Reporting under GAAP: Companies take initiative to fill the gaps

The practice of companies reporting financial metrics not prescribed by established Generally Accepted Accounting Practice (GAAP) frameworks, such as the International Financial Reporting Standards (IFRS), has proliferated over the years.

This practice of “non-GAAP” reporting employed by companies to narrate a financial story using their own terminology is causing concerns for corporate regulators and raising questions about the adequacy of established financial reporting frameworks.

In an environment where some view traditional, periodic financial reporting propped up by rigid reporting frameworks and overzealous corporate regulators as restrictive, we are seeing a significant increase in the use of non-GAAP measures.  Even the flexibility offered by the principles based IFRS framework does not seem enough.

CPA Australia funded research into non-GAAP disclosures by listed companies under the IFRS reporting regime in New Zealand indicates that 58 per cent of companies were reporting non-GAAP disclosures by 2013.  Research in the United States indicates that 88 per cent of S&P 500 companies applying US GAAP used at least one non-GAAP metric in 2015.

It is clear that companies are increasingly capitalising on technology-enabled information expressways to broadcast information they believe is important to investors and other stakeholders.  Social media channels and other web-based communication platforms allow companies to provide instantaneous and targeted messages to readers.

Non-GAAP measures such as “EBIT” and “operating profit” are commonly used and commonly understood.  Then there are some non-GAAP measures that are less commonly used, but still provide accurate and useful information that supplements GAAP based financial information.  One-off non-GAAP measures for non-recurring items can sometimes fall into this category.

Certainly there are risks with non-GAAP measures.  There are no well-developed frameworks for non-GAAP numbers, creating consistency and comparability problems. Unlike GAAP based financial statements, non-GAAP metrics are not subject to scrutiny through an independent audit designed to engender confidence in the financial reports.

That said, regulators and standard-setters concede that non-GAAP measures are an important communication tool for companies.  The chairman of the International Accounting Standards Board, Hans Hoogervorst, says “we do not intend to ban alternative performance measures, because some of them clearly have added value”.

It’s an acknowledgment that non-GAAP reporting has an important part to play in corporate disclosure, particularly when companies seek to communicate key metrics above and beyond the metrics catered for through local GAAP.

It is for this reason that work has begun on ways to see commonly used and understood non-GAAP disclosures incorporated into GAAP.  For example, the IASB’s Primary Financial Statement project will consider approaches to incorporating the “EBIT” and “operating profit” into the IFRS framework.

Professional Development: Preparing annual financial statements: learn to compile financial statements using a final trial balance and other background information and the sundry disclosures required for a set of financial statements.

Regulators and standard-setters can sometimes play a part in promulgating non-GAAP disclosures too.  Take the Australian Board of Taxation’s Voluntary Tax Transparency Code as an example.  The Australian Accounting Standards Board is assisting the Board of Taxation initiative by developing guidance material for companies that choose to be more transparent and adopt the voluntary code.  

Until standard-setters and regulators accept that these voluntary disclosures form part of GAAP based reporting in Australia, such disclosures would fall within the realm of “non-GAAP” reporting, although clearly providing valuable and useful information that will shine a light into company tax affairs.

There’s no doubt that, as with most things, there is a “dark side” to the use of non-GAAP measures.  Non-GAAP earnings can sometimes be used by companies to “window-dress” their financial performance and hide their real performance through non-GAAP adjustments. 

In his 2016 letter to shareholders, Warren Buffett warns about misleading information through massaged earnings’ numbers: “Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings” says Buffett in his letter to Berkshire Hathaway shareholders.

To Buffett’s point, non-GAAP measures were the second most frequent topic raised by the United States Securities and Exchange Commission (SEC) in the comment letters it issued to companies for the year ended 30 June 2016.

Indeed, the SEC’s very first enforcement action to address the abuse of pro forma earnings figures focused on the third-quarter 1999 earnings release of Trump Hotels & Casino Resorts Inc.  

The SEC noted that "the method of presenting the pro forma numbers and the positive spin the Company put on them were materially misleading. The case starkly illustrates how pro forma numbers can be used deceptively and the mischief that they can cause."

It will be interesting to see how the Trump administration’s choice for SEC boss, Jay Clayton, whose nomination is all but confirmed, will tackle the issue of non-GAAP disclosures by US listed companies under his watch.

There’s little doubt that companies will continue to seek avenues to express their financial performance story through non-GAAP metrics when GAAP frameworks prove insufficient. 

And while the work of the IASB to incorporate the more commonly used non-GAAP measures will assist in improving the credibility of financial information, and financial literacy initiatives can also assist with a better understanding of non-GAAP measures and how to read them in the context of the company’s performance, corporate regulators will need to remain vigilant. 

Both companies and their stakeholders should also ensure there is responsible use of non-GAAP measures that does not undermine the objectives of financial reporting.

Alex Malley is chief executive of CPA Australia.

This article originally appeared on The Accountant.

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