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.
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.
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.
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:
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:
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.
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.