Performance reporting - Balancing comparability and flexibility to meet stakeholder needs

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Point of view , PwC US Oct 24, 2016

PwC’s perspective on how the FASB can change performance reporting to balance comparability and flexibility.

Providing a framework that is meaningful across industries  

  • Currently, GAAP and SEC rules require the income statement to include certain specific line items, subtotals, and totals. In a number of cases, management can choose to include additional lines and subtotals. Yet the proliferation of non-GAAP measures—many of which are derived from the income statement—may suggest that today’s financial statements are not fully capturing all measures of corporate performance which may be of interest to preparers and users.
  • The FASB has asked stakeholders whether it should add a performance reporting project to its agenda. Based on investor feedback and recent scrutiny over the prevalence of non-GAAP measures, we encourage the FASB to add this project to its standard-setting agenda. We recommend the Board consider creating a flexible and scalable performance reporting framework.
  • A performance reporting framework would provide guidelines for how companies present and disclose items that are unlikely to have a continuing effect on their businesses—items that are unique, infrequent, or otherwise incidental—or changes caused by remeasurements of the carrying values of assets and liabilities, with the goal of enhancing the utility of the financial statements. The framework should also have parameters that allow for some flexibility to disaggregate operating results but provide enough guidance for preparers so that comparability is maintained or enhanced and there is sufficient transparency to help users understand the nature of what is being reported.
  • This approach may result in reporting measures similar to the non-GAAP measures some companies currently share. A performance reporting framework could provide additional layers of insight—within the context of audited or reviewed financial statements—into the drivers of performance in a way that gives users the ability and discretion to include or exclude certain items when assessing the company’s performance. This type of structured approach would be an improvement over today’s ad hoc and unaudited non-GAAP disclosures.

Steps the FASB can take to pave the way for change

Déjà vu: Rethinking the income statement

The FASB has asked stakeholders whether it should add a performance reporting project to its agenda, and what potential path it might take.

While it has been a few years since the FASB has focused significant attention on redesigning the income statement, it’s a subject that has been on the radar since the turn of the millennium. To date, no significant changes have been made, which is more a testament to how difficult it is to find a solution, rather than to the lack of an appetite for change. 

Why change performance reporting now?

Feedback from stakeholders and the proliferation of non-GAAP measures suggest that preparers and users may not find the current model for financial statements as useful as they desire.

Preparers sometimes provide non-GAAP measures to communicate an aberration in a given year or to provide additional insight into a company’s business. In other cases, preparers may use non-GAAP measures simply because others in their industry use them and their investors and analysts request the comparable information. Users may find non-GAAP metrics helpful in understanding whether certain aspects of the company’s performance may, or may not be, predictive of future cash flows.

Recent SEC staff focus on monitoring compliance with its non-GAAP regulations, together with media focus on the potential for such measures to be misused and/or misunderstood, has given the topic heightened prominence. Enhancing GAAP to fill some of the needs that companies and users are currently trying to meet with non-GAAP measures may alleviate some of the concerns associated with those measures. 

A performance reporting framework

In lieu of specifying new income statement line items or prescribing subtotals as is being contemplated by the FASB, we advocate a new framework that would drive a measure of consistency in how numbers are reported, yet provide the flexibility necessary to produce useful information across all industries and organizational structures.

Under our framework, companies would present their financial information in a manner that may help users delineate items that are unique, infrequent, incidental to the business, or unlikely to have a continuing effect on results (e.g., the gain or loss from sale of a significant asset or business) or are caused by remeasurements (e.g., changes in the fair value of a derivative financial instruments).

This framework would present these items in three categories: infrequent, non-core, and remeasurements either on the face of the income statement or as a separate schedule. The presentation would be accompanied by a footnote that explained the nature of the items included in each of the categories.

Investors, creditors, managers, and others need information about the causes of changes in an entity's assets and liabilities - including results of its ongoing major or central operations, results of its incidental or peripheral transactions, and effects of other events and circumstances stemming from the environment that are often partly or wholly beyond the control of the entity and its management.

Paragraph 30, Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises

The benefit of such a performance reporting framework would be that companies would be able to share much of the information currently shared via non-GAAP measures, but do so in accordance with GAAP and under the assurance of audited and reviewed financial statements.

However, our suggested framework would not eliminate the use of all non-GAAP measures. This is because it is highly unlikely that a performance reporting framework could facilitate the presentation of all the variations of non-GAAP subtotals reported today. Rather, such a framework would provide guidelines and additional structure around the building blocks for many non-GAAP measures—e.g., requiring separate identification of revenues/gains and expenses/losses that meet criteria outlined by the framework.

Details behind such a performance reporting framework will not be easy to pin down. However, the FASB’s renewed focus on the Conceptual Framework and its proposed Concepts Statement on presentation and disclosure establish a solid foundation on which the FASB can build.

The hard part: Ironing out the details

In particular, the FASB proposals identify a few key concepts (highlighted in the callout boxes throughout this document) that revolve around two themes: the potential predictive value of financial information and the identification of transactions or events that are unique, infrequent, unusual, or unlikely to have a continuing effect on the business. Identification of the latter theme may inform users about the former and should be a central tenet of any performance reporting framework the FASB develops.

A new definition for “infrequently occurring”

GAAP currently has a definition for “infrequency of occurrence.” However, as part of its research project on performance reporting, the FASB has discussed replacing this definition with a more conventional one, governed by a range of factors that could be used to evaluate frequency of occurrence.

We support this approach and encourage additional research into what stakeholders consider to be infrequently occurring in nature and how it impacts their views about predictive value. Understanding the range of views will help the FASB create a list of factors that will guide the development of a framework.

...information presented in financial statements should help resource providers to: (a) Distinguish between the types of transactions, events, and changes in circumstances that are likely to occur in the future and those that are not...

Paragraph 18(a), Proposed Concepts Statement 8 Conceptual Framework for Financial Reporting, Chapter 7: Presentation

Identifying what is “core” to the business

Companies often use non-GAAP measures to identify the impact to earnings of items they believe to be “non-core”—items that are unique, unusual, or incidental to a company’s core operations. Sometimes items that occur infrequently would also meet the definition of non-core, but in other cases, non-core items may recur (e.g., sales of a business or assets in consecutive periods).

There will likely be a wide range of views among stakeholders on what constitutes “core” business activities and no single definition will work for all companies. However, through additional research and stakeholder feedback, we believe the FASB can develop a set of indicators that will guide companies as they assess what should be identified as “non-core.”

Different events have different effects on or send different signals about future profitability and, ultimately, cash flows. Some might clearly be one-time occurrences, but others might indicate the beginning, continuation, or end of a pattern of similar events.

Paragraph 41, Proposed Concepts Statement 8 Conceptual Framework for Financial Reporting, Chapter 7: Presentation

Considering remeasurements

Remeasurements, also referred to as mark-to-market adjustments, are required in several areas of GAAP, such as derivatives and hedging, investments in securities and certain financial liabilities, certain share-based payment awards, and some elements of pension accounting.

From a performance reporting perspective, companies sometimes exclude mark-to-market adjustments from non-GAAP performance measures because those gains or losses don’t reflect realized cash flows and are often volatile and therefore may have less predictive value to users. Some users agree with this concept while others believe that the remeasured assets and liabilities reflect the potential for future cash flows and as a result, remeasurements do provide predictive value.

In certain circumstances, remeasurements could also fall into the “non-core” bucket. For example, for a manufacturing company that invests its excess cash in a portfolio of securities, management may consider the remeasurement gains or losses on those securities as “non-core.”

Applying the concept

How might the framework be applied?

The FASB could develop a performance reporting framework that would require identification of infrequent items, non-core items, and remeasurements. These items could either be presented as separate sub-totals on the income statement or disclosed in a structured tabular format in the financial statement footnotes to drive consistency and accessibility. These amounts could be accompanied by qualitative disclosures describing the nature of the items and judgments made by management so that users of the financial statements can make their own assessments about how to factor the information into their analyses.

Take, for example, restructuring charges. Today, these are often excluded in calculating non-GAAP performance measures such as adjusted EBITDA or adjusted net income and earnings per share. These charges may consist of various types of expenses, including inventory and asset impairments, lease termination costs, and employee severance payments.

In some instances, it may be clear that these costs are one-time in nature. In such instances, the performance reporting framework could permit companies to identify these costs as “infrequently occurring.” Depending on the nature of the costs, the framework might allow them to be separately identified as a single line item on the income statement, supplemented by a disclosure that explains the nature of the costs and why management considers them “infrequently occurring” and/or “non-core.” In other instances, if the nature of the costs doesn’t lend itself to single line presentation in the income statement, the performance reporting framework could permit quantitative and qualitative disclosure in an “infrequently occurring” footnote—doing so in a more structured and complete manner than may typically be reported currently.

In another set of circumstances, restructuring may be something that happens relatively frequently. In this instance, a performance reporting framework might permit a company to consider these costs to be “non-core” because, although they are not “infrequent,” they remain ancillary to the core business operations or lack predictive value because they lack a relation to the current period’s operations. As such, they could still be separately identified. In contrast, based on the performance reporting framework’s guidelines, it may also be possible for these costs to be considered neither “infrequently occurring” nor “non-core.” The FASB’s approach will depend on the feedback gathered from stakeholders as it develops the framework and related guidelines.

In conclusion

We encourage the FASB to add performance reporting to its standard-setting agenda. We recommend that it develop a performance reporting framework that encourages preparers to provide information in a manner that they believe enhances the predictive value of the income statement and its supplemental disclosures and identifies infrequently occurring items, “non-core” items, and remeasurements. Users of the financial statements would receive increased transparency and qualitative differentiation of income statement elements in the context of audited or reviewed financial statements. Preparers would benefit from the ability to present information in a way that is meaningful within the context of their respective industries and in a manner that more closely aligns with how they assess the performance of their business.

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Heather Horn

US Strategic Thought Leader, National Professional Services Group, PwC US

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