Are the following statements true or false?

• An audit covers the Management Discussion & Analysis (MD&A) commentary.
• Interim financial statements are audited.
• EBITDA, Free Cash Flow, and Adjusted Earnings are defined under GAAP and are audited.
• Companies within the same sector define key metrics the same way.

If you think these statements are all true, you may be disappointed to learn that they are, in fact, all false. This gap between user expectations and current practice continues to grow each day, and it’s not just a Canadian issue.

One of the most profound changes brought on by the Internet has been the proliferation of information sources. Thirty years ago, investors and financial analysts would wait for the mail carrier to deliver printed annual audited financial statements so they could perform their investment analyses.

Today, information is downloaded at the click of a button. While audited GAAP financials still remain an essential part in allocating capital, they now represent only 10 to 20 per cent of the information used in the investment decision process, according to a 2016 CFA Institute survey. That’s down approximately 50 per cent from 30 years ago.

For the remaining 80 to 90 per cent of the information being used, investors and analysts are far more likely to turn to MD&A, analyst calls, meetings with and presentations from management and broker analysts, and corporate filings. The challenge, however, is that the metrics reported outside the GAAP financials are not prepared using recognized GAAP, and have not been independently verified—and there are few to no recognized standards in determining them.

In our view, this situation represents a gap (no pun intended) between the expectations and reality of investors and analysts. It also warrants attention from accounting standards setters, securities regulators, financial statement preparers, corporate directors, and the investors and analysts who rely on this information to make investment decisions.

Types of Information

Companies typically publish four types of corporate performance measures (CPMs):

1. traditional GAAP financial statements (which are audited) such as Net Income and EPS;
2. non-GAAP financial measures (unaudited) such as EBITDA, Adjusted Earnings, and Cash Flow;
3. other financial key performance indicators (KPIs; unaudited) such as Average Revenue per Subscriber, Same Store Sales, and Cost per Ounce; and
4. operating KPIs (unaudited) such as Subscribers, Units Produced, and Stores.

With the exception of GAAP financial statements, the reporting standards for other types of performance measures are defined and calculated by management. The Canadian Securities Administrators (CSA) has provided guidance that these measures should be “defined in a way that is not misleading” and should be “presented on a consistent basis from period to period.” In terms of verification, the audit firm is required to read the MD&A and identify any information that’s materially inconsistent with the GAAP financials for management attention.

In 2017, CFA Society Toronto surveyed financial analysts and institutional investors (including Canada’s leading pension plans) to better understand their perspectives on CPMs. There was unanimous agreement about the importance of audited GAAP financials, and that they created the foundation for fundamental analysis.

However, respondents highlighted the growing use of CPMs in making investment decisions, including the following:

• key CPMs in evaluating company performance aren’t often clearly identified or defined;
• CPMs aren’t always calculated consistently from one period to the next; and
• the same CPM is often defined differently by companies in the same industry, making inter-company comparability difficult.

Initiatives Under Way

The CSA is currently reviewing its Staff Notice 52-306—Non-GAAP Financial Measures—with the intent of elevating it to become a formal rule. Since a “rule” is a more significant and meaningful requirement for an issuer (compared with a staff notice or guidance), this initiative is welcome. A draft rule is scheduled for release this fall and will be available for public comment.

Canada’s Accounting Standards Board has an initiative under way to publish a draft framework for CPMs this month. A comment period will follow, and interested parties are encouraged to provide their input.

Have Your Say

The CPM issue is global. No country has yet to formally adopt standards governing CPMs, and the steps being taken in Canada put the country at the forefront internationally. The key is for users of financial information to get involved in helping to shape the standards. Here are a few steps you can take.

• Provide feedback in the comment process.
• Understand the risks associated with the lack of current CPM standards and that the information is not independently verified.
• Ask company management how they define their CPMs, how they’ve changed and modified those definitions from period to period, and how those definitions differ with other companies in the industry.
• Ask audit committee members how they’ve verified the information.