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 may have 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.

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.

​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 52-112 Non-GAAP and Other Financial Measures Disclosure, 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, to foster fair and efficient capital markets and confidence in capital markets, and to contribute to the stability of the financial system and the reduction of systemic…+ 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?

Companies are expected to provide you with information about non-GAAP financial measures. These requirements are outlined in CSA 52-112 Non-GAAP and Other Financial Measures Disclosure.

If you are presented with a non-GAAP financial measure, it is important to ask probing questions to make sure that you understand the financial measure and how it is being used. Some 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.

Summary

Publicly traded companies must prepare their financial statements under Generally Accepted Accounting Principles (GAAP).

Non-GAAP financial measures are disclosed outside of financial statements. This could be in press releases, investor presentations, sections of annual reports, securities offering documents and more. These financial results may be presented differently than in the financial statements.