Tag: KPIs

Neutrality, relevance and comparability of non-GAAP and additional GAAP measures

In the first of a two-part article, originally published by Wiley, 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® Standards 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 Standards 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:

  1. excludes amounts that are included in the most directly comparable measure calculated and presented in accordance with the issuer’s GAAP, or
  2. 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:

  1. 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 Standards (paragraphs 55 & 85), or
  2. 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&A

Neutrality 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

Operating income

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 Standards, 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.

Gross profit

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.

Boilerplate language

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.

Reconciliation issues

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.

Management bias

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.

Sheer volume

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 Standards 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 Standards and Canadian regulatory rules on the use of these measures, and also position that guidance within the global context.

Controversy Surrounding the Credit Risk of Liabilities and the Counterintuitive Effect on Performance Measures

This article was originally published by Wiley.

1) Do you think that non-performance risk should be considered in the measurement of financial liabilities at fair value through profit or loss?

Note that the standard refers to the credit risk (or non-performance risk) specific to the liability and not to the credit risk of the entity itself, usually referred to as “own credit risk”. Changes in the credit risk of the entity will not necessarily be mirrored by changes in the credit risk of its liabilities, for example, liabilities that are secured by collateral may be unaffected.

IFRS 13 defines the fair value of a liability as the price that would be paid to transfer the liability in an orderly transaction between market participants at a specific date. The standard clarifies that the valuation measurement takes place in the principal market for the liability or in the absence of a principal market, in the most advantageous market.

Applying the definition of fair value from IFRS 13 means the fair value measurement takes into account the effect of non-performance risk related to the liability. There are problems with such an outcome, however, such as: in what sense is there a market or market participant here given that such liabilities are rarely, if ever, traded? These practical problems of measurement are ignored in this response to Global Insights.

Despite the theoretical feel of taking into account the credit risk of the liability in measuring liabilities at fair value, in my opinion, this is the correct accounting in order to reflect an accurate financial position of the entity at a point in time. The alternative would be to exclude this credit risk effect from the carrying amount of the liability, which would effectively be a change in the definition of “fair value” used for financial reporting purposes versus fair value in other valuation applications. Furthermore, as pointed out in the Basis for Conclusions to IFRS 9, paragraph BCZ 5.31(d), such a change would be inconsistent with the measurement of liabilities at initial recognition because the fair value at that point in time reflects the liability’s credit risk.

2) If so do you think that the outcome generated by the accounting for financial liabilities at fair value through profit or loss provides useful information to investors?

Under IFRS® Standards, an entity’s overall performance is measured by comprehensive income, within which entities can use other additional GAAP performance measures. Profit and loss is also a required GAAP performance measure. The International Accounting Standards Board (the Board) has not defined a principle for which items are presented in profit and loss and which are included in other comprehensive income (OCI).

The previous accounting for financial liabilities at fair value through profit and loss under IAS 39, presented the total change in fair value in profit and loss. If the credit risk related to the liability deteriorates then the entity recognizes a reduction in liabilities and an increase to profit/reduction in loss, hence the counterintuitive financial reporting. This is clearly a distortion of profit and loss, a key performance measure under IFRS Standards, which thereby diminishes the usefulness of this measure to investors.

In an earlier round of amendments to IAS 39, the Board attempted to fix this issue, by requiring disclosure of the amount of the fair value change that relates to changes in the credit risk of the liability. It seems ironic that an entity is not permitted to use additional disclosures to rectify a departure from an accounting standard, while the Board took exactly this approach in an attempt to rectify a presentation issue!

Clearly the effect of credit risk on the fair values of liabilities is not relevant to how the entity has performed, as measured by profit and loss, and, if this amount is to be recognized, it should not be included in that measure.

3) Do you think that the solution proposed by the Board of accounting for changes in an entity’s own credit worthiness in other comprehensive income resolves the counterintuitive outcomes generated by the current accounting treatment?

Under IFRS 9, paragraphs 5.7.1(c) and 5.7.7, the change in fair value of a financial instrument liability designated as at fair value through profit and loss attributable to changes in the credit risk of that liability is recognized in OCI. The remaining change in fair value of the liability is recognized in profit and loss, unless that presentation would create or enlarge an accounting mismatch in profit or loss, in which case the entire change in fair value is recognized in profit and loss.

Given the opinion that the statement of financial position should reflect the credit risk specific to liabilities at fair value through profit and loss, there are two alternatives to present the other side of the entry. One is to record the change directly in equity, and the second alternative is to present the change in OCI. The former was considered in the exposure draft on own credit risk in 2010, however, almost all respondents to the draft did not support it and the Board agreed. Therefore inclusion in OCI appears to be the best option remaining.

The IFRS 9 solution is an improvement in financial reporting because the profit and loss performance measure is not distorted. A definitive conclusion with respect to inclusion in OCI is difficult to reach in the absence of clear principles of what, exactly, OCI represents and what the objective of the measure is.

4) Do you think that recycling between OCI and profit or loss for changes in own credit risk is appropriate?  If so, under what circumstances?

The premise behind the “no recycling” rule set out by the Board is that any adjustments will net off to zero once the debt is settled for the contractual consideration at the instrument’s maturity date. The fair value of the debt between initial recognition and maturity is likely to deviate from the contractual liability of the instrument. Therefore such a liability settled at maturity would not give rise to any amount to be recycled from OCI to profit and loss. An amount to be recycled only exists if the liability is settled during the term.

In the event that a liability is settled early, it seems reasonable that the difference that is crystalized should be recycled because it then represents a realized gain or loss. This view arises from the opinion that OCI represents recognized but unrealised gains and losses that should be moved to profit and loss when realized. The Board took issue with this approach on the grounds of a comparison with investments in equity instruments measured at fair value with changes presented in OCI for which recycling is prohibited.

Related to the lack of a principal behind OCI, there is no clearly defined principal as to what items should be recycled and which should not. Some clarity around this topic would help to achieve a consistent treatment that is justified on theoretical grounds. The IASB has included a requirement to disclose the amount of accumulated OCI that has been realized during the period. In addition, IFRS 9 gives an entity the option to transfer the accumulated gain or loss within equity in the event of an early settlement.

5) Do you think own credit risk is specific to financial liabilities measured at fair value through profit or loss or should IFRS® Standards provide clearer guidance on the role of own credit risk in other standards such as the ones dealing with insurance contracts or provisions?

Insurance contract accounting is the subject of an ongoing project. Therefore, in answering this question, only provisions have been considered.

Paragraph 47 of IAS 37, states that the discount rate to be used should reflect the current market assessment of the risks specific to the liability, in addition to the time value of money. This is consistent with the requirement in paragraph 37 of that standard of measuring the liability as the best estimate of the expenditure required to settle the present obligation at the end of the reporting period or to transfer it to a third party at that time.

The practice in the Canadian market is to exclude the effect of changes in own credit risk related to the entity itself when measuring provisions. This is consistent with the measurement of financial liabilities at fair value through profit and loss under IFRS 9. The accounting treatment of the change related to the change in credit risk of the liability is not consistent because there is no requirement under IAS 37 to recognize that amount through OCI. The nature of these two types of liability does not appear to justify different treatment on the comprehensive income side of the entry. This inconsistency warrants attention by the Board as part of a project on OCI.