The article was first published in Compliance Week, 15 February 2017
By Gary R Kabureck
Will the proliferation of non-GAAP earnings measures ever end? The short and long answers are ‘no – neither now nor ever’. Almost every public company uses them in some manner, as do most analysts. Properly used, non-GAAP measures are extremely valuable. For example, they can enhance financial analysis by isolating the effects of items that do not promote an understanding of historical or future trends of earnings or cash flows. At the other extreme, unfortunately sometimes non-GAAP performance reporting is used to ignore inconvenient charges or to perfume the pig, thereby giving non-GAAP reporting a bad name.
Above the pretax income line neither IFRS Standards nor US GAAP provide much in the way of guidance for defining, requiring or even permitting the reporting of operating results labelled such as: recurring income; earnings from core business operations; EBIT (earnings before interest and tax); operating profit; etc. I could list more, but you see the point. So if non-GAAP measures can and do serve legitimate purposes which are not being met by current reporting standards, what can—or should—accounting standard-setters do about it? This article explores some of the issues and challenges and describes what we at the International Accounting Standards Board (IASB) are doing to address them.
What we are doing
Acknowledging this is an issue, in December 2016 at the IASB we added to our work plan a major research project innocuously titled ‘Primary Financial Statements’. While the project is multi-faceted, we have tentatively decided to focus on improvements to the income and cash flow statements with much of our attention on the income statement (‘the P&L’). This is where we will start addressing non-GAAP earnings measures, often referred to as ‘alternative performance measures’ (APMs), such as income before non-recurring items. We are starting with a mindset that APMs are valuable when properly used and are here to stay. The question then becomes to what extent, if any, should we require or permit the traditional income statement to include APMs on its face.
Isn’t this mostly about subtotals? If so, what’s the problem?
In one word, yes; this is mostly about subtotals on the face of the P&L. Whether one is applying international or US standards, there is very little guidance for the reporting of operating results between the lines of total revenue and pretax profit. To be sure, an entity can present individual line items for significant, unusual or infrequent items or for some types of recurring expenses such as amortization. It should generally be feasible for a company to create various subtotals of APMs such as EBIT; earnings before non-recurring charges; operating profit and numerous others. Since APMs are so widely used by reporting entities, financial analysts and data aggregators, it is clear many people find them useful.
Unfortunately, today’s APMs are anything but uniformly applied. The challenge for us is to put some order and structure into the reporting of financial performance while simultaneously providing relevant information that faithfully represents the performance of the company. In many ways the challenge is how precisely can we define any of these APMs and to then decide which should be required or merely permitted? Should we be successful, some of today’s APMs will become GAAP measures tomorrow.
Illustrating the reporting problem by attempting to define
As part of deciding what should be presented and reported, we also need to provide guidance as to the composition of any APM(s) we settle on. Seems simple, right? Let’s illustrate the challenges using a few of the more common APMs found in practice:
- EBIT – a widely used debt-related credit metric for commercial and industrial companies. However, it doesn’t appear to be so widely used for financial institutions where interest on customer accounts is treated as an operating expense. Accordingly, we might have to decide which industries an EBIT sub-total would be most relevant to. Further, conglomerates with a mixture of financial and non-financial operations are a separate challenge. In IFRS reporting, interest on pensions is a separate expense – would this be considered interest in any EBIT definition we might propose? And what are the implications of capitalized interest costs?
- Income before non-recurring items – the challenge, of course, is defining what is recurring from non-recurring. Is the line based on frequency or size? For example, all big companies typically have recurring litigation charges – most of the time these are small and a normal cost of doing business. But what happens when a company loses a big case? If the recurring/non-recurring determination is to be a size-based test, how would we ever define it? Traditional materiality tests might be insufficient. But if the nature of the event – losing a legal case – is what’s determinative, then all litigation is conceptually the same and should, regardless of size, be classified the same way. Should non-recurring be a look- back test or a forward looking test and what should be done when some phenomena or event previously assessed as infrequent has become recurring?
- Income from core operations – many of the same problems as above with some analogies to challenges in determining operating segments. What is core today might not be tomorrow and vice versa. How does one rationally isolate this from the normal evolution of product lines and tactical changes in business priorities? Would large but stable, low-growth, high-cash generating units be non-core and smaller, but high-growth areas, be ‘core’? And then consider the challenge of differentiating so called core operations from continuing operations.
- Operating profit – many companies have an internal definition of operating profit but that doesn’t automatically equate to how the outside world sees it. We know items such as restructuring and impairment charges are often considered ‘non-operating’ as are gains and losses on sales of businesses or long lived assets. Add to the list FX transaction gains and losses, equity income from affiliates, litigation and one starts to see the picture. But if equity income originates from operationally integrated affiliates, one can certainly argue these results should be reported in operations. In practice, this is not always the case. Major workforce actions to right size the employee base have the feel of an operational charge, especially if frequent. So defining operating profit will be difficult and it could end up being defined by default – i.e. by us determining what isn’t ‘operational.’
So, as is evident by the questions posed and challenges described, trying to develop a widely accepted solution which provides comparable, relevant information that faithfully represents the company’s performance will be daunting. The above examples are not mutually exclusive – for example a final standard could require both EBIT and operating profit line items. So, how can this move forward?
Even before any new line items are established, we need to agree upon a philosophical approach for determining the composition of the APM itself. There are at least three possible avenues:
- Explicit requirements for composition – expressly define what is included, or excluded, in say ‘Operating profit’ or ‘Income before non-recurring items’. As should be evident from the above, I think a rule-based approach is a non-starter and would likely do nothing to reduce the proliferation of APMs.
- A managerial approach similar to segment reporting – while feasible, one has to question how it would improve comparability between companies and whether it could be consistently applied since companies change internal reporting more frequently than we change standards.
- A ‘principles-based’ approach – this would be compatible with the IASB’s general philosophy on standard setting but I do wonder if we could obtain a consensus and develop a principle that defines, for example, what is recurring, non-recurring, operational, etc?
Assuming we settle on an approach, we then need to decide whether any subtotal(s) we develop should be required or only permitted. I suspect many companies would like to include APMs on the face of the P&L and thus have them sanctified as ‘GAAP.’ However, having been on the preparer side of the table most of my career I know they certainly will want flexibility in how to define them.
Two new and critical disclosures
Assuming we get through the above, the IASB then needs to consider what a related accounting policy disclosure should include. Presumably it will be the company’s definition of what is, or is not, included in any new earnings measures we promulgate. Professional analysts, with whom we have met, are generally supportive of this project but are under no illusions as to its challenges; they have uniformly advised that APMs will continue to exist no matter what we may decide. We have been advised to be mindful of the invisible boundary between our bailiwick (accounting) and theirs (analysis). We are also being strongly encouraged to require a tabular disclosure, covering several years and summarizing which transactions or events are on which side of ‘the line’. They also want transparency on reclassifications between the reported amounts.
The IASB’s research project is in its early stages so it’s hard to predict where this will eventually come out. I will go out on a limb and predict we will end up at least permitting one or more APMs to be included on the face of the P&L plus requiring the two new disclosures discussed above. Time – years, in fact – will tell. And you thought it was just a simple project about subtotals!
Mr. Kabureck is a member of the International Accounting Standards Board (IASB). The views expressed in this article are his alone and do not necessarily represent the views of the IASB or individual IASB members.