Understanding non-GAAP financial measures

Publicly traded companies as well as some private companies are required to prepare their financial statementsFinancial statements Reports that sum up a company’s financial data and tell you how it is doing. The four basic statements are: the statement of financial position (balance sheet, statement of profit or loss (income statement), cash flow statement, and statement of changes in equity.+ read full definition under Generally Accepted Accounting PrinciplesGenerally accepted accounting principles A common set of accounting principles, standards, and procedures that companies follow when they prepare their financial statements.+ read full definition (GAAP) such as International Financial Reporting StandardsInternational Financial Reporting Standards A set of international generally accepted accounting principles (GAAP).+ read full definition (IFRS). These are a common set of accounting rules, standards, and practices. Among other things, GAAP, such as IFRS, help make financial statements relevant, reliable, understandable, comparable, and consistent for investors and other stakeholders.

In addition to GAAP, some companies also report alternative financial measures such as “adjusted net income,” “free cash flow” and “adjusted earnings per share”. These are typically referred to as non-GAAP or non-IFRS financial measures and a company must identify them as such.

Non-GAAP financial measures are disclosed outside of financial statements (e.g., press releases, investor presentations, sections of annual reports, securities offering documents etc.) and present financial results differently from the financial statements – often in a more positive light.

Since non-GAAP financial measures are developed by management, not prepared in accordance with a standardized accounting framework, and are typically unaudited, it is critical to understand the additional risks associated with these measures before considering them in your investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition decisions.

Why are non-GAAP financial measures reported?

Companies often disclose non-GAAP financial measures to provide additional information about the business. These measures present financial results differently from the financial statements prepared under GAAP, with the general goal of facilitating an investor’s understanding of the company’s financial performance, financial position, and/or cash flow.

What are the risks associated with non-GAAP financial measures?

A company has flexibility in which non-GAAP financial measures it chooses to report, if any, and how it calculates such measures, subject to certain regulatory expectations. Although non-GAAP financial measures are commonly used, they are not standardized and therefore may not be comparable from one industry to another or even one company to another.  Differences in definitions, labelling, calculations, and presentations make these measures particularly susceptible to misunderstanding.

What’s a simple example?

Consider the following simplified example. Company A and Company B are two hypothetical Canadian manufacturing companies. An extract from their individual financial statements and press releases are included below.

Company A Company B
   

Financial Statement (Extract*)

Financial Statement (Extract*)

GAAP

GAAP

Sales $1,000,000 Sales $1,000,000
Operating expenses (700,000) Operating expenses (700,000)
Loss on sale of land (150,000) Loss on sale of land (150,000)
Restructuring expenses (200,000) Restructuring expenses (200,000)
Net Loss $(50,000)   Net Loss $(50,000)
         

Press Release (Extract*)

 

Press Release (Extract*)

Non-GAAP

 

Non-GAAP

Adjusted Net Income

$300,000

  Adjusted Net Income         

$100,000

*For simplicity, the above extracts do not include the required accounting and/or regulatory disclosures.

​Both companies report a $50,000 net loss, calculated in accordance with GAAP, in their financial statements.

Company A, in its press release, reports a non-GAAP financial measure of “adjusted net income” of $300,000 because it considers real estate and restructuring transactions as being outside of its core business activities. The Company discloses that financial performance is best evaluated without these transactions. It excludes both the loss on sale of land and the restructuring expense from its income and reports an “adjusted net income” of $300,000 (Sale of $1,000,000 – Operating expenses of $700,000).

Company B, in its press release, reports a non-GAAP financial measure of “adjusted net income” of $100,000. Unlike Company A, Company B only considers real estate transactions as being outside of its core business activities. Although restructuring transactions are infrequent, they were incurred to improve the core business. The Company discloses that financial performance is best evaluated by excluding only the real estate transactionTransaction The process where one person or party buys goods or services from another for money. Examples include taking money out of an account, buying something with a credit card or taking out a loan.+ read full definition. It excludes the loss on sale of land from its income and reports an “adjusted net income” of $100,000 (Sale of $1,000,000 – Operating expenses of $700,000 – restructuring expense of $200,000).

Although Company A and Company B have the same financial statement results calculated in accordance with GAAP, their non-GAAP financial measures portray a different picture of performance. Although both companies report a similarly labelled non-GAAP financial measure (adjusted net income), each is calculated differently. The appearance of similarity does not always equate to similarity!

How are non-GAAP financial measures regulated?

To help ensure the non-GAAP financial measures reported by companies are, among other things, transparent and understandable, Canadian Securities Administrators have issued guidance in CSA Staff Notice 52-306 Non-GAAP Financial Measures, which outlines various disclosure expectations for companies that choose to report such measures. The Ontario Securities CommissionOntario Securities Commission An independent Crown corporation that is responsible for regulating the capital markets in Ontario. Its mandate is to provide protection to investors from unfair, improper or fraudulent practices and to foster confidence in fair and efficient capital markets.+ read full definition has been actively monitoring the disclosure practices regarding non-GAAP financial measures and continues to caution companies that regulatory action may be taken if non-GAAP financial measures are disclosed in a manner considered misleading and therefore potentially harmful to the public interest.

If presented with a non-GAAP financial measure, what should I consider?

If presented with a non-GAAP financial measure, it is important to ask probing questions. As CSA Staff Notice 52-306 Non-GAAP Financial Measures outlines various disclosure expectations, answers to many of such probing questions should be in the document that contains the non-GAAP financial measure.

Examples of probing questions may include:

  • What added insight does the non-GAAP financial measure provide beyond what’s provided in financial statements prepared under GAAP?
  • Why is this non-GAAP financial measure useful? Why are certain adjustments removing financial items? Does this make sense?
  • How does management use the non-GAAP financial measure?
  • How is the non-GAAP financial measure calculated?
  • How does the non-GAAP financial measure reconcile to the corresponding GAAP measure disclosed in the financial statements?
  • Does the company focus on a non-GAAP financial measure rather than the corresponding GAAP measure? If so, why?
  • Has the non-GAAP financial measure been reported previously? If so, was it calculated using the same formula? If not, why has the formula changed?

Non-GAAP financial measures can be an additional source of information, which can supplement information in the financial statements, but if, and only if, the non-GAAP financial measures are well understood.

Additional resources

Sign-up to receive Investor News from the OSCOSC See Ontario Securities Commission.+ read full definition.

Follow the Investor Office on Twitter @smarter_money and Like GetSmarterAboutMoney.ca on Facebook.

Read the CSA Notice Regarding Online Advice for requirement details.

Last updated