Non-GAAP Financial Measures: Canada's Securities Regulators Propose Stricter Rules

Canada's securities regulators are proposing new rules on how companies present non-GAAP financial measures like adjusted earnings, adjusted EBITDA, free cash flow, pro forma earnings, distributable cash, earnings before non-recurring items and others.

The new rules would have the force of law, unlike the existing regulatory guidance on non-GAAP financial measures. This means that the regulators would have stronger compliance and enforcement tools if a company's non-GAAP financial measures are misleading. 

Comments on the proposed rules are due by December 5.

Overview of the Proposed Regime

Because of the ever-evolving nature of non-GAAP disclosures across a range of industries, the regulators decided not to prohibit any particular types of non-GAAP measures or impose any industry-specific requirements. Instead, the rules would formalize and expand on the existing staff guidance.

The new regime would classify financial measures into four mutually exclusive categories: non-GAAP financial measures (which may also be ratios or financial outlooks); supplementary financial measures; segment measures; and capital management measures.

Non-GAAP financial measures would be subject to more stringent requirements than the other three types of measures, as described below. Financial measures presented orally would not be subject to the new rules, but written transcripts of oral statements would be. The proposed companion policy cautions companies that non-GAAP financial measures should not be disclosed through social media channels like Twitter where character limits preclude disclosing all required information.

The key elements of the proposed Canadian rules are substantially the same as the U.S. rules on non-GAAP financial measures. The U.S. regime is similarly prescriptive. That said, the new Canadian regime would be more detailed, especially in light of the examples and guidance in the proposed companion policy.

Non-GAAP Financial Measures

 A non-GAAP financial measure would be defined as:

• a measure of financial performance, financial position or cash flow that is disclosed outside the financial statements and that is not a disaggregation, calculated in accordance with IFRS,¹ of a line item in the primary financial statements, or
• a financial outlook for which no equivalent financial measure is presented in the primary financial statements.

Consistent with existing regulatory guidance, non-GAAP financial measures would have to be labelled appropriately and distinctly from line items, subtotals and totals in the financial statements. The proposed companion policy provides the following examples of expectations for labelling non-GAAP financial measures:

• It would be misleading to present "cash flows from operations," calculated as cash flows from operating activities before changes in non-cash working capital items, because doing so creates confusion with the IFRS item "cash flows from operating activities" in the Statement of Cash Flows.
• A label like "results from operating activities" would be misleading if the measure excluded items of an operating nature, such as inventory write-downs, restructuring costs, impairment of assets used for operations, or stock-based compensation. For resource issuers, the exclusion from operating measures of asset retirement obligations and environmental remediation recovery is unlikely to be permissible.
• A label like "free cash flow" should not be used to inappropriately imply that residual cash is available for discretionary spending, if the company has mandatory debt service requirements or other non-discretionary obligations that have not been deducted.
• Labels like "protected returns" may be overly optimistic and misleading.

Consistent with existing regulatory guidance, non-GAAP financial measures must be presented with no more prominence than the most directly comparable IFRS measure from the financial statements. The proposed companion policy provides the following examples:

• A non-GAAP measure should not appear in a news release headline or caption without the most directly comparable IFRS measure.
• Non-GAAP measures should not be accompanied by commentary, (e.g., "record performance") without equally prominent commentary about the corresponding IFRS measure.
• Graphics or tables should not be used to present non-GAAP measures without similar graphics or tables presenting the corresponding IFRS measures.

The proposed rules on reconciling and explaining non-GAAP financial measures are substantially similar to existing regulatory guidance in respect of the following:

• The first time a non-GAAP financial measure appears in a document such as MD&A or a news release, it must be identified as such (unless it is a ratio of which all financial components either come from the financial statements or are disaggregations, calculated in accordance with IFRS, of line items).
• A non-GAAP measure must be accompanied by a warning that it does not have a standardized meaning and may not be comparable to other companies' similar non-GAAP measures.
• The company must explain how management uses a non-GAAP measure.
• The measure must be reconciled to the most directly comparable IFRS measure. For ratios, the reconciliation requirement may be met by identifying the components of the ratio, describing how it is calculated, and reconciling each component. Alternatively, the ratio itself may be reconciled using the most directly comparable IFRS measure.
• Companies must not describe reconciling items as non-recurring, infrequent or unusual when similar losses or gains are reasonably likely to occur within the next two years or have occurred in the past two years.

The proposed rules and companion policy expand on existing regulatory guidance in the following respects:

• Companies would have to explain how a non-GAAP measure is useful to a reasonable person (as opposed to being useful to an investor).
• The method of calculating non-GAAP measures would have to be explained and disaggregated in a manner that permits a reasonable person to understand each reconciling item.
• Significant management judgements or estimates used in calculating non-GAAP measures would have to be disclosed, along with the circumstances giving rise to reconciling items, e.g., an adjustment for impairment of goodwill should be supported by the cause of the impairment.
• Comparative period non-GAAP measures would have to be presented and reconciled.
• Any period-to-period changes in the label, composition or calculation of a non-GAAP measure would have to be explained.

To satisfy the above requirements, a company could footnote non-GAAP measures the first time they appear in a document and provide the required reconciliations and related disclosures in a different section of the same document. Cross-references to different documents would not be permitted, although website disclosures of non-GAAP financial measures could contain links to the location of the reconciliations and other required information.

Forward-Looking Non-GAAP Measures

The existing regulatory guidance contains a general statement that it covers forward-looking non-GAAP measures. The proposed new rules are more detailed. Forward-looking non-GAAP financial measures (e.g. financial outlooks such as forecasted adjusted earnings or projected free cash flow), would generally be treated the same as historical non-GAAP measures, unless an historical measure equivalent to the financial outlook is presented on the face of the financial statements.

Financial outlooks would have to be reconciled to the most directly comparable item in a forward-looking statement of financial position, statement of comprehensive income or statement of cash flows. Alternatively, if a company does not prepare forward-looking financial statements, the outlook would have to be accompanied by the equivalent historical non-GAAP financial measure and the company would have to either:

• describe each material difference between the financial outlook and the most directly comparable financial outlook for which an equivalent historical measure is presented on the face of the financial statements, or
• describe each significant component of the financial outlook used in its calculation.

Supplementary Financial Measures

Supplementary financial measures are measures that a company discloses periodically—often key performance indicators (KPIs) like same-store sales for a retailer—that are disaggregations, calculated in accordance with IFRS, of line items in the financial statements. Supplementary financial measures would be subject to less onerous requirements compared to those for non-GAAP measures in 1-3 above.

• The first time a supplementary financial measure appears in a document, it would have to be accompanied by disclosure (or a footnote referencing such disclosure) that describes how it is calculated.
• The corresponding measure for the comparative period would have to be provided, if previously disclosed by the company.
• Any period-to-period changes in the label, composition or calculation of the measure would have to be explained.

Segment Measures

The new rules would define a segment measure as a measure of segment profit or loss or segment revenue, expenses, assets or liabilities that is disclosed in the notes to the financial statements. Totals of segment measures would have to be reconciled to the most directly comparable IFRS measure presented on the face of the financial statements. These totals could not be presented with greater prominence than the corresponding IFRS measures, and the comparative period measure must also be presented, if previously disclosed by the company. The additional requirements for non-GAAP measures in 1-3 above would not apply.

Capital Management Measures

The new rules would define a capital management measure as a financial measure that is disclosed in the notes to the financial statements that enables users to evaluate a company's objectives, policies and processes for managing capital.

No requirements would apply to capital management measures that are totals, subtotals or line items on the face of the financial statements or that are merely disaggregations, calculated in accordance with IFRS, of line items.

Other capital management measures would have to be reconciled to the most directly comparable IFRS measure presented on the face of the financial statements. They could not be presented with greater prominence than the corresponding IFRS measures. The first time a capital management measure appears in a document such as MD&A or a news release, it would have to be accompanied by:

• a description of how it is calculated, including whether it is calculated pursuant to a lending or other agreement;
• a statement that its calculation is not determined by IFRS;  
• an explanation of how the measure provides useful information to a reasonable person and any additional purposes for which management uses the measure; and
• the comparative period capital management measure, if previously disclosed by the company.

The additional requirements for non-GAAP measures in 1-3 above would not apply.

Measures in the Financial Statements

Any financial measure that is presented on the face of the primary financial statements would be entirely excluded from the scope of the rules.

Any financial measure disclosed in the notes to the financial statements (other than segment measures and capital management measures) would also be excluded from the scope of the rules. 

Broad Application

The proposed new regime would apply to all issuers, not just reporting issuers, including investment funds.

Foreign issuers whose securities are listed on a U.S. stock exchange or who are otherwise SEC-reporting issuers would not be subject to the new rules. This is consistent with how the SEC treats Canadian MJDS issuers, (i.e., they are generally exempt from the U.S. rules on non-GAAP financial measures).

Other foreign issuers would be subject to Canada's proposed new rules, even if they have minimal Canadian shareholdings and are incorporated in a jurisdiction with sophisticated securities laws, such as the U.K., Germany or Australia. Cross-border compliance burdens will increase for these issuers, to the extent the new Canadian rules are more onerous than their home country’s rules on non-GAAP measures. This approach to regulation is at odds with the current treatment of designated foreign issuers, which are generally exempt from many Canadian securities laws.

Recommended Steps for Companies

The proposed rules are subject to comment by market participants and may be revised by securities regulators before being finalized. The rules will not be retroactive, and a transition period will likely be provided to give companies time to prepare amended or new disclosures of non-GAAP and other financial measures. We recommend that companies begin reviewing their disclosure documents, such as MD&A and news releases, as well other materials like investor relations documents and website content, with a view to eventual compliance with a more onerous regime. Companies should determine whether their existing non-GAAP disclosures would be treated as non-GAAP financial measures, supplementary financial measures, segment measures or capital management measures to help identify which rules would apply and any current gaps in the company's practices compared to what the new rules would require. Doing this work will enable companies to develop a strategy for amending, if necessary, how they present financial measures once a new regime is adopted.

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¹ International Financial Reporting Standards as issued by the International Accounting Standards Board, which is the GAAP required to be used by most Canadian public companies. If an issuer uses a different GAAP, such as U.S. GAAP, references in this bulletin to IFRS may be read as references to the other GAAP.