Through various forums, questions regarding the usage of Non-GAAP financial measures or alternative performance measures have been raised repeatedly as companies approach the preparation of their annual financial reports. The “unprecedented” year in 2020 effectively sums up the challenging year for most companies in the past 12 months. So how could non-GAAP measures be used by companies to communicate to investors the impact that Covid-19 has had on their performance in FY 2020? What do companies need to look out for when considering the type of adjustments to present as non-GAAP measures to investors? There are obviously no right or wrong answers to these questions, but for those who use non-GAAP measures, here are some ways we think could maximise the potential of how non-GAAP measures are used in communicating companies’ financial performance.
Coherent communication strategy - use of non-GAAP measures is one of the tools in a company’s communication toolkit, not the only tool
Companies thinking of using non-GAAP measures to communicate how the pandemic has impacted their businesses would benefit from thinking about their communication strategy in a holistic manner. What do we mean by that? Using non-GAAP measures is one way to explain the Covid-19 impact. Narrative explanation in the MD&A and notes to the financial statements are other channels companies could use to provide investors with the information they need to understand the magnitude of the impact, areas of the business that are most affected, strategies that management has deployed to navigate the challenges and where the uncertainties lie in the coming months ahead.
In fact, non-GAAP measures should act as a bridge to GAAP information. Historical financial information provides an important input into investors’ evaluation of a company’s prospects; non-GAAP information allows investor a glimpse into management’s own perspective of the company’s performance and facilitates forecasts of future performance. The two types of information serve different objectives and purposes for investors. Both local and overseas regulators alike, have similar prohibitions on giving non-GAAP measures greater prominence to GAAP measures to ensure the information quality in a company’s reporting is kept high.1 Overall, the information that management chose to provide to investors, should provide more clarity and understanding to an investor on the business’s underlying performance, without injecting some form of management bias to the information presented.
Certainty on normalized earnings
Ultimately, investors are looking for data and information on what is exceptional versus what is normalized earnings. Therefore, the adjustments that companies make to GAAP measures are essentially conveying and implying what normalized earnings look like in the absence of unusual events. It would be worthwhile stepping back to assess whether that objective is achieved by the chosen non-GAAP measures and adjustments made before the data are presented to investors. Especially when an “one-off” event could have the potential to become a more frequently occurring event.
On that note, it is worth mentioning that hypothetical situations e.g. adding back projected lost revenue in the absence of Covid-19, is certainly not non-GAAP adjustments. In general, a non-GAAP measure adjusts items included within the GAAP measure which are removed to arrive at a non-GAAP measure. In some cases, management is effectively providing an indication of future revenue based on its own forecast of the recovery pattern for the entity, in which case it is more akin to providing information on forecast or projected revenue. If companies choose to provide forward looking projections, then these should be labelled as such, and not mislabeled as a non-GAAP measure.
The chosen non-GAAP measure to be presented should be clearly defined and an explanation of the basis of calculation provided.2 The label given to the non-GAAP measure should also be clearly distinguishable from GAAP measures. For example, one of the most commonly used non-GAAP measure, adjusted EBITDA (Earnings before interest expense, taxes, depreciation and amortization) – is commonly adjusted for non-recurring (or irregularly recurring) and non-cash items e.g. goodwill impairment, share-based payment. Generally, adjustments adopted by companies could differ by sector and by companies within a similar sector. Hence it is crucial to label the non-GAAP measure appropriately and specify the items which have been included in the adjustments.
In terms of considering Covid-19 related items in the context of non-GAAP adjustments, the first practical consideration that comes to mind is whether expense items such as sanitization and costs for personal protective measures are indeed incremental and unique one-off expenses, and whether or not including such items as non-GAAP adjustments would achieve the overall objective of presenting the “normalized” results of the entity. Looking at the current pandemic situation, the characterization of Covid-19 as a non-recurring one-off event may not be as tenable as one might have thought at the start of the pandemic. Furthermore, these expenses may not be that significant to warrant the effort for tracking separately from other general administrative expenses.
Some have also asked whether other types of expenses that would be incurred regardless of COVID-19 e.g. depreciation of idle plant facilities and rental payments for gyms and restaurants with restricted operations, could be adjusted and presented in non-GAAP measures. Typically, the type of adjustments investors expects to see are those made to eliminate non-recurring one-off items outside of normal operations. It is also worth mentioning that HKEX GL103-19 is explicit that recurring items should not be described as non-recurring, infrequent or unusual without sufficient explanation and companies need to exercise judgement in their determination of what constitutes recurring vs non-recurring. Therefore, items that are recurring and have been significantly impacted by the pandemic, it would be more useful to investors that companies provide meaningful explanation of the impact.
Illustrative case study of adjustments due to COVID-19
Company A is in the apparel retail sector and operates its own stores globally. During the 2020 financial year, certain stores in various jurisdictions were subject to mandatory temporary shutdown periods imposed by the local governments when the number of COVID-19 cases spiked in those areas. During the shutdown, Company A continues to incur operating costs for these retail stores including rental payments, utilities and the salaries of the employees who are affected in accordance with terms of their employment contracts.
For employees whose families are severely affected by the pandemic, Company A decided to pay these employees a fixed amount of hardship payment, notwithstanding that such payment is not required under the employment contracts or any applicable laws and regulations. The hardship assistance are costs incurred on a voluntary basis. Furthermore, Company A has made certain donations to a few local charities to support the communities on their COVID-19 relief efforts. Company A has not made similar hardship payments or charitable donations in the past and does not expect such payments to be made in future periods.
In this case, whilst the mandatory shutdown itself was considered to be one-off and non-recurring, the operating costs during the shutdown periods including rental payments, utilities and normal salary costs that Company A is obliged to pay are not incremental and are expected to be recurring. However, Company A has deemed the voluntary hardship assistance payments to employees and the COVID-related charitable contributions to be incremental and not likely to recur in the foreseeable future. Accordingly, Company A has included the hardship payments and the charitable contributions as non-GAAP adjustments in its presentation of the Adjusted Net Profit for the year.
Comparable and consistent over time
The non-GAAP measures chosen should be consistent and companies should not cherry pick which adjustments to include or exclude based on what would reflect a biased and often better outcome. If one chooses to add back one-off charges, the same should apply to one-off income items e.g. government assistance and rent concessions. Furthermore, the type of adjustments made should be consistent and comparable to prior periods’ non-GAAP measures. In other words, if a new adjustment is proposed for this coming period, there ought to be similar adjustments made to the comparative period in order for the results to be comparable.3 This disciplined approach to presenting non-GAAP measure would allow investors to better understand management’s viewpoint of the performance of a company overtime.
Final thoughts on use of non-GAAP measures
There has been more attention on non-GAAP performance measures with the ongoing COVID-19 pandemic situation and companies are looking at the options available to them to explain the unusual year they have had in 2020. Non-GAAP measures can provide a different perspective alongside with GAAP information. Together with narrative reporting, which has a crucial role to play in providing context and meaningful insights to quantitative information, a holistic approach and communication strategy to the various pieces of information presented in the annual report is very much needed. In an environment where there is increasing demand for more transparent and better information, the key reminders discussed above would hopefully serve as a timely reminder on the key considerations for companies when using non-GAAP metrics as a way to enhance the value and quality of their annual reports.
Additional resources on related financial reporting are available on:
Resource Centre on the financial reporting impacts of coronavirus - Where and how should COVID-19 impacts be presented in the income statement and related notes?
- For guidance on not giving undue prominence to non-GAAP measures, refer to HKEX Guidance Letter HKEX-GL103-19 (April 2019) section 4(c); ESMA Guidelines on Alternative Performance Measures (ESMA/2015/1415) paragraph 35-36; and US SEC Regulation S-K Item 10(e).
- Refer to HKEX GL103-19 section 4.1(a)(i)
- Refer to HKEX GL103-19 section 4.1e(ii)