Improved Communication With Supplementary Financial Measures

Draft for Comment

General Principles and

Guidance for Reporting Net

Free Cash Flow and EbiTda

improve

d Communication

with Supplementary

Financial Measures

Improved Communication with Supplementary Financial Measures

General Principles and Guidance for Reporting Net Free Cash Flow and Ebitda

© 2013 Chartered Professional Accountants of Canada

All rights reserved. This publication is protected by copyright and written permission is required to reproduce, store in a retrieval system or transmit in any form or by any means (electronic, mechanical, photocopying, recording, or otherwise).

For information regarding permission, please contact [email protected].

This publication may be downloaded at www.cica.ca/cpr.

ISBN 978-1-55385-757-0

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PREFaCEImproved Communication with Supplementary Financial Measures – General Prin-ciples and Guidance on Reporting Net Free Cash Flow and EBITDA is published by CPA Canada’s Canadian Performance Reporting Board (CPRB). It contains general principles for reporting supplementary financial measures, which it defines as those financial measures not specifically identified with a GAAP framework.1 As well, it sets out recommendations specifically directed at reporting Net Free Cash Flow and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). The guidance should be useful wherever these measures are publicly reported. This may include the financial statements, the Management’s Discussion and Analysis (MD&A), the Annual Report, or press releases.

This guidance consolidates and updates two previous publications: Reporting Supple-mentary Financial Measures and Improved Communication with Non-GAAP Financial Measures. A summary of significant differences between the publications is set out in the Appendix to this material.

Supplementary financial measures have become increasingly popular among preparers and investors who find they provide additional insight into an entity’s performance and financial condition. Indeed, the popularity of such measures extends beyond general purpose financial reporting and many financial agreements contain conditions that are determined by reference to supplementary financial measures.

One of the major issues with respect to supplementary financial measures is the lack of consistent definitions governing their calculation and disclosure, even among entities in the same industry. This lack of standard definitions is one reason that regulators have restricted the use of some measures in financial statements and require extensive disclosure and reconciliations. However, the widespread use of such measures, even given such inconsistencies, indicates that users believe they have value. Investors have indicated that while they would prefer some degree of standardization in supplementary financial measures, they will likely continue to use non-standardized entity-specific information.

1 In the terminology of the Canadian Securities Administrators, supplementary financial measures comprise additional GAAP measures in IFRS financial statements and non-GAAP financial measures outside financial statements.

IMPROVED COMMUNICATION WITH SUPPLEMENTARY FINANCIAL MEASURES


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The adoption of the International Accounting Standards Board’s (IASB) International Financial Reporting Standards (IFRSs) by publicly accountable entities in Canada has introduced a new issue with respect to such measures. A specific requirement of International Accounting Standard (IAS) 1 is to present additional items in the financial statements when this is relevant to understanding an entity’s financial performance or financial position, including information in the notes that is relevant for an understanding of any of the financial statements.2 This has led many preparers to consider reporting within the financial statements measures that hitherto were only considered for the MD&A, for example EBITDA.

At the same time, the Basis for Conclusions of IAS 1 contains cautionary language concerning the exclusion of items from any sub-total described as “operating activi-ties”. It notes that excluding items “on the grounds that they do not involve cash flows, such as depreciation and amortization expenses” would be inappropriate, as would excluding items clearly related to operations “because they might occur irregularly or infrequently or are unusual in amount.”

The Canadian Securities Administrators (CSA) provide guidance in CSA Staff Notice 52-306 (Revised) – Non-GAAP Financial Measures and Additional GAAP Measures (CSA Staff Notice). The CSA Staff Notice recognizes the above-noted IAS 1 require-ments and sets out practices when presenting additional GAAP measures in IFRS financial statements and disclosures that should accompany non-GAAP financial measures. The CSA Staff Notice also specifically discusses the use of EBIT and EBITDA, “Results from Operating Activities”, “Adjusted Statement of Comprehensive Income” and additional columns in presentation of the results of operations.

The United States Securities and Exchange Commission (SEC) also has material about non-GAAP financial measures, primarily in Regulation G. It should be noted, however, that the SEC’s guidance generally forbids the presentation of supplementary financial measures in US GAAP-compliant financial statements.

Beyond the IASB’s statements and the securities regulators’ materials there is little guidance governing the criteria for determining whether and where a supplementary financial measure should be reported and its calculation, presentation, and disclo-sure. Accordingly, this CPRB material aims to provide guidance about reporting supplementary financial measures outside the financial statements when permitted

2 IAS 1, paragraphs 55, 85, and 112 (c).

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PREFACE

Draft for Comment

by a jurisdiction’s securities regulations and within financial statements prepared in accordance with IFRSs.

In view of the widespread use of supplementary financial measures and their lack of comparability, the CPRB believes it is useful to provide guidance on two questions:1. What are the specific considerations – such as what, when and where – that

govern whether supplementary financial measures can be externally reported, either outside the financial statements or within IFRS financial statements?

2. If supplementary financial measures are reported outside the financial statements or within IFRS financial statements, what specific presentation, measurement and disclosure issues need to be considered?

Accordingly, this guidance sets out a disclosure framework to enable entities to determine where a measure should be reported. It also gives definitions for standard-ized measures of Net Free Cash Flow and EBITDA and contains presentation and disclosure considerations for Net Free Cash Flow and EBITDA. The improved comparability and transparency resulting from applying the disclosure framework should lead to more transparent supplementary financial measures and additional clarity for investors.

Part I of this guidance provides some general guidelines that apply to the decision to publish supplementary financial measures. Parts II and III address the application of the general guidance to Net Free Cash Flow and EBITDA.

This guidance reviews matters that the CPRB believes should be considered when an entity decides to report supplementary financial measures. It is not a substitute for either the IASB’s requirements for reporting supplementary financial measures within IFRS financial statements or securities regulators’ application guidance. While not directly aimed at the needs of users of financial statements, the CPRB guidance should also help users understand the strengths and weaknesses of supplementary financial measures when used in the analysis of financial reports.

The CPRB recognizes that supplementary financial measures are an area where little standard “good practice” exists. Accordingly, this guidance is presented as a draft for comment until July 31, 2013. While comments about any area of the guidance



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are encouraged, the CPRB would especially appreciate comments on the following matters:1. The criteria for relevance for additional GAAP measures and non-GAAP financial

measures.2. The criteria for faithful representation for additional GAAP measures and non-

GAAP financial measures.3. The inclusion of and criteria for verifiability for additional GAAP measures and

non-GAAP financial measures.4. The components for Standardized Net Free Cash Flow.

Please send comments to: Chris Hicks, CPA, CA Principal, Research, Guidance and Support CPA Canada 277 Wellington Street West Toronto, ON M5V 3H2

[email protected]

February, 2013

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CoNtENts

PART I: General Guidance on Supplementary Financial Measures

i.1 Nature and objective of supplementary Financial Measures .................................................................................................................. 1

i.2 Relationship of CPRb Guidance to securities Regulators’ Requirements ............................................................................. 2

i.3 Qualitative Characteristics of Useful Financial information ...... 2

i.4 interpreting the Qualitative Characteristics in Practical terms ...............................................................................................5

i.5 Categorization as an additional GaaP Measure or a Non-GaaP Financial Measure .......................................................... 7

i.6 supplementary Financial Measure Presentation and disclosure ....................................................................................................11

PART II: Application to Specific Measures: Net Free Cash Flow

ii.1 Free Cash Flow and Net Free Cash Flow ............................................15

ii.2 applying the Qualitative Characteristics of the Conceptual Framework ...................................................................17

ii.3 Net Free Cash Flow as an additional GaaP Measure or a Non-GaaP Financial Measure ....................................................... 22

ii.4 the Presentation and disclosure of Net Free Cash Flow ......... 24

PART III: Application to Specific Measures: EBITDA

iii.1 Ebitda ....................................................................................................................31

iii.2 applying the Qualitative Characteristics of the Conceptual Framework ...................................................................31

iii.3 Ebitda as an additional GaaP Measure or a Non-GaaP Financial Measure ....................................................... 33

iii.4 the Presentation and disclosure of Ebitda ................................... 35

APPENDIX

differences from Previous CPRb Guidance .................................................. 41

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PaRt i: GENERal GUidaNCE oN sUPPlEMENtaRy FiNaNCial MEasUREs

I.1 NATuRE AND OBjECTIvE OF SuPPlEMENTARy FINANCIAl MEASuRESMost financial reporting frameworks, such as IFRSs and US GAAP, specify particular items to be reported in the financial statements. For example, International Accounting Standard (IAS) 1 Financial Statement Presentation specifies the minimum line items to be presented in reporting comprehensive income. As well, however, IAS 1 requires entities to present additional line items, headings and sub-totals when they are relevant to an understanding of financial performance or financial position, and information in the notes that is not presented elsewhere but which is relevant to an understanding of any of the financial statements.

Supplementary financial measures are those financial measures that are not specifically identified by a GAAP framework. They fall into two categories. The first category comprises financial measures reported outside the financial statements in communications such as Management’s Discussion and Analysis (MD&A). These are usually referred to as “non-GAAP financial measures”. The second category comprises those measures under IFRSs that have sufficient attributes to be reported as additional items within the financial statements, as noted above. These are referred to by the Canadian Securities Administrators (CSA) as “additional GAAP measures.”1

Unlike measures prescribed by an accounting framework, supplementary financial measures do not have generally accepted definitions. In addition, supplementary financial measures frequently use selective information in that they either omit amounts from a GAAP measure or add in amounts omitted from a GAAP measure. As well, their calculation may involve

1 CSA Staff Notice 52-306 (Revised) – Non-GAAP Financial Measures and Additional GAAP Measures.



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subjective assumptions, judgments, and estimates that are not required by an entity’s GAAP. Supplementary financial measures involve a range of levels of complexity and subjectivity in their construction. For example, many entities report a supplementary financial measure such as profit before tax expense as a separate financial statement line item, being the sum of the specified IFRS amounts “tax expense” and “profit or loss” (assuming no discontinued operations). On the more complex side, some entities report supplementary financial measures involving amounts that are not defined by any measure-ment criteria, for example “maintenance capital expenditures”.

Many supplementary financial measures are widely used by management and investors, for example EBITDA, Distributable Cash, and Free Cash Flow. Such measures are believed to provide management and users of financial reports with additional analytical insight into an entity’s performance and financial condition, expanding on the information stipulated by the GAAP framework. The importance of such measures is further illustrated by their use outside of financial reporting in debt covenants, executive compensation plans, and purchase and sale agreements. Moreover, in interviews, preparers and investors express the belief that supplementary financial measures provide incremental information value beyond that found in stipulated financial statement disclosures.

I.2 RElATIONShIP OF CPRB GuIDANCE TO SECuRITIES REGulATORS’ REquIREMENTSEntities should follow the practices and disclosures for non-GAAP financial measures and additional GAAP measures that are set out by securities regula-tors in CSA Staff Notice 52-306 (Revised) — Non-GAAP Financial Measures and Additional GAAP Measures (CSA Staff Notice). The CPRB believes that Improved Communication with Supplementary Financial Measures will expand on the CSA material and provide a framework for disclosure.

I.3 quAlITATIvE ChARACTERISTICS OF uSEFul FINANCIAl INFORMATION In the CPRB’s view, a useful basis for analyzing the qualities of additional GAAP measures and non-GAAP financial measures is the International Accounting Standards Board’s Conceptual Framework For Financial Reporting

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PART I: GENERAl GuIDANCE ON SuPPlEMENTARy FINANCIAl MEASuRES

Draft for Comment

(Conceptual Framework). The IASB states that the qualitative characteristics in that framework apply to information in financial statements as well as to other financial information. The CPRB believes this should include reports such as the MD&A and accordingly the framework can be applied to both additional GAAP measures and non-GAAP financial measures.

The Conceptual Framework identifies two fundamental qualitative charac-teristics that are prerequisites for the provision of financial information, and four enhancing qualitative characteristics. The fundamental characteristics are that the information be relevant and faithfully represent the phenomenon that it purports to represent. This latter quality requires that the measure be complete, neutral, and free from error.

The Conceptual Framework provides the following discussion of the funda-mental qualitative characteristics of relevance and faithful representation.



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The following are exTraCTs from The ifrs ConCepTual framework

relevance

Relevant financial information is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources.

Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value or both.

Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. Financial information need not be a prediction or forecast to have predictive value. Financial information with predictive value is employed by users in making their own predictions.

Financial information has confirmatory value if it provides feedback about (confirms or changes) previous evaluations.

faithful representation

Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. To be a perfectly faith-ful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximize those qualities to the extent possible.

A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. For example, a complete depiction of a group of assets would include, at a minimum, a description of the nature of the assets in the group, a numerical depiction of all of the assets in the group, and a description of what the numerical depiction represents (for example, original cost, adjusted cost or fair value). For some items, a complete depic-tion may also entail explanations of significant facts about the quality and nature of the items, factors and circumstances that might affect their quality and nature, and the process used to determine the numerical depiction.

A neutral depiction is without bias in the selection or presentation of financial informa-tion. A neutral depiction is not slanted, weighted, emphasized, de-emphasized or otherwise manipulated to increase the probability that financial information will be received favourably or unfavourably by users. Neutral information does not mean information with no purpose or no influence on behaviour. On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions.

Faithful representation does not mean accurate in all respects. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. In this context, free from error does not mean perfectly accurate in all respects. For example, an estimate of an unobservable price or value cannot be deter-mined to be accurate or inaccurate. however, a representation of that estimate can be faithful if the amount is described clearly and accurately as being an estimate, the nature and limitations of the estimating process are explained, and no errors have been made in selecting and applying an appropriate process for developing the estimate.

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Draft for Comment

These “fundamental” qualitative characteristics are necessary for financial information to be “useful”. In addition, the four enhancing qualitative characteristics should improve the usefulness of financial information. These characteristics can be summarized as follows: • Comparability: This enables users to identify and understand similarities

and differences among items. Consistency in the use of the same methods for the same items helps achieve the goal of comparability.

• Verifiability: Different knowledgeable and independent observers could reach consensus that a particular depiction is a faithful representation.

• Timeliness: Information should be available in time to be capable of influencing decisions.

• Understandability: Information should be classified, characterized, and presented clearly and concisely for users who have a reasonable knowledge of business and economic activities and who are diligent in the review and analysis of financial information.

All of these characteristics are subject to a constraint that the cost of obtaining and processing the information must be justified by the benefits obtained by reporting that information.

I.4 INTERPRETING ThE quAlITATIvE ChARACTERISTICS IN PRACTICAl TERMSThe qualitative criteria in the Conceptual Framework are expressed abstractly. That framework suggests that these criteria are applied by identifying informa-tion concerning an “economic phenomenon” that would be useful to users of an entity’s financial reports, identifying the type of information about the phe-nomenon that would be relevant and capable of faithful representation, and then seeing if information is available with those qualities. For supplementary financial measures, the measures have already been identified and are being communicated by preparers. The issue is whether those measures have any meaning (an attribute of relevance), that is, actually represent a phenomenon, as well as meeting the other fundamental and enhancing qualitative criteria expressed in the Conceptual Framework.

To interpret these criteria in practical terms, this guidance assesses the qualita-tive characteristics in terms of who uses the measure and the purpose for which it is used.



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RelevanceRelevance is defined in the Conceptual Framework as an attribute of informa-tion that is “capable of making a difference in the decisions made by users.” To be relevant, therefore, a measure’s depiction of an economic phenomenon should have the potential to affect users’ decisions and evaluations of an entity.

For practical purposes, a measure can affect users’ decisions and evaluations when it is used: • by management to allocate and/or assess the financial performance of

allocated resources to specific projects or activities;• in the entity’s industry to assess performance or to estimate the values of

businesses bought or sold; and• by investors to assess performance and estimate value.

A measure that is used for all three purposes is clearly relevant.

Faithful RepresentationFaithful representation is the quality of a measure that makes it complete, neutral, and free from error. In practical terms, the CPRB believes a supple-mentary financial measure would be:• complete, when it is not in need of “adjustment” or “complementary

information” to have meaning for users;• neutral, when it is relatively incapable of being slanted, weighted, or

manipulated to obtain a desired result or to generate a desired inference; • free from error, when the components that it purports to represent

comprise the measure, and it is as free as practicable from significant uncertainty or estimation error; and

• described in an explicit caption that is not ambiguous or misleading in what it purports to include or exclude.

Generally, when all these attributes are present in a measure, it faithfully represents what it purports to report.

Enhancing CharacteristicsA supplementary financial measure’s usefulness is enhanced when the measure is:

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• comparable, by being prepared on a consistent basis from entity to entity and in a consistent fashion from period to period;

• verifiable, by being presented in accordance with recognized criteria or with sufficient information to enable an observer to see that a measure is complete, neutral and free from error;

• timely, by being available at the same time as other elements of financial reports; and

• understandable, in that users who follow the entity’s activities should be able to comprehend the measure’s construction and limitations.

This guidance considers factors to consider in determining verifiability. As well, the disclosures it advocates should contribute to comparability and understandability. Timeliness is not addressed as it is a consideration of the financial reports in which supplementary financial measures reside, rather than the supplementary financial measures themselves.

I.5 CATEGORIzATION AS AN ADDITIONAl GAAP MEASuRE OR A NON-GAAP FINANCIAl MEASuREAs noted above, IFRSs require entities to present additional items in the finan-cial statements when they are relevant to understanding an entity’s financial performance or financial position, including information in the notes that is relevant for an understanding of any of the financial statements. There are many potentially relevant measures, however, some of which are subjective or impossible to define outside an entity’s specific situation, such as non-recurring events.2 Many such measures are in regular use outside of financial statements. Accordingly, the question arises as to how to assess whether a measure has the necessary attributes for presentation in IFRS financial statements or whether the financial information should only be presented outside of the financial statements, such as in the MD&A, or in conjunction with other information distributed by an entity.

2 The CSA Staff Notice states “In staff’s view, non-GAAP financial measures generally should not describe adjustments as non-recurring, infrequent, or unusual, when a similar loss or gain is reasonably likely to occur within the next two years or occurred during the prior two years.”



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To be relevant, a measure needs to have the potential to affect users’ decisions and evaluations of an entity. In the CPRB’s view, this condition exists for an additional GAAP measure in IFRS financial statements when it is used by the entity’s chief decision makers in explaining value drivers, liquidity, or performance.3 These criteria are similar to those employed by the IFRSs in determining whether a component of an entity constitutes an operating segment, and in determining the segment’s reported performance measure.

Financial statements provide an objective perspective of the financial perfor-mance and financial position of an entity, presented in accordance with all the principles of an accounting framework. These attributes need to be considered in determining whether an additional GAAP measure meets the test of faithful representation with qualities sufficient to be included in IFRS finan-cial statements. In practical terms, faithful representation should exist when a measure’s components are defined with the same precision as other elements of the financial statements. Therefore, a reasonable basis for concluding that a measure is representationally faithful is that the components are defined by IFRSs (i.e., an item of revenue, expense, asset, or liability defined by IFRSs).

As well, the caption used to describe the measure should not be ambiguous or misleading in what it purports to include or exclude. Accordingly, an additional GAAP measure should be described in terms that: • distinguish it from minimum IFRS disclosure requirements; • are meaningful given its composition; and• clearly explain which IFRS components it includes and excludes.

When the caption for an additional GAAP measure is not expressed in terms of its IFRS components, the measure should be defined in a way that identi-fies those components and the caption used to describe the measure should be consistent with those components. The word “adjusted”, per se, does not satisfactorily identify omitted or added components.

Verifiability — the ability of knowledgeable users to reach consensus that a measure provides a faithful representation of what it purports to depict — is another important characteristic for financial statements. This characteristic

3 To be relevant for inclusion in the financial statements, a measure should also comply with the CSA’s practices and, in the CPRB’s view, the tests for faithful representation and verifiability discussed below.

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Draft for Comment

should exist when knowledgeable users can identify the components of a measure and understand that they are defined by IFRSs. Accordingly, if not clear from a measure’s caption, the financial statements should state that the components of any additional GAAP measures are determined in accordance with specific IFRSs.

In the CPRB’s view, if an entity can demonstrate that a measure is relevant, faithfully represents the information it purports to report, and is verifiable, as discussed above, then there is a good argument supporting its inclusion in the financial statements as an additional GAAP measure provided it also satisfies the practices set out in the CSA Staff Notice. A measure that meets these tests will likely also be presented in a manner that is relevant, reliable, comparable, and understandable, as contemplated by IAS 1.4

In the CPRB’s view, supplementary measures presented outside the financial statements do not need to meet the same objective criteria as additional GAAP measures. While non-GAAP financial measures still need to meet the test of fair presentation, the tests of relevance, faithful representation, and verifi-ability can be less rigourous and considered from the perspective of providing management’s views.

The CPRB believes a measure used by an entity’s chief decision makers would normally be relevant for reporting as a non-GAAP financial measure. Some-times, however, a measure not used by management is nevertheless seen to be useful by investors. Management may then want to present the measure, and would need to facilitate communications with investors about the components of the measure. Accordingly, in the CPRB’s view, an alternative practical test for relevance of a non-GAAP financial measure is whether it is requested by knowledgeable investors.

A non-GAAP financial measure will often include adjustments for items not specified by rules set out in the entity’s accounting framework, and accordingly may not be defined and calculated with the same completeness and neutrality as an additional GAAP measure. In these circumstances, to be a faithful representation, two matters need consideration. First, in view of the absence of an accepted definition, the measure, if portrayed as one used

4 IAS 1, paragraph 17(b).



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internally by management, should comprise the same components as that actually used by management; or, if it is a measure requested by investors, it should comprise the components that management believes investors need. Any adjustments between the measure used in management of the entity and its reported amount should be disclosed and explained.

Second, any reported non-GAAP financial measure should be supplemented with a discussion about any assumptions, judgments, and estimates used in calculating the measure and other information necessary to understand any limitations in the measure’s completeness or neutrality. Such additional disclosure should include an explanation of what the measure represents to management, the components involved in its construction, how those components were calculated, including the assumptions made, how any estimates were formulated, and the implications for items excluded from a measure. For example, when a measure adds back “non-recurring” costs, but not corresponding “non-recurring” revenues, this obvious lack of completeness should be explained. Similarly, a measure’s limitations should be explained by discussing how changes in items included in the measure are correlated with changes in items that have been excluded from it. For example, an explanation should be provided if a measure includes labour costs that have been benefi-cially reduced by the introduction of automated equipment, but that measure excludes depreciation cost on that equipment.

For a non-GAAP financial measure to be verifiable, an entity should communicate information that will enable knowledgeable observers to reach a consensus that it is a faithful representation of what it purports to report. This will be achieved by providing a reconciliation of the measure to the nearest GAAP measure, and by showing each adjustment, and its purpose, together with the above noted disclosures about estimates, assumptions, completeness, and neutrality.

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I.6 SuPPlEMENTARy FINANCIAl MEASuRE PRESENTATION AND DISClOSuRE

Characteristics of Supplementary Financial MeasuresAs noted above, supplementary financial measures, especially non-GAAP financial measures, will have one or more of the following three character-istics: lack of a standard definition, selectivity, and subjectivity. The CPRB believes an entity that complies with the following principles of presentation and disclosure should address any concerns with these characteristics. The presentation and disclosure of such measures should:• comply with securities regulators’ application guidance such as the

disclosures set out in the CSA Staff Notice;• state management’s purpose for providing the measure;• when available, present a “Standardized Measure” in addition to any

“Adjusted Measure” that deals with entity-specific adjustments;• unless presented as a sub-total within a particular financial statement,

provide a reconciliation to the nearest GAAP measure;• discuss the effects of selectivity, i.e., inclusions and exclusions of items in

the measure, and the reason for it; • discuss the basis for any subjective determinations and judgments;• discuss how items excluded from a measure relate to the entity’s overall

performance, financial position, and/or liquidity; and• avoid misleading titles or financial references.

The following detailed presentation and disclosure guidance expands on these principles.

Presentation and Disclosure Guidance for Supplementary Financial Measures

General

An entity may present a measure in its financial reports using the same title but different components than other entities, for example, a Free Cash Flow measure including entity-specific components. Accordingly, in view of the absence of standard definitions, an entity should:



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• disclose the definition of any supplementary financial measure it presents; • state that the measure is unlikely to be comparable to measures described

using the same term (or similar terms) used by other entities;• avoid presenting a supplementary financial measure with more prominence

than the most directly comparable GAAP measure; • calculate a measure in accordance with its definition and title, and not

include or exclude items that are not self-evident from the title of the measure; and

• label measures in unambiguous terms that are not capable of being confused with defined IFRS terms.

Purpose

When an additional GAAP measure is reported, the financial statements should explain how management uses the measure. Correspondingly, the purpose for a non-GAAP financial measure should be discussed. When a non-GAAP financial measure is reported, but not used by management, this should be stated.

Presentation of standardized measures as well as any entity-specific adjustments

Some users have indicated that the process of comparing and assessing perfor-mance would be improved if there were standard definitions for supplementary financial measures, even though other users note that they use entity-specific information conveyed by adjusted measures. Accordingly, Parts II and III of this guidance propose standardized definitions for Net Free Cash Flow and EBITDA to provide a basis for comparison between entities. When entities make entity-specific adjustments to such measures, this guidance also advocates disclosing them as adjustments to the standardized amount. This would provide both comparability and entity-specific information and minimize users’ effort needed to understand the entity-specific amount.

Provide a reconciliation to the nearest GAAP measure

An entity-specific measure should be reconciled to the standardized measure (if applicable) and the nearest GAAP measure in the financial statements. For each adjustment, the corresponding item in the financial statements should be identified, located, and quantified. In addition, subjective terms such as “non-recurring” or non-standardized items such as “same-store” in “same-store sales” should be defined. Further, an entity should disclose the consistency

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of the calculation of such subjective amounts. When a change is made to the components of a measure, the change should be explained and comparative amounts should be presented in accordance with the new basis. Consistency should also be considered in terms of the measure’s calculation in the period. For example, when a measure includes a “non-recurring” or “non-cash” item, the entity should consider disclosing whether it has applied the same criteria to all other items in the measure or has been selective in its application.

In some cases, the issue may not be so much one of consistency of application as one of nomenclature. For example, some entities report restructuring expenses incurred after a business combination as non-recurring. This is presumably based on the assumption that business combinations are not an ongoing part of business operations. However, other business combinations may occur, and restructuring expenses may be incurred repeatedly. It is suggested that such items should be labelled “expenses associated with a business combination”. This would provide more predictive insight by users into the circumstances in which similar expenses may recur.

The effects of selectivity and the reason for it

Selectivity generally applies when a supplementary financial measure eliminates an item from a measure specified by the accounting framework, for example IFRSs. Accordingly, the definition and purpose for providing an adjustment should be explained, including the economic phenomenon presented by including or excluding an item from a GAAP measure.

For example, an entity may eliminate an expense such as depreciation from an income measure because it believes depreciation is not a useful representation of the costs of consuming capital assets. Other reasons might include the fact that the entity does not intend to incur new investment in that particular business. Or the expense is omitted because it is a sunk cost and the entity’s management believes that the difference between revenues and variable costs is the most significant short-term performance measure.

The basis for subjective determinations and judgments

The disclosure of significant accounting assumptions, estimates, and judg-ments is an integral part of IFRSs. Accordingly, any assumptions, estimates and judgments in an additional GAAP measure should already be disclosed. When reporting a non-GAAP financial measure, any significant assumptions,



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estimates and judgments should also be disclosed, for example, judgments made in determining maintenance levels of capital expenditures.

Discussion and analysis of supplementary financial measures

The MD&A should provide context for supplementary financial measures by discussing matters that the measure includes or excludes to provide aware-ness about other factors that may need to be considered in assessing overall performance. Matters included or excluded from a measure may be the most significant contributors to the change and their implications need to be discussed to avoid misleading inferences. For example, the MD&A should discuss any implications for future performance when a decrease in capital expenditures results in an increase in Free Cash Flow.

Specific considerations for additional GAAP measures

When an additional GAAP measure is to be reported on the face of an IFRS financial statement, it should be a natural sub-total of a sequence of items disclosed in the financial statement provided it complies with the application guidance in the CSA Staff Notice. The CSA Staff Notice states that it would be misleading if EBITDA excluded amounts for impairment losses, restructur-ing expenses, or fair value changes. When an additional GAAP measure is reported in the notes to IFRS financial statements, the note should cite the various GAAP inclusions and exclusions in the measure.

In addition, an additional GAAP measure should be accompanied by discus-sion and analysis in the MD&A.

This discussion has considered some general principles for disclosing supple-mentary financial measures. Parts II and III of the guidance consider the application of these general principles to Net Free Cash Flow and EBITDA, including suggestions for standardized definitions for these measures.

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PaRt ii: aPPliCatioN to sPECiFiC MEasUREs: NEt FREE Cash Flow

II.1 FREE CASh FlOw AND NET FREE CASh FlOwFree Cash Flow is a theoretically-developed measure that is used in calculat-ing “enterprise value”, which is the value of an entity’s assets irrespective of financing arrangements. Free Cash Flow is defined as the entity’s periodic cash flow from operating activities, before the after-tax cost of interest, and after deducting capital expenditures and other asset acquisitions.5

ROLE OF FREE CASH FLOW IN VALUATION

Cash Balances

Present Value of Free Cash Flow

Present Value of Dividends

Present Value of Share Buybacks

ContinuingOperations

Market Valueof

Enterprise

Market Valueof

Debt

Market Valueof

Shares

DiscontinuedOperations

Market Valueof

Enterprise

Market Valueof

Debt

Market Valueof

Shares

TotalEnterprise

Market Valueof

Enterprise

Market Valueof

Debt

Market Valueof

Shares

Free Cash Flow: - cash collected from customers - cash paid to suppliers (including employees) - capital expenditures and other asset acquisitions

Free Cash Flow is not necessarily a pure cash flow measure. In order to estimate enterprise value from Free Cash Flow, it is necessary to deduct all

5 See Financial Statement Analysis and Security Valuation, Fifth Edition, Stephen H. Penman, chapter 4.



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asset acquisitions, regardless of the source of funding. Thus assets acquired by the non-cash issuance of shares and assumption of debt would be subtracted from operating cash flows as if they had been paid in cash. This could easily result in large negative amounts of Free Cash Flow in periods in which busi-ness combinations occur. This may cause some concerns as investors generally prefer to see positive amounts of Free Cash Flow. However, in theory, negative Free Cash Flow should not be a concern: the measure is intended to be applied in a multi-period environment where single-period negative Free Cash Flows from such investments are expected to generate subsequent multiple years’ inflows. However, while the term Free Cash Flow is often used in financial reports, it is rarely constructed in this manner. Despite the theory, preparers view business combinations as a use of Free Cash Flow, not an element of its definition.

Variations on the definition of Free Cash Flow involve rearranging the enterprise value equation. For example, assuming the debt is a perpetual amount, Free Cash Flow minus after-tax interest expense can be related to enterprise value less the value of related debt; this, in turn, can be related to the entity’s equity.

As noted, expressing asset acquisitions such as business combinations funded through debt or equity as if they had been acquired for cash will often result in significant negative single period Free Cash Flow measures. These could generate misleading inferences about the entity’s operations unless readers are provided with information about the expectations of future years’ operating cash flows. As well, in a financial reporting context, a measure described in terms of “cash flow” would not be expected to include non-cash items as deemed cash transactions. As a consequence, this guidance focuses on Net Free Cash Flow, an actual cash flow variation of Free Cash Flow that deducts from cash flows from operating activities after-tax interest expense and preferred dividends and actual cash outlays for capital expenditures and other asset acquisitions. Deducting cash outlays for other asset acquisitions provides a measure relevant for common equity valuations in steady-state financing situations that only involve cash funded asset acquisitions. In other circumstances, such as when entities employ share funded asset acquisitions or deleveraging situations, an entity should consider providing sufficient informa-tion to enable an investor to employ the full Free Cash Flow model described

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PART II: APPlICATION TO SPECIFIC MEASuRES: NET FREE CASh FlOw

Draft for Comment

above. The CPRB recognizes that in practice many entities reporting Free Cash Flow treat cash funded asset acquisitions as a use of Free Cash Flow rather than as a component in its computation. Entities would be able to reflect this view by providing an Adjusted Net Free Cash Flow (see below).

II.2 APPlyING ThE quAlITATIvE ChARACTERISTICS OF ThE CONCEPTuAl FRAMEwORk

The Relevance of Net Free Cash FlowThe underlying phenomenon that Net Free Cash Flow is trying to enable investors to estimate is the value of an entity’s assets after adjusting for the cost of its interest-paying liabilities. In a stable state, the discounted amount of Net Free Cash Flow at the entity’s after-tax cost of equity capital will provide an estimate of the value of the entity’s net assets, that is, its aggregate equity (including non-controlling interests). This notion makes sense under two important assumptions: first, that the entity makes those capital investments that are necessary for the maximization of the value of the entity’s assets, and second, that the entity has a liability structure that will be relatively constant, so that after making provision for the periodic after-tax carrying cost of debt, no further payments will be made on account of these liabilities. That is, it is assumed that the entity’s debt structure is constant and the relevant cash flows do not involve repayments of debt. In essence, the principal amount of debt is assumed to be continuously “rolled over.”6

These assumptions would appear to be reasonable for an established entity that is either maintaining or growing capacity through capital investments and maintaining a constant debt to equity ratio. In those circumstances, Net Free Cash Flow, based on cash flows from operating activities adjusted for cash-funded asset acquisitions, is a relevant measure. It is an indicator of the cash flows that are free for use in funding future investments, or making payments

6 It is also implicitly assumed that the interest component of all discounted other liabilities such as asset retirement obligations and pension obligations are likewise stable, which may be reasonable given the other assumptions made.



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to equity holders, whether as dividends or other forms of capital distributions such as share repurchases.

The measure may be less meaningful, however, when an entity is reducing capacity, generating positive cash flows from net dispositions of capital assets and consequently likely to be permanently reducing debt. Nor is it likely to be meaningful for start-up entities with investment requirements that exceed operating cash flows, i.e., entities that have “negative free cash flow”. Even if a start-up entity is projected to have operating cash flows that will in the future exceed its investment requirements, the assumption of constant capital expenditure and debt financing levels would appear to be unrealistic. But for those entities that have achieved a reasonable scale of business and for which debt financing levels appear to be reasonably stable, the measure of Net Free Cash Flow is generally a faithful representation of a relevant underlying phenomenon of interest to investors.

Faithful Representation of Net Free Cash FlowThe qualitative characteristics expected of elements of financial reports, as established in the Conceptual Framework, include the idea that an appropri-ately described measure faithfully represents what it purports to report when it is complete, neutral, and free from error. The following discussion reviews factors to consider in evaluating the extent to which these three qualities exist for Net Free Cash Flow measures.

Complete

There are several issues concerning the completeness of the measure as defined here compared to the underlying phenomenon it is trying to represent.

Operating activities before or after discontinued operationsThe GAAP defined measure “cash flows from operating activities” is the logical starting point for a Net Free Cash Flow measure. Since users are primarily interested in predicting future cash flows, it would appear that discontinued operations would be of little enduring relevance. Hence cash flows from operating activities should be exclusive of the operating cash flow consumed or provided from discontinued operations. It should be noted, however, that any valuation based on a Net Free Cash Flow calculation eliminating discontinued operations needs to consider separately the value of the discontinued operations.

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Working capital and other operating expendituresTo be complete as a cash flow measure, Net Free Cash Flow should reflect the cash consumed or provided by such matters as changes in working capital or Research and Development (R&D) efforts. However, a profitable but rapidly-growing firm that is building inventory levels or spending cash on R&D at a greater rate than it is producing cash flows from its other operating transactions generally exhibits negative Net Free Cash Flow. Taken at face value, this would indicate a negative equity valuation. However, the stable state assumption required to make the measure relevant would not be met: the cash flows expected to be generated would not be completely described by the current period’s levels, and additional data would be needed. On the other hand, mature entities that are generating strong operating margins and maintaining a stable working capital position will likely continue to produce positive Net Free Cash Flow. The current period’s data would then normally be complete.

Capital expenditureSome believe the capital expenditure that is deducted in the computation of Net Free Cash Flow is the expenditure that “must be made” or is critical to the firm. Some definitions consider this to be only those expenditures that are necessary for the maintenance of the firm – known as “maintenance capex.” However, there is no standardized definition for maintenance capital expendi-tures. Furthermore, preparers have noted that sometimes the number used by analysts is not the amount needed for maintenance, but the minimum amount the entity could spend on capex and still survive. Nonetheless, given that the relevant Net Free Cash Flow amount comes from historical results, the aggregate capital expenditure amount should be deducted. Once an amount is spent on capex, it is no longer available for alternative uses. Net Free Cash Flow on an historical basis is thus calculated deducting the actual amount of total capital expenditures. Since the cash re-invested in capital expenditure is of interest, total capital expenditure would be reduced by proceeds from dispositions, other than those of discontinued operations.

Dividends on preferred sharesSince Net Free Cash Flow is that utilized in the valuation of common equity, dividends on any preferred shares not categorized as liabilities would be deducted in arriving at Net Free Cash Flow.



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Business combinationsAs noted above, the CPRB considers cash-funded asset acquisitions to be deductions in arriving at Net Free Cash Flow. When an asset acquisition involves non-cash consideration, the entity should consider following the full Free Cash Flow model.

Another of the anomalies of business combinations is that while the cost of acquisitions is considered as a form of separate expenditure in the cash flow statement, the resulting increase or decrease in periodic cash flows from the acquired operations is not usually separately identified. Under IFRS standards, the full-year effect of business combinations on an entity’s revenues and costs is generally disclosed, allowing users to understand profit on a full-year basis. However, while equivalent adjustments for cash flows would be likewise useful, they are generally unavailable. The best that can be said is that any MD&A analysis of the results of operating cash flows in periods that involve acquisitions, either in the current or comparative period, should either adjust Free Cash Flow to reflect the acquisition’s full year effect in the year of acquisi-tion or state that no adjustments have been made.

ConsolidationAnother issue is whether the measure should be computed on a corporate or on a consolidated basis. Even when an entity’s subsidiaries are wholly owned, the parent may not be able to access the subsidiaries’ cash balances due to, for example, supplier or financing agreements at subsidiaries that mandate maintaining a minimum level of cash in the subsidiary. Restrictions on the ability to access cash are even more likely in partially owned subsidiaries. Thus Net Free Cash Flow at a subsidiary level may not be “free” at a parent level, at least in the sense of being available for general corporate purposes. Hence the consolidated measure of Net Free Cash Flow may in certain circumstances not necessarily be a faithful representation of the cash flows available to the parent entity for use in paying parent dividends. For example, an amount of Net Free Cash Flow at a partially-owned subsidiary may be used to pay dividends to the non-controlling interest. If the objective for the Net Free Cash Flow calculation is to compute a valuation of the parent company’s common equity, consideration should be given to deducting such dividends paid that are included in the scope of any consolidated financial statements.

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The same essential challenge exists, however, with many consolidated financial statement or GAAP measures, such as operating cash flows, or capital expenditures. The best practice in these circumstances may be to disclose Net Free Cash Flow at the parent level and on a segmented basis if the segments reflect the varying degrees of parent ownership. This would be improved if coupled with the disclosure of restrictions about an entity’s ability to access subsidiaries’ cash balances.

NeutralA challenge to the quality of Net Free Cash Flow as a supplementary measure is that the operating cash flows may not be neutral, as they are subject to practices such as delaying the payment of bills or employing other devices for increasing reported operating cash flows when there is no real underlying change in financial conditions. However, such weaknesses are inherent in all measures of operating cash flows. This challenge emphasizes the need for supplementary financial measures such as Net Free Cash Flow to be consid-ered in their entire context rather than in isolation. For example, Net Free Cash Flow should be considered in the context of the entity’s profitability and changes in the entity’s working capital balances.

Free from errorNet Free Cash Flow, as defined, should be free of measurement error. The major components of Net Free Cash Flow are cash measures, relatively free of estimation, whose elements are determined in accordance with a GAAP framework, such as IFRSs. Accordingly, there should generally be little concern about errors in measurement.

verifiability of Net Free Cash FlowSince the components of Net Free Cash Flow are determined with little need for estimation and in accordance with definitions provided by an accounting framework, there should be little difficulty establishing the verifiability of such measures.



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II.3 NET FREE CASh FlOw AS AN ADDITIONAl GAAP MEASuRE OR A NON-GAAP FINANCIAl MEASuREPart 1 of this guidance concluded that, in the CPRB’s view, to be treated as an “additional GAAP measure” that can be included in an entity’s IFRS financial statements:• the measure should be used by the entity’s chief decision makers in

evaluating an entity’s value drivers, liquidity, or performance; • its components should be defined by IFRSs; and • the caption used should be consistent with the measure’s IFRS components.

Net Free Cash Flow as an Additional GAAP Measure The qualitative characteristics of Net Free Cash Flow, as outlined in the preceding discussion, indicate that it is relevant, representationally faithful, and verifiable, although some of these qualities are not without challenge. However, these challenges may be addressed by the disclosure and presenta-tion recommendations provided below. Subject to these presentation and disclosure considerations, the relevance, representational faithfulness and verifiability of Net Free Cash Flow indicate that it can be used as an additional GAAP measure as well as a non-GAAP financial measure.

Net Free Cash Flow does not lend itself to presentation as an additional GAAP measure, however. It is very unlikely that it could be reported on the face of an entity’s IFRS financial statements. The measure is a cash flow measure involving elements of an entity’s operating and investing cash flows, but there is nowhere in the financial statements that conveniently aggregates such amounts. Net Free Cash Flow is drawn from items that appear in the operating, investing, and, in the case of interest and preferred dividends, possibly the financing sections of the cash flow statement. However, the components cannot be grouped in such a way as to present a sub-total within that statement as it is conventionally displayed in three or more sections. It would be inappropriate to include the measure on an entity’s income state-ment, as Net Free Cash Flow is a cash flow measure.

Accordingly, to present the measure as an additional GAAP measure the amount would have to be disclosed in the notes to the financial statements,

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Draft for Comment

although there may be few circumstances where the measure can be effectively related to a note. One possibility would be to include it in the note that discusses policies and processes for managing capital, but it is not clear what purpose such a measure would have in that note unless the entity’s dividend policy was related to its determination of Net Free Cash Flow. Another possi-bility would be to present it in the note that discusses segmented information, if the entity provides cash flow information by segment to its chief operating decision-maker.

The term Net Free Cash Flow does not literally indicate the nature of its components. Accordingly, if the measure is presented in the notes to financial statements, an entity should define its components and present them in a reconciliation to cash flows from operating activities, identifying where each component is disclosed on the financial statements, which would most likely be in the statement of cash flows.

Entities reporting Net Free Cash Flow as an additional GAAP measure should also consider providing context for the measure in the MD&A by discussing the suite of information noted below under the heading Discussions that Provide Context.

Alternative or Adjusted Net Free Cash Flow MeasuresAn alternative or “adjusted” definition of Net Free Cash Flow may not have sufficient qualitative characteristics for inclusion in the financial statements. For example, an entity may believe that Net Free Cash Flow is only meaning-ful if it is defined by the entity to include or exclude subjective elements such as “one-time” or “non-recurring” charges. These amounts are generally not defined by IFRSs and there may be difficulty in obtaining agreement as to their interpretation. As a result of this challenge to its verifiability, the adjusted measure could not be included in the financial statements.

In such circumstances it may nonetheless be possible to present Adjusted Net Free Cash Flow as a non-GAAP financial measure in other areas of the entity’s financial reports, such as the MD&A and press releases. It is recom-mended below that any use of an adjusted Net Free Cash Flow measure be accompanied by disclosure of a standardized Net Free Cash Flow measure with additional disclosure of the entity specific adjustments.



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Any adjusted Net Free Cash Flow should possess appropriate characteristics of relevance, faithful representation and verifiability even when reported outside the financial statements as a non-GAAP financial measure. Whether entity-specific adjustments are sufficiently verifiable and a faithful representation of a relevant phenomenon would have to be determined in the circumstances, considering the factors discussed in Part I of this guidance. Challenges to these qualities could generally be satisfied by disclosure about the purpose for the adjusted measure, clarity in the description of the measure’s calculation, and a discussion of its implications and context. These points are considered further in the discussion of entity specific Net Free Cash Flow measures below.

II.4 ThE PRESENTATION AND DISClOSuRE OF NET FREE CASh FlOwSpecific disclosure recommendations for entities that report Net Free Cash Flow either in the financial statements or in the MD&A are set out below. These include:• general considerations;• a standardized and adjusted Net Free Cash Flow measure; and• discussions that provide context.

General ConsiderationsWhen an entity reports Net Free Cash Flow, it should follow the general considerations for presentation and disclosure set out in Part I of this guid-ance. These include disclosure of:• the definition of the measure;• management’s purpose for providing the measure; and• a reconciliation to cash flows from operating activities, and the effects of

selectivity in the measure.

Additional aspects of these disclosures are discussed below.

A Standardized and Adjusted Net Free Cash Flow MeasureAn entity should provide disclosures as noted below for standardized and entity-specific measures.

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Users have indicated that while a degree of standardization in the definition of Net Free Cash Flow is desirable for the measure to be comparable across entities, non-standardized entity-specific information can also be useful in specialized contexts. Accordingly, this guidance advocates the presentation of a Standardized Net Free Cash Flow measure, with any entity-specific adjust-ments separately presented in an Adjusted Net Free Cash Flow measure.

Standardized Net Free Cash Flow

The following standardized definition of Net Free Cash Flow reflects the preceding discussion.

Cash flows from operating activities,7 less:i. total capital expenditures minus proceeds from the disposition of

capital assets other than those of discontinued operations;ii. other cash-funded asset acquisitions;iii. dividends on preferred shares, unless they were already deducted in

arriving at cash flows from operating activities; and,iv. cash provided or consumed by the operating activities of

discontinued operations;all as reported in the GAAP financial statements.

Standardized Net Free Cash Flow should be reconciled to cash flows from operating activities, with each of the above-noted adjustments separately disclosed.

An Explanation of the Meaning of Net Free Cash Flow

Any disclosure of Net Free Cash Flow should also be accompanied by an explanation of what the measure represents, such as the following:

Standardized Net Free Cash Flow represents an indication of the entity’s capacity to generate discretionary cash for common equity investors. It represents cash flows from continuing operating activities less net capital expenditures, other cash-funded asset acquisitions, and dividends on preferred shares. Since it reflects post-acquisition cash

7 Interest payments are deducted from Free Cash Flow in arriving at Standardized Net Free Cash Flow. Under IFRSs, interest paid and received may be classified as cash flows from operating activities, or as financing and investing activities. To the extent that such amounts are not capitalized and not included in arriving at cash flows from operating activities, they should be deducted (interest paid) or added (interest received) in arriving at Net Free Cash Flow.



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flows of any business acquisition occurring in a period, it may not be comparable to subsequent periods’ measures that will include full period effects.8 Standardized Net Free Cash Flow does not necessarily represent the cash flow in the period available for management to use at its discre-tion, which may be affected by other sources and non-discretionary uses of cash. It is employed internally in the entity’s internal processes to evaluate management’s performance.

To avoid confusion, a measure of Net Free Cash Flow that varies from the above-noted definition should not be described as Standardized Net Free Cash Flow.

Adjusted Net Free Cash Flow

If entities adopt the preceding definition of Standardized Net Free Cash Flow, the result would be comparable from entity to entity and consistent between periods. However, entities may believe that other adjustments should be made to cash flows from operating activities in addition to those made in arriving at Standardized Net Free Cash Flow.

For example, there may be a cyclical or periodic nature to the pattern of cash flows generated from operating and investing activities. In certain seasonal industries, inventory is built up (consuming cash) in the summer months, and is sold (producing cash) in the winter. This can result in excluding the effects of changes in working capital from the Net Free Cash Flow measure.

In other circumstances, non-capitalized major repairs and maintenance occur cyclically and result in cyclical patterns to operating cash flows, such as significant scheduled maintenance activities once every three to five years. In other industries, routine maintenance requires a multi-year cycle of capital expenditures on compressors or capacity rebuilds that may also require capacity to be taken off-line for extended periods.

The relative predictability of the pattern of such cash flows can motivate management to describe Net Free Cash Flow not in terms of the actual historical cash patterns, but after adjusting for the cyclical or seasonal components of operating and investing activities. These cyclical patterns could

8 This guidance does not advocate including pre-acquisition cash flows in the standardized measure because they were not generated while the acquiree was under the entity’s control.

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Draft for Comment

be communicated as part of the explanation of the variance in Standardized Net Free Cash Flow between periods. Alternatively, they may be addressed by reporting an Adjusted Net Free Cash Flow that adjusts for such known patterns. In that event, there should be a discussion of any estimates and assumptions involved in the adjustment’s calculation. For example, an adjust-ment to eliminate the seasonal fluctuations of working capital changes may involve an assumption about future selling prices.

Similarly, management may wish to communicate the special or non-recurring nature of certain transactions that in their view should not inform a user’s reasonable expectation of future cash flows. Entity-specific adjustments may also include significant commitments that an entity considers in determining the amount of cash available for discretionary activities, such as significant commitments for future capital expenditures to be funded from operations.

The term Net Free Cash Flow suggests that the measure should reflect cash generated in the period available for discretionary purposes. As noted, this is not necessarily the case. For example, an entity’s Net Free Cash Flow may be restricted by an operating financial covenant. Similarly, there can be restrictions on an entity’s ability to utilize cash held in a subsidiary. Entities may consider it informative to highlight circumstances such as these through entity-specific adjustments. Alternatively, these matters would be discussed as part of the financing strategy discussed later in this guidance.

When an entity wishes to provide an Adjusted Net Free Cash Flow for items such as these, the following disclosures should facilitate users’ understanding of the adjusted measure:

i. reporting the adjusted amount as Adjusted Net Free Cash Flow;ii. the definition for the entity-specific measure and why it provides

insight;iii. a reconciliation, incorporating Standardized Net Free Cash

Flow, separately disclosing each adjustment between the reported Adjusted Net Free Cash Flow and cash flows from operating activities;

iv. the definition and purpose of each adjustment, including the basis for subjective determinations and judgments, for example, the basis for determining “maintenance capex”; and



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v. for each adjustment, the identification, location, and quantification of the corresponding item in the financial statements.

Entity-specific adjustments should be consistent from period to period, both with respect to the items adjusted and their computation. As well, the compu-tation of adjustments should be consistent within the period. When this is not the case, this fact should be reported and an explanation for the inconsistency provided.

When a change is made to the components of the entity-specific measure, users’ understanding will be enhanced if the reason for the change is explained and comparative amounts are presented in accordance with the new basis.

Discussions that Provide Context As previously noted, the Net Free Cash Flow measure, used in isolation, has limitations. For example, the measure addresses the quantum of operating cash flows and investing cash flows, but does not consider such matters as the stage of the entity’s business, that is, whether it is growing (so that Net Free Cash Flow is often negative) or stable (so that Net Free Cash Flow is often positive). Accordingly, entities should complement their Net Free Cash Flow disclosure with the following MD&A discussions to provide a suite of infor-mation that enables users to interpret the measure in specific circumstances.

Relationship of Standardized Net Free Cash Flow to investing and financing activities

In effect, Standardized Net Free Cash Flow is a reorganization of the GAAP Statement of Cash Flows to reflect the net of an entity’s cash flows from operating activities and its capital expenditures. Understanding the entity’s policies and actions with respect to the other sources and uses of cash provides a more complete basis for the interpretation of Standardized Net Free Cash Flow. These other sources and uses of cash, categorized in the cash flow statement as financing and investing activities, include cash distributions to common shareholders in the form of dividends or share repurchases, and debt and equity financing.

The relationship of an entity’s Standardized Net Free Cash Flow to its investing and financing activities may best be explained by providing an analysis of how those activities complement and differ from Standardized

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Draft for Comment

Net Free Cash Flow. For example, outside debt financing may fund all or a portion of the capital expenditures of an entity, and hence complement the Standardized Net Free Cash Flow. Conversely, the repayment (rather than refinancing) of maturing debt or lines of credit may compete with dividends to shareholders as a use of Standardized Net Free Cash Flow.

In addition, disclosure of the entity’s financing strategy will assist users to understand this relationship. This could include matters such as the entity’s target debt to equity or leverage ratio, the degree to which it has fixed but uncapitalized commitments such as operating leases and purchase commit-ments, and the likelihood of compliance with covenants. Some of this information should already be provided in the MD&A table of contractual obligations and the statement of capital disclosures required by GAAP.

Relationship of the entity’s capital expenditures to its productive capacity strategy

In order to assess the likelihood that an entity’s Net Free Cash Flow will be sustained, a user needs to understand the entity’s strategy for productive capacity and whether that capacity is maintained, grown, or shrunk. This could be facilitated if the entity were to define how it views productive capac-ity, explain how the capacity has been changing, and discuss how capacity has been affected by, for example, capital expenditures, acquisitions, intellectual property, and information systems. In particular, investors want to distinguish capital expenditures focused on growth from those made to maintain existing levels of productive capacity. This discussion should also address the categories of capital asset expenditures and how each asset category contributes to growth or productive capacity maintenance.

Financing-type activities that are characterized as operating activities

In some cases, cash flows from operations are affected by financing-type activi-ties that are characterized as operating activities. The most common of these are long-term operating items that are subject to timing differences between their accrual in the income statement and the ultimate cash expenditure. Examples are asset retirement obligations, free rent arrangements, and accrued interest on discounted long-term obligations. These accrued income statement items are non-cash operating transactions until funded. The funding of such amounts may be over the life of the contract, such as free rent obligations, which are



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deferred until rent commences to be paid. They may also be paid at the conclu-sion or termination of a contract, such as accrued interest on a debt instrument originally issued at a discount, which is paid at redemption.

Such operating activities may have a significant impact on the entity’s current and/or future Standardized Net Free Cash Flow. Accordingly, entities should ensure that the communication of Standardized Net Free Cash Flow identifies how such items impact current and future cash flows. The analysis could explain the extent to which such activities have consumed or provided cash in the period, and the extent to which they have deferred cash inflows and outflows to future periods, including when such deferrals are expected to affect Standardized Net Free Cash Flow. As well, the analysis could identify the total amounts required to fund obligations arising from these activities and the amounts expected to be paid in each of the next five years. This disclo-sure would be similar to that required for conventional financing transactions provided as part of the table of contractual obligations.

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PaRt iii: aPPliCatioN to sPECiFiC MEasUREs: Ebitda

III.1 EBITDAEBITDA, an acronym for earnings before deductions for interest, taxes, depreciation and amortization, represents an accounting measure of operating performance of a group of assets independent of the manner in which they are financed (hence the omission of interest and taxes) and independent of the recovery of the costs of associated capital assets (hence the omission of depreciation and amortization). It is not defined in any set of authoritative accounting standards, and there is no theoretical or conceptual basis for its use in security valuation. It is nonetheless a very commonly used measure in the financial markets, and users have expressed a need for guidance on its presentation and disclosure.

This discussion considers its relevance, representational faithfulness, and verifiability as an additional GAAP measure and as a non-GAAP financial measure, and the implications of these factors for the disclosure that should accompany its use in either of these contexts.

III.2 APPlyING ThE quAlITATIvE ChARACTERISTICS OF ThE CONCEPTuAl FRAMEwORk

The Relevance of EBITDAEBITDA is an example of a performance measure that has grown out of practice rather than by design. The utility of using an EBITDA measure has not been conceptually established nor is there significant empirical evidence of its utility in security valuation other than in a “method of comparables,” a rule of thumb based on the fact that a company that is twice as large as another company, but virtually identical in other respects, should exhibit double the EBITDA, double the revenues, etc. EBITDA is nevertheless extensively used in the investment community, for example, as a measure of performance in



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loan covenants. Some use it as an intermediate step in calculating a relevant measure of cash flow, while others use EBITDA valuation multiples when comparing entities in the same industry.

There are well-known limitations in the measure, the most obvious being that it ignores the costs of capital assets consumed in the generation of operating income, and it does not reflect the implications of the entity’s capital structure for equity investors. In addition, many entities use variants of EBITDA or an “adjusted EBITDA” that omit further items to illustrate aspects of their performance. Such adjusted measures may be relevant for a particular purpose; for example, loan covenants often use an adjusted EBITDA to focus on a specific aspect of performance relevant for assessing an individual entity’s ability to repay a loan.

The widespread use of EBITDA supports its disclosure by entities as an additional GAAP measure in IFRS financial statements or as a non-GAAP financial measure outside of the financial statements. But the lack of an authoritative definition, the use of many “adjusted” variants, and its known weaknesses indicate that its use in any context should be carefully considered and should be accompanied by clear and transparent disclosure.

Faithful Representation and verifiability of EBITDA EBITDA, literally calculated as the sum of its components, is, in the case of IFRSs, the profit or loss defined under IFRSs plus the amounts reported for interest, taxes, depreciation and amortization.9 As literally defined, this measure should meet the conditions set out for faithful representation and verifiability of an additional GAAP measure discussed in Part I of this guidance. Faithful representation should exist as the measure is simply the sum of the components in its title. Verifiability exists as these components are each separately determined under IFRS in a manner that can be readily corroborated.

The above-noted calculation does not consider the effects of discontinued operations or business combinations. In this regard, much of the Net Free Cash Flow discussion in Part II of this material related to excluding operating cash flows from discontinued operations and including pre-acquisition oper-

9 Depletion is another form of depreciation and amortization.

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PART III: APPlICATION TO SPECIFIC MEASuRES: EBITDA

Draft for Comment

ating cash flows of business acquisitions applies equally as well to the treatment of the corresponding incomes or losses in EBITDA. Adjusting for such factors may provide a more complete representation of the phenomenon being reported, depending on the purpose for which the measure is to be used. If discontinued operations are excluded, however, the title of the measure should be likewise amended to preserve its representational faithfulness.

When EBITDA is adjusted for items other than discontinued operations, the faithfulness of the measure from a GAAP perspective may be less clear. For example, adding back restructuring costs incurred in business combinations but not adjusting for the additional income or costs from that acquisition would not generally give a faithful representation of the business combination event in the financial statements. However, in the context of the MD&A, in which the objective is to provide management’s perspective on the results of operations, such adjustments may be a faithful representation of the informa-tion used by management. It may therefore be appropriate to employ EBITDA adjusted only for restructuring costs as a non-GAAP financial measure in the MD&A if that is how management measures performance.

III.3 EBITDA AS AN ADDITIONAl GAAP MEASuRE OR A NON-GAAP FINANCIAl MEASuRE

EBITDA as an Additional GAAP MeasureEBITDA and adjusted EBITDA measures reflect a spectrum of qualitative characteristics that vary with the extent to which the components are relevant, representationally faithful and verifiable. The presentation of a particular mea-sure as an additional GAAP measure in IFRS financial statements should only occur when those qualities are highly evident. When they are less evident, the measure may nonetheless qualify for presentation as a non-GAAP financial measure in an entity’s financial reports but outside the financial statements.

In EBITDA measure that is described as such and that is literally computed as profit or loss defined under IFRSs, adjusted for IFRS definitions of interest, taxes, depreciation and amortization expense should be considered relevant when it is used by management’s chief decision makers, representationally faithful when its elements are consistent with its literal definition, and



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sufficiently verifiable when it comprises IFRS-defined elements reported in the financial statements. An EBITDA measure that meets these tests should qualify as an additional GAAP measure or alternatively could be presented as a non-GAAP financial measure.

Alternative or Adjusted EBITDA MeasuresIt may be possible in specific circumstances to demonstrate that the relevance, representational faithfulness and verifiability of another measure of EBITDA are sufficiently established that it can be used as an additional GAAP measure. In so doing, however, any other EBITDA-based additional GAAP measure should have its components literally identified by its title to preserve its representational faithfulness. This will dispel any possibility that it is mislead-ing because it includes or excludes amounts that are not identified in its title. Verifiability for financial statement purposes would also generally require that the adjustments comprise elements that are defined by IFRSs.

Sometimes EBITDA may not have the qualitative characteristics necessary for inclusion in IFRS financial statements. The relevance of EBITDA to the entity may not be established when, for example, the entity’s internal processes do not use EBITDA, as in the case of many financial institutions. Alternatively, some adjustments to the measure may not meet the tests of representational faithfulness and verifiability, for example, when an entity adjusts EBITDA for subjective non-IFRS components.

These circumstances would not necessarily prevent an entity from presenting EBITDA adjusted for such components as a non-GAAP financial measure in other areas of the entity’s financial reports, such as the MD&A and press releases where the tests for faithful representation and verifiability may be less rigourous. In these circumstances, the test for relevance is met when the entity uses the measure internally or knowledgeable investors or analysts request the measure.

Whether an adjusted EBITDA measure is verifiable and constitutes a faithful representation of a relevant phenomenon sufficient for presentation as a non-GAAP financial measure would have to be considered in conjunction with disclosure about the purpose for the adjustment, the clarity of the measure’s

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description and calculation, and discussion of its implications. These points are considered further in the discussion of entity-specific EBITDA below.

III.4 ThE PRESENTATION AND DISClOSuRE OF EBITDAThe specific disclosure recommendations for entities that disclose an EBITDA measure either in IFRS financial statements or in the MD&A are set out below.10 These consist of:• general considerations;• a standardized and adjusted EBITDA measure;• discussions that provide context; and• additional presentation and disclosure considerations when reporting

EBITDA in IFRS financial statements.

General ConsiderationsWhen an entity reports EBITDA, it should follow the general considerations for presentation and disclosure set out in Part I of this guidance. These include:• disclosure of the definition of the measure;• management’s purpose for providing the measure; and• a reconciliation to the closest GAAP number.

Additional aspects of this disclosure for EBITDA are discussed below.

A Standardized and Adjusted EBITDA MeasureUsers have indicated that a degree of standardization in the definition of EBITDA is desirable for the measure to be comparable across entities, but that non-standardized entity-specific information can also be useful. Accordingly, to facilitate users’ understanding of the measure, an entity reporting any ver-sion of EBITDA should also report a standardized measure, with any entity-specific measure presented as an adjustment to the standardized measure.

10 The CPRB believes that following this guidance will comply with the specific application guidance for reporting EBITDA as an additional GAAP measure set out in the CSA Staff Notice.



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Standardized EBITDA

Standardized EBITDA is defined as profit or loss, adjusted for interest, taxes, depreciation and amortization, all determined in accordance with GAAP.

The basis for this definition of Standardized EBITDA can be found in the CSA Staff Notice although the CSA does not use the term “standardized”. As well, that notice makes several observations that illustrate how six practices for reporting additional GAAP measures apply to reporting EBITDA as an addi-tional GAAP measure. It states that presenting EBITDA as a subtotal in the statement of comprehensive income would only be appropriate if the amounts of interest, taxes, depreciation and amortization are clearly identified on that statement and presented below the subtotal. In addition, the Staff Notice states that in calculating EBITDA it would be misleading to exclude amounts for items such as restructuring expenses, fair value changes, or impairment losses.

To avoid confusion, a measure of EBITDA that varies from the above-noted definition should not be described as Standardized EBITDA.

Adjusted EBITDA

An entity’s definition of EBITDA may exclude or include adjustments, identified here as entity-specific items, for example, other non-cash charges or non-recurring items that are not in the standardized EBITDA definition. If so, the EBITDA measure should be reported as “Adjusted EBITDA” to stand in contrast to Standardized EBITDA.

The following disclosures should facilitate users’ understanding of an entity’s Adjusted EBITDA measure:

i. the adjusted amount, reported as Adjusted EBITDA, or the Standardized amount, if no adjustments are made;

ii. the definition of the EBITDA measure and why it provides insight;iii. a reconciliation, incorporating Standardized EBITDA, separately

disclosing each adjustment, between the reported Adjusted EBITDA and the closest GAAP measure;

iv. the definition and purpose for each adjustment, including the basis for subjective determinations and judgments, for example, non-recurring expenses; and

v. for each adjustment, the identification, location and quantification of the corresponding item in the financial statements.

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The entity’s EBITDA definition should be accompanied by an explanation of how management uses the measure. The following is an example of such an explanation for a non-GAAP financial measure:

Adjusted EBITDA is defined as the entity’s net income before dis-continued operations, excluding the costs of financing in the form of interest, income taxes, and the depreciation of property, plant, equip-ment, and intangible assets, as each of these is measured by GAAP. It also excludes restructuring charges incurred as the result of a business combination and reflects the acquiree’s EBITDA since acquisition. Adjusted EBITDA is employed internally by the entity’s chief decision makers to evaluate the performance of continuing operations excluding the costs of consuming capital assets which are in the nature of sunk costs, the financing costs which do not affect the value of the entity’s assets, and restructuring costs which are not representative of continu-ing operational costs.

As noted in Part I, adjustments should be applied consistently, both across the components of the EBITDA measure and for comparative amounts. For example, when an adjustment is made for non-recurring costs, there should also be an adjustment for any non-recurring income that is not part of normal operations. If not, the limited scope of the application of the adjustments should be specifically disclosed, i.e., it should be made clear to readers that the application of “non-recurring” is limited to certain forms of expenses and not to gains or revenues.

When a change is made to the components of the entity-specific measure, users’ understanding is generally enhanced if the reason for the change is explained and comparative amounts are presented in accordance with the new basis.

Discussions that Provide Context

Reporting EBITDA in the context of the entity as a whole

Once an entity discloses EBITDA as a supplementary measure in its IFRS financial statements or in the MD&A, the issue then becomes how to discuss the implications of period-to-period movements in the measure. For example, assume EBITDA improved for the period compared to the prior year because earnings decreased but depreciation increased, while amortization, interest and



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tax expense remained the same. The substantive issue is the meaning that can be attached to such a change in EBITDA.

One characterization is that the short-run profitability of the enterprise rose in the period, measured before the costs of consuming capital assets and financing. However, it would be difficult to characterize this as an unequivo-cally positive message in the absence of an explanation for the increased costs of capital assets as reflected in increased depreciation. For example, the increased EBITDA may simply reflect a shift of expenses from labour costs to depreciation incurred by using labour-saving but capital-intensive technolo-gies. Likewise, there may be no period-to-period change in reported EBITDA even though the entity reported increased interest costs and lower net income. The increased interest costs may reflect the assumption of additional debt and leverage as the result of poor liquidity, and reflect the entity’s inability to produce sufficient liquidity to satisfy the entity’s needs even though EBITDA is positive and stable. In each instance, context is relevant to the interpretation of EBITDA.

In short, to identify the significance of a change in EBITDA, the MD&A should consider not only the change in the measure, but also changes in those items that are excluded from the measure yet have significance for its interpretation, namely the state of the entity’s costs of productive capacity and the entity’s financing strategy. This should include insights as to the relative cost and productivity of existing capacity compared to that envisioned in the future and how the financing strategy is expected to affect the costs of interest and taxes and any changes in policies that might affect the disposition of the amounts reported as EBITDA. Insights on both of these factors are needed in order to provide context for the measure, which excludes costs related to these activities. In some circumstances, these discussions may best be placed with the EBITDA discussion. In others, they may be best discussed in some other area of the MD&A, for example, the liquidity discussion.

Information about an entity specific adjustment

An entity reporting an Adjusted EBITDA should discuss in the MD&A how specific activities related to that adjustment are expected to affect the revenues or costs of the entity and any changes in policies that could affect the amounts included in or excluded from EBITDA. This discussion should include insights as to the implications of such items for the future.

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Additional Presentation and Disclosure Considerations when Reporting EBITDA in IFRS Financial StatementsWhen EBITDA is reported as an additional GAAP measure in the income statement, it is presented as a subtotal, which should exclude from earnings only the precise components excluded in the definition. It is self-evident that this presentation will provide information on the depreciation, amortization, interest and tax expenses excluded from EBITDA. However, even in this case, an understanding of the relevance of EBITDA should be communicated to users by including in the entity’s MD&A the above noted contextual discus-sion that addresses the significance of the items omitted from EBITDA as an earnings measure.

Sometimes the amounts constituting the entity’s measure of EBITDA may not be disclosed on the face of the income statement. For example, an entity may present income from certain assets (usually financial assets) or expenses from non-financial liabilities such as interest on pension obligations together with interest expense. It is then difficult if not impossible to arrange the elements of the financial statement so that they subtotal to EBITDA. Similarly, an entity that classifies expenses by function would not be in a position to report EBITDA on the face of the income statement. In these situations, note disclosure is the only viable location for presentation of EBITDA within the financial statements. When this is the case, disclosure in the financial state-ments should be similar to that for EBITDA measures reported as non-GAAP financial measures discussed above, including, for example, a reconciliation between EBITDA and profit or loss for the period, separately disclosing each adjustment.

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aPPENdiX

DIFFERENCES FROM PREvIOuS CPRB GuIDANCE

2013 guiDanCe preVious guiDanCe

General Principles

A non-GAAP financial measure is relevant when requested by knowledge-able investors, even if it is not used by management.

The previous guidance noted that in determining relevance in the context of a non-GAAP financial measure, consid-eration should be given to whether it is used internally, in the industry, and by investors, and whether it provides an additional perspective that management believes is important to understanding performance.

An additional GAAP measure is relevant when it is used by the entity’s chief deci-sion makers in explaining value drivers, liquidity, or performance.

The previous guidance noted that to be relevant for reporting in financial state-ments, a measure should be consistent with the financial statement in which it is reported as well as meeting the above-noted relevance test for a non-GAAP financial measure.

A non-GAAP financial measure should be a faithful representation when it comprises the components used by management or components that management believes investors need. As well, to be a faithful representation, the measure should be accompanied by assumptions, judgments, and estimates used in calculating the measure and other information necessary to under-stand any limitations in the measure’s completeness or neutrality.

The previous guidance noted that a non-GAAP financial measure should have an appropriate caption, be consistent between periods, and should be consis-tent in the components it omits.



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An additional GAAP measure should be described in terms that:

• distinguish it from minimum IFRS disclosure requirements;

• are meaningful given its composition; and

• clearly explain which IFRS compo-nents it includes and excludes.

The original guidance noted that all supplementary financial measures should use appropriate captions.

An additional GAAP measure is verifi-able when knowledgeable users can identify the components of a measure and understand that they are defined by IFRSs.

verifiability was not addressed in the earlier guidance. Both the current and previous guidance, however, note that to be representationally faithful, an additional GAAP measure should be comprised of components defined by IFRSs.

A non-GAAP financial measure is verifi-able when it provides a reconciliation to the nearest GAAP measure, showing each adjustment, and its purpose, together with the above noted disclo-sures about estimates, assumptions, completeness, and neutrality.

verifiability was not addressed in the earlier guidance. The need for a reconcil-iation was discussed, however, as part of the discussion of faithful representation.

Net Free Cash Flow

The guidance uses the term Net Free Cash Flow to distinguish the measure from the term Free Cash Flow that is discussed in various texts as a measure of cash flow before taking into account the impact of interest costs, and used in estimating enterprise value.

The original guidance used the term Free Cash Flow, although its definition reflected the after-tax cost of interest.

The definition of Standardized Net Free Cash Flow now includes a deduction from cash flows from operating activities for all cash-funded asset acquisitions.

The original guidance deducted capital expenditures in arriving at Free Cash Flow, but treated cash outflows for business combinations as uses of Free Cash Flow.

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The definition of Standardized Net Free Cash Flow excludes cash provided or consumed by discontinued operations as this will not be relevant in estimating future cash flows.

The original guidance included cash from operating activities of discontinued operations as part of Free Cash Flow.

The definition of Standardized Net Free Cash Flow deducts preferred dividends from cash flows from operating activities to enable valuations of common equity.

The original guidance deducted “stipu-lated” dividends in arriving at Free Cash Flow as they were more in the nature of interest than dividends.

when an Adjusted Net Free Cash Flow is presented, the definition and purpose for each adjustment should be disclosed, including the basis for subjective determinations and judgments.

The original guidance did not specifically advocate disclosure of the basis for sub-jective determinations and judgments.

EBITDA

The guidance notes that there is no definition of EBITDA within accounting standards and there is no theoretical or conceptual basis for its use in security valuation. The guidance also recognizes, however, that EBITDA is extensively used in the investment community.

The original guidance, while noting the limitations of EBITDA, explained that it was often used to facilitate an enterprise valuation.

To align with the CSA’s views on EBITDA as an additional GAAP measure, Stan-dardized EBITDA is defined as profit or loss, adjusted for interest, taxes, depreci-ation and amortization, all as determined in accordance with the entity’s GAAP.

In its definition of Standardized EBITDA, the original guidance eliminated income from discontinued operations and deducted impairment charges for capital assets.

when an Adjusted EBITDA is presented, the definition and purpose for each adjustment should be disclosed, includ-ing the basis for subjective determina-tions and judgments.

The original guidance did not specifically advocate disclosure of the basis for sub-jective determinations and judgments.

Chartered Professional Accountants of Canada277 Wellington StreetToronto, Ontario, M5V 3H2(416) 977-3222 www.cica.ca

Improved Communication With Supplementary Financial Measures

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