Conflict between management and external user needs

The following article was originally published by Wiley.

Conflict is inherent between management’s use of historical financial statements for interpreting and explaining the financial position and performance of an entity and investors’ use which includes comparability between entities.

The ultimate decision to be made is in answer to the question: Should management be permitted to incorporate their discussion and analysis into the general purpose financial statements prepared in accordance with IFRS® Standards?

In raising this question, the staff of the International Accounting Standards Board (the Board or IASB®) are blurring the distinction between non-GAAP and additional GAAP measures which may also make global regulatory differences more apparent.

A note on terminology and source

The Board has adopted the terminology of Alternative Performance Measures (APMs) and describes those measures as “competing with” IFRS Standards measures, and as typically receiving more emphasis than the IFRS Standards measures. The equivalent term, non-GAAP measures, is used in this article, and also by the Canadian regulator.

IAS 1 distinguishes between information that is specifically required to be included in financial statements because it is necessary for an understanding of financial position or performance (additional GAAP measures), and any other information that is not required for an understanding or non-GAAP.

The agenda papers in which the staff discuss these and related issues can be found at the end of the article.

Inclusion of non-GAAP information in financial statements

The staff papers contemplate allowing the inclusion of non-GAAP information in general purpose financial statements prepared in accordance with IFRS Standards. Examples include sales per square metre, churn rates and capital expenditure.

IASB staff do appear to be addressing investor needs:

“placing some types of information together, such as management’s plans and strategy together with actual results, can help an entity to tell an integrated story about its financial position and financial performance.”

The Canadian regulators specifically disallow a reporting issuer from including non-GAAP measures in financial statements. Therefore, the change would go well beyond the Canadian rules and be a fundamental shift in international financial reporting.

The change would also bring financial statements more into line with – and indeed, competing with – management’s discussion and analysis (MD&A) which is intended to be written from management’s perspective, “through the eyes of management.”

Issues arising

Under current rules, entities must determine which information is above and beyond what is actually required by IFRS Standards to make the financial position and performance understandable. That is a judgment call. If non-GAAP information is permitted, or required, to be included in financial statements then the difference between GAAP measures and non-GAAP measures becomes academic.

Gross profit and operating profit

It seems clear that presenting non-GAAP information in financial statements would make such differences apparent. For example, the staff provide examples such as gross profit and operating profit as non-IFRS. Global differences in what are considered non-GAAP as opposed to additional GAAP measures already exist. In some jurisdictions those sub-totals would be considered non-GAAP measures by regulators. To avoid regional versions of financial reporting any disclosure standard would have to provide detailed guidance and examples.

Presentation and prominence of non IFRS metrics

Other concerns include that the additional information would draw attention away from the IFRS Standards compliant information, or that it may be “given undue prominence or credibility merely because of its location.” Ultimately, the staff paper concludes that the benefits of bringing MD&A-type discussion and metrics into the financial statements would provide better information for users and would outweigh the concerns.

Audit costs and requirements

The IASB staff consider including such MD&A type discussion and information in the financial statements, but excluding certain information from the audit requirement. This gives rise to a concern about being able to “identify a complete set of financial statements, including, in a set of audited financial statements, whether the information is audited or not.”

Annual financial statements of reporting issuers are subject to audit. The paper points out that audit cost and the sensitivity of disclosing information to competitors would act to control the volume of such information included in financial statements.

What is required to make this happen

The IASB staff considers that the primary financial statements act as a high altitude overview of the financial position and performance of an entity and allow a user of the financial statements to go into more detail in certain areas of interest. In addition, the consistency of presentation also allows a comparison of financial position and performance between different entities.

The information included in the primary statements has a “summary and signposting role” which may be given “undue prominence” by management and “hence receive excessive attention” by users. Therefore the IASB staff recommend that a new disclosure standard would be necessary.

The Board has approved narrow focus amendments to IAS 1 which are effective for annual periods commencing on or after 1 January 2016 with earlier adoption permitted. Those amendments provide standards that need to me met for an entity to include additional subtotals on the face of the statement of financial position and comprehensive income. The broader discussion over non-GAAP measures continues.

Criteria for inclusion

In serving the needs of the investor community and making historical financial statements more relevant and useful, the Board is looking to identify the criteria that would need to be in place to allow non-GAAP information to be included in the financial statements or in the notes. Possible criteria suggested by the IASB staff could include:

“(a) be reconciled (where possible) to the most directly comparable measure defined or specified in IFRS and presented in the statement of financial position or performance;

(b) explain why the APM provides relevant information about an entity’s financial position or performance and why the adjustments to the most directly comparable measure …have been made;

(c) be presented and labelled in a manner that makes it clear and understandable what the APMs show and how they are constructed;

(d) provide comparatives and be clear and consistent…from period to period and explain if adjustments have been made…;

(e) not be displayed with more prominence than the subtotals and totals required in IFRS for that statement; and

(f) be clear whether the APM forms part of the financial statements and whether it is audited…on the same basis as the IFRS information.”

Similarly, guidance could also be put in place regarding the presentation or disclosure of items that are non-recurring or that only occur infrequently. And that guidance would include definitions of those terms which are currently not provided in IFRS Standards.

In conclusion

The staff paper concedes that investors find additional measures useful in analysing financial position and performance. At the extreme the IASB staff note that “even APMs that are viewed as being biased can provide information that is useful in assessing management’s character.”

The needs of investors are driving the IASB staff argument for including such information in financial statements, and the Board is looking to expand the IFRS Standards framework to not only allow, but to encourage, their use within the confines of new reporting rules.

Such a shift in the IFRS Standards would require the Canadian regulators to change their position to allow non-GAAP measures in the financial statements of reporting issuers.

In the Canadian market the regulators have consistently raised concerns over the biased way in which certain entities have reported results outside of the audited financial statements. It seems clear that requiring an audit opinion to cover all the information included in the financial statements would act as a control over the quality of that information in addition to acting to limit the volume of such content.

Related material

IASB staff papers (February 2015): Disclosure Initiative: Principles of Disclosure

IASB staff paper on the Performance Reporting project (Global Preparers Forum Meeting) March 2015

Mind the Gap (Between non-GAAP and GAAP) – Speech by Hans Hoogervorst

Korean Accounting Review International Symposium, Seoul, Korea, 31 March 2015

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