Alternative performance measures need to stay in their proper place

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This article was first published in the April 2019 international edition of Accounting and Business magazine.

The term ‘fake news’ has never been more popular, thrust into the limelight by a certain prominent American. While corporate reporting may seem a far cry from the bear pit that is US politics, this historically sober affair appears to increasingly favour what might be described as sexed-up financials.

Most of the largest companies in the world now use non-GAAP measures, often referred to as alternative performance measures (APMs) or management performance measures. Their annual reports headline corporate numbers that differ from the statutory figures required from the financial statements, which can lead to confusion among users.

While it is certainly the case that preparers of financial statements can assume that users possess a reasonable level of business knowledge, it is increasingly difficult for even educated users to identify which figures should be used when assessing the financial performance of an entity.

Misleading?

Recently at the University of Liverpool, we set final-year degree students a project to select a company and then use research tools to analyse its performance and position based on its most recent annual reports and other publicly available information. It wasn’t long before they started to encounter a common problem: which figures should they be focusing on?

To highlight just one of the issues, let’s take a recent example from a company’s financial statements. On page one of its annual report for the year ending December 2017, Domino’s UK refers to ‘group system sales’ of £1.18bn. Impressive, certainly – only it isn’t the revenue that Domino’s earned in that year. The statutory revenue (reported 16 pages later) was actually £475m. Still very good, but far from the headline figure given.

The difference is that group system sales relate to all sales made by all franchised and non-franchised Domino’s stores in the UK. Now, this is clearly an important figure, as it can show the strength of the brand, and the volume of sales made under the brand compared with the previous period. It does, however, raise a question: is this figure more important than the statutory revenue made by Domino’s UK, which incorporates only the franchise fees and sales to the stores themselves? As the group system sales figure also incorporates sales made by franchisees, which are not part of the Domino’s group, it is perhaps questionable whether this figure should be presented with greater prominence than the revenue of the group.

None of this is to point the finger at Domino’s – 95% of UK FTSE 100 companies use APMs. But the confusion arising from the Domino’s figures was repeated numerous times, with students querying whether they should be looking at operating profit before exceptional items, statutory operating profit, EBITDA or other key metrics highlighted in the annual reports.

Why use APMs?

Financial statement users often appreciate these measures. One of the major arguments for reporting them is that they can produce a clearer picture of the underlying business than simple statutory figures are able to do. Indeed, non-GAAP information can provide a good link between financial results and non-financial performance, and are a way for management to highlight the business’s key value drivers.

A good example of how APMs can bring clearer information is the use of ‘total indebtedness’ by UK supermarket chain Tesco. This figure included the present value of operating lease commitments, despite the liabilities not being recorded in the statement of financial position prior to the introduction of IFRS 16, Leases. As a result, users were given a clearer picture of Tesco’s longer-term debt commitments than the accounting entries under the previous standard, IAS 17, may have shown.

Despite the many good reasons for introducing APMs, there is also increasing concern that entities may use them rather than the statutory numbers as headline figures. This can lead to a lack of transparency and clarity.

Responses from regulators

The use of APMs has become a central part of the primary financial statements project of the International Accounting Standards Board (IASB). The project is examining APMs’ prominence, how they are presented and whether more detailed guidance is required.

In project feedback, preparers say they need flexibility to tell their story. And the initial feedback from users is that non-GAAP measures can provide useful information, particularly in relation to unusual or infrequent items. Importantly, users also feel that transparency needs to be improved.

The IASB is looking to reinforce how APMs should be used. It proposes to allow them in the notes, and that they should complement subtotals or totals required by IFRS Standards. The IASB is not contemplating any constraints on the calculation of APMs, but it is proposing that management should explain why the APMs are a good reflection of the entity’s performance.

In addition, the entities will be required to reconcile the APM to the most directly comparable subtotal in the financial statements – a practice that is generally adopted by most of the entities applying APMs. In making its proposals, the IASB hopes that ARMs will no longer be given greater prominence than the statutory figures.

The IASB’s focus is echoed by the Securities and Exchange Commission (SEC), the financial regulator in the US, which has become increasingly concerned about how APMs are being presented. To reflect the moves towards reversing the trend, the SEC fined security company ADT US$100,000 in December for presenting the non-GAAP figures with greater prominence than its statutory results.

Exceptional items

The use of exceptional items has long been a contentious issue, because of what qualifies as exceptional or unusual and what doesn’t. Items that are commonly adjusted for as exceptional include foreign exchange movements, gains or losses on disposals, impairments and restructuring costs. While some of these are genuine one-off items, it is not unusual to see entities reporting these costs as recurring every year, yet still including them within the exceptional items breakdown.

To show the impact of these, consider Tesla’s recent reporting of a GAAP loss per share of US$5.72 that shrank to US$1.33 when the non-GAAP figure was reported. The difference came from removing stock compensation for staff in calculating the non-GAAP figure.

Currently the IASB proposals do not really deal with this situation. The IASB proposes to introduce principles-based guidance in identifying unusual or infrequent items. This could go some way toward reducing the number of recurring items that are classed as exceptional, although it is unclear what the guidance will be.

The way forward

As the IASB and the SEC get to grips with the issues, it is interesting to see some major companies moving towards making the GAAP or IFRS figures more prominent. In 2017, Google’s parent company Alphabet decided it would no longer produce non-GAAP performance figures. A big part of its reasoning was to reflect stock compensation in the key earnings measure, unlike Tesla, as it saw this as a key tool in its financial structure in compensating staff. In 2017, Facebook followed suit and now adjusts only for foreign currency movements in providing non-GAAP measures.

In both cases, there was an immediate drop in earnings and an initially negative reaction from investors. As nothing had changed in the results of either company, it showed that some users were perhaps unaware of the reality of the entity’s performance, concentrating on the non-GAAP figure instead.

The increased focus on the prominence of non-GAAP figures, and recent action taken by the SEC, may result in these measures being displayed in the notes to the financial statements, complementing rather than obscuring the statutory measures. This would boost transparency, even if there is some way to go in the identification of exceptional or unusual items.

Adam Deller is a financial reporting specialist and lecturer.