Why non-GAAP measures lead to ethical dilemmas

Philip Maguire, CPA, CA, is a principal at Glenidan Consultancy Ltd. His practice focuses on internal controls over financial reporting for a number of publicly listed companies on the Toronto Stock Exchange.

ONE MATTER that is often overlooked when considering internal controls and ethical behaviour is non-GAAP (Generally Accepted Accounting Standards) measures. Of all the non-GAAP results the most prevalent is Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Management believes that EBITDA portrays “a truer picture” of the financial results since US GAAP or International Financial Reporting Standards (IFRS) statements are too focused on form over substance. Or at least that’s the story. 

EBITDA is suppose to represent the free cash flow earnings of a company, or in other words operating income. It is also used to assess the value of a company by applying a multiplier to EBITDA. EBITDA is the focus of press releases and earnings calls with analysts and often receives more attention that the audited results. 

The appeal of non-GAAP measures such as EBITDA 

Why has EBITDA become so prevalent? In fairness, today’s accounting standards have many deficiencies. Accounting standards have to be general enough to apply to all filers and yet specific enough to promote comparability amongst filers. Filers feel that the accounting standards fall down on the later objective. 

There are other problems too. For example, assets that are written down due to impairment cannot be subsequently written up should circumstances change. And the rule against capitalizing internally generated goodwill means that there will be a divide between the book value and market value of a company. We’re seeing this in particular in the technology sector where the book value can represent less that 1% of the market value of filers. 

Management feels that their only option is to apply non-GAAP measures to explain the financial results of its operations. 

The rift within the lute, that by and by will make the music mute 

What are some of the problems with EBITDA and other non-GAAP measures? The most significant issue is that management determines what balances to include, and exclude, in EBITDA. This is what is known as a conflict of interest. Expenses considered “non-operational” will be removed from the calculation and yet one-time revenue boosts included. Even more egregious is management’s practice of changing the numerator or denominator year over year to reflect the most favourable EBITDA. 

In May 2021 the Globe and Mail highlighted a study conducted in 2016 which found that, of 100 filers on the Toronto Stock Exchange, 70% were changing the EBITDA year over year to reflect the most favourable results. Only by reconciling EBITDA to the previous year could this matter be detected. And these are filers who require management to sign a code of conduct. 

Another problem is that the more precise the EBIDTA the less likely these results will be comparable to other files. A few years ago Manulife and Sun Life were reporting earnings that excluded one-time COVID costs since they wanted to focus on operating performance. In Q1 2020 Manulife did not report losses on investments ($.7B) and equity markets & guarantees on annuity products ($1.3B)- even thought these losses were off-set by unreported gains of $1.7B in interest income. Sun Life was reporting customized profits that strip out certain investment losses in order to arrive at underlying earnings. Analysts were struggling to define these various calculations, never mind comparing the results.

Other dilemmas 

CI Financial was in the news recently over a spat with a rating agency. CI Financial, and many other companies too, has taken EBITDA to a new level by refining EBITDA further to derive “adjusted” EBITDA. The rating agency noted that CI Financial, in the previous 15 quarterly financial statements, reported “adjusted” EBITDA that was four times the IFRS earnings. The rating agency was then fired by CI Financial. However, the agency was so concerned about the “adjusted” EBITDA results that they continued to monitor CI Financial on a pro bono basis. 

Developments 

Is there help on the horizon as a result of the abuses of EBITDA and its cousin Adjusted EBITDA? The securities regulators issued National Instrument (NI) 52-112 “Non-GAAP and Other Financial Measures Disclosure” in 2021 that outlines management’s responsibilities regarding fair and true disclosure of non-GAAP results. NI 51-201 “Disclosure Standards”, issued in 2002, emphasizes that management cannot apply selective disclosures to the detriment of fair and unbiased reporting.

Canadian Auditing Standard 720 “The Auditor’s Responsibilities Relating to Other Information in Documents Containing Audited Financial Statements,” issued in 2018, defines the role of the audit opinion. While the audit opinion does not encompass other (non-GAAP) information, the auditor must read this information because the credibility of the financial statements could be undermined if the non-GAAP results are misleading. The upcoming IFRS 18 , amongst other changes, will require companies to reconcile their non-GAAP measures to the closest IFRS results. 

Caveat Emptor 

Users should tread carefully when relying on EBITDA. And accountants have ethical responsibilities to our professional bodies to behave in an honest manner. Don’t fall into the slippery trap of turning a blind eye to non-GAAP reporting.

Philip Maguire, CPA, CA, is a principal in Glenidan Consultancy Ltd. His practice focuses on internal controls over financial reporting for a number of publicly listed companies on the Toronto Stock Exchange. Philip teaches a number of CPD (continuing professional development) courses in Canada, England & Wales and Ireland. Author photo courtesy Philip Maguire. Title image: iStock photo ID 2259146008.