAAP financial measures, as well as reduce the potential for misleading disclosure. The Securities Exchange Commission (SEC) and UK Financial Reporting Council (FRC) have issued similar guidance.

In this light it is unnerving that management remuneration packages can be based on adjusted earnings. Knowing that even GAAP numbers can be vulnerable to earnings management, remuneration committees should be wary of basing their policies on earnings adjusted by management itself.

There have been recent media reports dissecting examples of shareholder revolt, whereby a CEO of a major company may see an increase in remuneration, despite the company’s loss. Often in these cases, this remuneration is based on non-GAAP measures that almost completely insulate executive income from factors that are considered to be outside the control of management.

One of these measures is the notion of ‘underlying profit’, which is also considered to be an important performance metric for the company as a whole. Such metrics can provide useful insights into a company’s performance, but they should also be approached with caution.

Some costs are routinely left out as being ‘exceptional’, yet others might consider these the normal costs of doing business. A common example is restructuring costs, which are often left out from adjusted operating profit. The problem with these exceptional costs is that they keep on recurring.

Cutting back on non-GAAP

Cutting back the use of non-GAAP measures is primarily the task of securities regulators, but the IASB has a role to play too. It has to acknowledge that non-GAAP measures are popular because it provides too little guidance in terms of formatting the income statement. The flexibility under existing accounting standards is an invitation for non-GAAP to step in.

If IFRS numbers are to effectively serve as the primary performance measures by which companies describe their financial position and performance, they must be neutral, comparable, and verifiable. IFRS financial statements must provide information that markets can trust. In many cases, companies are able to use non-GAAP measures to enrich the IFRS data in financial statements.

However, it is important to ensure that there are some basic ground rules. The information presented must not be misleading and must not be given greater prominence than the IFRS numbers.

Next steps for the IASB

The IASB has some work to do here. It needs to define more subtotals in the income statement; provide a principle-based definition of ‘operating income’ that does not allow for obfuscating, restructuring or impairment charges; create a rigorous definition of the commonly used non-GAAP metric Earnings Before Interest and Tax (EBIT).

If the IASB provides more rigorous definitions of performance metrics above the bottom line, these could provide more reliable information to the investor than non-GAAP measures. The IASB has to give the investor more tools to decide whether a company is a George Clooney or the Hunchback of Notre Dame. There is also a role for the IASB to play in providing adequate discipline around the presentation of non-GAAP measures, to ensure that they are represented as alternative non-IFRS numbers.

Despite this, the bottom line of the income statement will always be the most important performance measure over time.

Warren Buffett once expressed his suspicion of companies that trumpet earnings projections and growth expectations: ‘Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly’.

This is not only a warning to preparers, it is also a reality check for users who make their living by forecasting earnings based on their perception of the persistence of earnings.

Economic reality is unpredictable and difficult for management to control. That is why the number that counts most is the unadjusted bottom line, where all elements of income come together, both recurring items and exceptional items.

No one can predict the extent to which seemingly extraordinary elements of income are recurring and not. That is why it is important that the bottom line is as inclusive as possible and that it shows everything, warts and all.

Hans Hoogervorst is Chairman of the International Accounting Standards Board

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