A NED’s guide to non-GAAP disclosures
The Financial Markets Authority (FMA) recently released new guidance on the reporting of non-GAAP financial information, with the Authority encouraging all organisations to reassess how they present performance measures outside of generally accepted accounting practice (GAAP).
In addition, the New Zealand External Reporting Board (XRB) recently released research on whether alternative measures of profit are meeting user needs. The research found that while alternative measures of performance are a useful supplement to GAAP in understanding a company's performance, they are used with caution. Users question why some measures are used, how they have been calculated, why they tend to show a rosier picture of performance and to what extent they have been audited.
NEDs are tasked with challenging the thinking and performance of the company, and working in the best interests of shareholders. The new FMA guidance and the XRB research make useful reference points for NEDs when reviewing and approving financial reports and press releases.
Since the FMA last released guidance notes on non-GAAP reporting in 2012, the Authority has been monitoring how organisations present that information. After noticing a tendency for some to favour non-GAAP financial information over GAAP – in the belief that it better reflects their performance, cash flows and/or financial position – the FMA has now updated its principles to help keep financial disclosures clear and honest.
Below we set out a NED's guide to the new FMA guidance, and examples of some questions you can ask management when presented with alternative performance measures.
1. Clarity
What does the new guidance say? Non-GAAP information is non-standardised, so the definitions of terms like 'adjusted earnings' are considered opaque. The FMA recommends non-GAAP information be well defined and clearly labelled to give shareholders and investors a better understanding of the financial reality.
Entities should also clarify the reasons for using non-GAAP information, including an explanation of why the information is useful to investors and how it is used internally by management.
Questions for management: "Why has an alternative performance measure been used, have we made the reasons clear in our notes, and have we labelled which are GAAP and which are non-GAAP measures?"
2. Placement
What does the new guidance say? Non-GAAP information should not be presented with 'undue or greater prominence, emphasis or authority' than the most directly comparable GAAP information; nor should it in any way obscure or confuse the presentation of GAAP information.
Questions for management: "Could non-GAAP measures be enhanced by being placed beside GAAP information?" Research from the XRB suggests information is most useful when users can view GAAP and non-GAAP measures alongside one-another.
3. Reconciliation
What does the new guidance say? When presenting comparative non-GAAP information for a previous period, entities should reconcile it with the corresponding GAAP information from that period. If that's not possible, accompanying notes should be provided to show how the number is calculated.
Questions for management: "How have we shown comparative non-GAAP information between different years or periods? Are we being clear on how that's been calculated?"
4. Consistency
What does the new guidance say? Non-GAAP information can be ill-defined and therefore inconsistent period to period, whether that's accidental or purposeful. A consistent approach should be used to keep reporting of non-GAAP information (should an entity choose to present it) consistent and unbiased, including presenting non-GAAP information from comparative periods.
Questions for management: "Have we explained the definition and calculation of non-GAAP measurements in our notes, and kept this consistent for different periods? Have we reconciled to the closest GAAP measure?"
5. Integrity and bias
What does the new guidance say? Companies should be as honest as possible in their reporting. The example used by the FMA is regarding 'one-off or non-recurring items'. Impairment losses or restructuring costs cannot be considered 'one-off' as they are may reasonably be expected to happen more than once in a business's lifecycle.
Questions for management: "Have we provided appropriate definitions for non-recurring, one-off, and infrequent items?"
6. Pro-forma financial information
What does the new guidance say? The FMA pays particular attention to the disclosure of pro-forma non-GAAP information – information intended to show the effects of proposed, completed or hypothetical events or transactions on the entity's financial position, performance, prospects or cash flow. The Authority says it has noticed that information can be misleading, inadequately clear on how it was prepared or ill-aligned with the corresponding GAAP financial information.
For any entities in the situation of disclosing pro-forma financial information, specific observations can be found in the full document linked below.
Questions for management: "Have we based pro-forma financial information on the broadest possible range of independent, unbiased data? Have we shown our calculations in the report?"
What does this mean for NEDs?
PwC's 2017 CEO Survey showed that 41% of New Zealand's business leaders are worried about a lack of trust in the current commercial environment. The XRB research found that users treat non-GAAP measures cautiously "with a grain of salt", particularly if the measures paints a rosier picture.
We can do better, but it's up to individual companies to make sure their reporting represents their financial situation in the most open, honest and transparent way possible. The new FMA guidance can be found in its entirety on the Financial Markets Authority website, while the XRB research can be found here.
We hope you find this guide useful. If you have any questions in relation to the FMA guidance or the XRB research, please do not hesitate to get in touch with your usual PwC contact or contact me directly.
Contact us
