Non-GAAP within GAAP: A Genius Step or One Step too Far?

In December 2019, the International Accounting Standards Board (IASB) published a proposal for a dramatic reform that revolutionizes the presentation of results within the statement of profit or loss, as well as the disclosure provided for them in IFRS. This investor-oriented reform embodies a revolutionary shift, that greatly undermines accepted principles that have taken root over the years.

The main principles of the proposed reform – which includes a proposal to introduce a new standard and replace and revise existing ones – has two main components: The first – changing the structure of the statement of profit or loss and introducing new disclosure requirements as a result; and the second, more revolutionary one – including non-GAAP management information in the financial statements. There is no doubt that nowadays, investors attach great, and sometimes even too much, importance to companies’ non-GAAP measures, which often “steal the show” from the financial statements. This problematic phenomenon, that has gained traction in the USA, may be disastrous since it might potentially mislead investors. This is due to the quality of non-GAAP information, which is subjective in nature and subject to management’s many reporting interests. This may be reflected, inter alia, in the companies’ eliminating one-off expenses while avoiding to do so for one-off income, or in highly problematic adjustment of items, such as expenses in respect of share-based payment.

The trivial change

The first part of the proposed reform applies to the structure of the statement of profit or loss – this mainly involves classifying income and expenses in the statement of profit or loss into three categories: the results of operating, investing and financing activities. This important structural change – along with a new disclosure requirement regarding unusual income and expenses – is essential and even critical for investors. This is consistent with the concept of appraisals, and will assist investors in making projections based on the financial statements. As a result, for the first time, the different elements of the financial statements – such as the statement of financial position (balance sheet), the statement of profit or loss, and the statement of cash flows – will be coherent, and at long last “communicate” with one another. This much-needed step constitutes, among other things, a response to the criticism directed at IFRS, in particular due to the use of fair value as the leading measurement basis of income-generating properties – whereby the relevance of the statement of financial position supersedes that of the statement of profit or loss. It appears, then, that with a bit of thinking, the statement of financial position can be rendered more relevant, without compromising the relevance of the statement of profit or loss, potentially even greatly improving its relevance.

The controversial change

The second part of the proposed reform is much less trivial and even controversial. It addresses the inclusion of non-GAAP metrics in the financial statements, ones that management deems relevant for the assessment of its results, also known as Management Performance Measures (MPM). These metrics do not have to be relatively generic in nature, such as FFO, but rather can also be specific, tailor-made profitability metrics. According to the proposal, the abovementioned disclosure – which will be accompanied by full explanations – may even be included in the statement of profit or loss itself, provided that it does not compromise the presentation of accounting results. It is also proposed that non-GAAP operating results figures also be used to calculate earnings per share.

Indeed, this is, in a way, an institutionalization of sorts of an activity that has so far been subversive and unregulated – but it is more than that: It means that the accounting establishment is, in fact, embracing the criticism against it.

I presented a challenge to my students – I outlined the above revolutionary proposal by the IASB and asked them to what extent it is consistent with the conceptual framework of accounting. Judging from their answers, the students were very concerned about the prospect that a single set of financial statements might contain contradictory statements regarding profitability. It is very difficult to ignore the students’ concerns. Think, for example, of equity compensation for employees. As far as modern accounting is concerned, it is considered a payroll expense for all intents and purposes (and rightly so) since employees provide services to the reporting entity; after all, in economic terms, two notional transactions take place: Payment of compensation and issuance of equity instruments to employees in exchange for the compensation they received as if they had invested in the company. On the other hand, as we noted above, many companies adjust this expense in their non-GAAP measures, claiming that it is not an expense that involves cash flows, but rather a transaction between employees and existing shareholders. This, of course, leads to much higher profits being presented. How is it possible, then, that the accounting establishment believes that it is an expense from an economic point of view, while also supporting the view that it is not an expense, or even legitimizing such a view?

These are no simple questions from the point of view of accounting theory. Relevance of information as a fundamental qualitative characteristic is, indeed, given precedence over comparability (an incremental characteristic); on the other hand, the second fundamental qualitative characteristic – fair presentation – can potentially be compromised. In this context, it should be noted that “without us noticing”, about a decade ago – following the adoption by IFRS of the innovative American concept of reporting operating segments according to management’s approach – nowadays non-GAAP metrics may be indirectly introduced into financial statements.

On the other hand, it is reasonable to assume that once non-GAAP information is introduced into financial statements that are audited by independent auditors, it will comply with higher standards of quality, consistency and full disclosure – in stark contrast to the unregulated non-GAAP data that are currently being provided by companies in published documents available to users of the financial statements, e.g. management commentary. In the current reality, securities authorities around the world – and especially the SEC – have had serious concerns about companies misleading investors; however, although this issue has constantly been on the agenda of such securities authorities, so far they have not been successful in alleviating these concerns. I hope that the inclusion of such information in companies’ official financial statements, accompanied by full explanations – to which companies’ independent auditors will have to agree eventually – will bring about an improvement in the quality of such information and its regulation. This might prevent the highly common adjustment of payroll expenses in respect of share-based payment. This adjustment is commonly used by technology companies reporting under US GAAP (e.g. Twitter and Tesla) and under IFRS (e.g. SAP). In this context, it is important to emphasize that the new proposal does not allow for cash-flow based measures such as Free Cash Flow (FCF) to be included in the financial statements. As a result, in my opinion, it would be difficult to rely solely on the notion that share-based payment is a non-cash flow expense in order to adjust it.

EBITDA shall remain outside

Additionally, the IASB has, indeed, already declared that it does not intend to define the operating results metrics at all. However, it is quite possible that we are currently at the beginning of an extensive move, where in the second phase accounting standards, or at the very least auditing standards, will inch closer to defining generic non-GAAP metrics, such as FFO. By the way, I believe, and to my understanding this is also established in the new proposal, that EBITDA, which adjusts depreciation and amortization expenses, cannot be considered a standalone performance metric. Therefore, it will be inappropriate to include EBITDA in financial statements even under the new reporting model, since it was originally introduced for comparative purposes, mainly for pricing shares using the multiple method.

Will the Americans come on board?

All in all – despite the conceptual and application difficulties – I personally support the IASB’s move that will result in multi-dimensional presentation of operating results information, which also includes the subjective manner in which management regards its representative profitability measure, and also believe that we still haven’t heard the last word on this issue. At the very least, the result of this move will be that when such information is included in the financial statements, it will be presented to investors as secondary and alternative information, rather than the principal information provided, as is sometimes the case today.

In any event, by making the abovementioned proposal, the IASB delivers a strong message whereby the new decade will be investor-oriented as far as accounting is concerned, i.e., something to the effect of “we are here for you”. This is a very important statement considering that in the past few years the IASB mainly dealt with complex recognition and measurement issues – that were probably of interest and generated quite a lot of work for all those involved in the field, but were less relevant for investors. Incidentally, this important reform, which focuses on representative profitability, may also sow the seeds for a future solution to one of the most pressing problems of modern accounting – other comprehensive income (OCI). As we all know, there is currently no clear conceptual basis as to which income and expense items should be charged to other comprehensive income, avoiding – at least when they are incurred – the statement of profit or loss.

It will be interesting to see whether the Financial Accounting Standards Board (FASB) – charged with the world’s largest capital market – will, in time, join the IASB’s revolutionary, pioneering move. It is important to note that if, indeed, the change is eventually approved, financial statements of foreign companies reporting in the US under IFRS and in accordance with SEC rules will present such non-GAAP data to US investors, essentially making the change unavoidable. It will therefore be very interesting to follow developments that have great potential to bring back accounting and financial statements to the center stage of capital markets in the new decade, following the continuous erosion in their status.

(*) Written by Shlomi Shuv