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Standards needed for computation and audit of non-GAAP measures
July, 19th 2007

In India, disclosure of non-GAAP measures is not very widespread, but they are steadily gaining in popularity.



D. Murali
C. Ramesh

Making non-GAAP measures routinely available to investors will provide a powerful incentive to managements to manage their companies in a way that would be beneficial in the long term, says Mr Dolphy DSouza, Partner, Ernst & Young.

Non-GAAP financial measures, for starters, can be numbers or ratios based on amounts that may be different from what are used for computing measures disclosed as per GAAP (generally accepted accounting principles).

For instance, economic value added is a financial non-GAAP measure, while employee turnover is a non-financial, non-GAAP measure. In contrast, EPS (earnings per share) is an example of a GAAP measure.

On non-GAAP measures and the need to popularise them in India, he said that investors and analysts are increasingly using these intangible attributes for their analysis of the true worth of a company.

According to him, the financial and non-financial measures derived from non-GAAP related information could provide insight into a company that a financial statement might not, as they are focused on the past and not the potential.

Having said that, it becomes important to have standards for disclosure and audit of non-GAAP measures, since there is always a possibility of non-GAAP measures being misused in order to show high value of a company.

Mr DSouza said that in the long run, more non-GAAP information some or much of which may be industry-specific customised to the user and which can be accessed far more frequently would be required.

Consider a retailer with strong growth in reported income, achieved largely by expansion of outlets in different countries, but with decline in repeat purchases by customers. The latter statistics would be a signal to investors that the companys stock merits a sell rather than a buy.

He added: Or imagine a pharmaceutical company that has a bad balance sheet but several blockbuster drugs approved by the FDA to be rolled out. Such a company may deserve a strong buy recommendation.

In his view, mandatory disclosure of non-GAAP measures can have several ramifications.

For instance, a company may have achieved rapid growth by putting employees under tremendous pressure. This may not reflect in the near term income numbers, but the dissatisfaction would be revealed by excessive employee turnover or unutilised leave. If this situation is not corrected, the future profitability of the company would be severely affected.

In such a scenario, disclosure of non-GAAP measures would force the management to consider a more appropriate employee policy, which in turn would ensure a stable long-term result. Besides, there is nothing better than having a satisfied workforce.

On the hurdles in making non-GAAP measure disclosures mandatory, he said that in 1998, the FASB had established working groups to look into the issues.

But many public companies opposed the efforts to require these additional disclosures, on the grounds of cost and potential liability. To develop a new reporting model along these lines will require a global conversation of investors, users, prepares, regulators and standard-setters.

In India, disclosure of non-GAAP measures is not very widespread, but they are steadily gaining in popularity.

Some 65 per cent of the Global 250 largest companies issue corporate sustainability reports, but only a marginal percentage of listed companies in India do so.

In a recent survey conducted by Ernst & Young, CFOs of Indian companies recommended that annual reports include non-GAAP measures such as proforma reporting, HR and brand valuations, environmental reporting, corporate social responsibility statements and economic value added analysis.

However, they also expressed concern that these measures could be misused.

According to Mr DSouza, to popularise these measures, a dialogue must take place between companies, SEBI, investors, and the ICAI.

Industry-specific measures should be identified after consultation with the relevant industry bodies.

He also called upon the ICAI to develop appropriate guidance for computation and audit of the various non-GAAP measures.

Besides, he suggested that the disclosure of non-GAAP measures could initially be recommendatory.

The disclosure can be made mandatory once there is wide-scale acceptability. India should take a lead in this area rather than wait for global changes to first take place.

MR DOLPHY DSOUZA, PARTNER, ERNST & YOUNG
 
 
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