Question

Answer the question:

Non-GAAP earnings, however, also generally result in a more positive or negative (please choose one) earnings outcome than GAAP earnings. Briefly explain your answer.

Answer 1

Looking at the IFRS income statements of many of the major listed groups in the UK, Germany, France, Denmark and Switzerland, there are two main types of non-GAAP measures reported by companies:

•    well-defined and commonly used non-GAAP measures, eg, earnings before interest and tax (EBIT) and earnings before interest, tax, depreciation and amortisation (EBITDA); and

•    specifically defined non-GAAP measures, which usually exclude some of the income statement items, eg, earnings before non-recurring items.

Consistent with other research, it was noticed that reporting formats of non-GAAP measures varied between countries, which perhaps reflects their 'historical heritage'. For example:

•    In the UK - many companies report extra sub-totals and columns to eliminate exceptional/special items in order to achieve an 'underlying result'.

•    In France - similar to the UK, ie, extra sub-totals, except that they refer to exceptional as 'non-recurring' items instead. EBITDA and EBIT are also popular. Columnar reporting is not popular.

•    In Germany, Denmark and Switzerland - companies are not keen on extra sub-totals, but provide extra line items similar to the above items.

Closer look

So management appears in favour of highlighting 'special/exceptional/non-recurring' items. But what are these items in more specific terms?

Our experience shows that the top five items that companies highlighted in one way or another on the face of their income statements are:

1. Goodwill impairment

2. Other impairments

3. Restructuring costs

4. Gains and losses on disposals of long-term assets and subsidiaries

5. Various fair value re-measurements.

From this analysis it appears that all of them are 'non-recurring' items or items which contribute to volatility of results from one period to another. It is also interesting to notice that some of them relate to re-measurements, while some of them relate to 'actual' gains and losses.

Are they a good thing?

In the vast majority of cases the information provided in non-GAAP measures can be easily obtained from a closer study of financial statements, including the notes.

However, managers decide to include/exclude/highlight some of the items in the primary financial statements. There are two main reasons for them to do this: (1) either local regulations requires them do so; or (2) they themselves decided to add a 'management's prospective'. The latter sometimes also relates to a specific industry practice.

As mentioned in the introduction above, non-GAAP measures have both their supporters and critics.

Supporters believe that non-GAAP measures provide:

•    more predictive and high quality information as it excludes the effects of unusual or one-time items;

•    more relevant information, ie, 'managers know their business best'; by disclosing a clearer picture of the company's underlying earnings, managers are assisting users of financial information, especially in respect of clarity and predictability;

•    more comparability via excluding non-recurring items, such as restructuring charges and 'one-off' gains and losses on the sales of assets.

Critics, however, challenge the usefulness of such information on the basis of the following practical and conceptual reasons:

•    lack of consistency in including/excluding various items; while companies commonly exclude multiple expenses in arriving at their non-GAAP measures, sometimes they do not exclude the same items in subsequent reporting once they have become 'more regular';

•    lack of comparability across companies because there are no standard definitions.

They are also concerned about the following behavioural points:

•    what are the managers' true motivations for reporting certain numbers? Non-GAAP measures may be motivated by managers' desires to meet or beat analysts' expectations or to avoid decreases in earnings;

•    investors sometimes pay more attention to non-GAAP measures than to audited GAAP figures;

•    some research shows that it is normally less-sophisticated investors who are at risk of being misled.

Because of these concerns, in the wake of prominent accounting scandals, legislators in the US responded with tougher disclosure laws.