CSA Staff Notice 52-329 Distribution Disclosures and Non-GAAP Financial Measures |
April 12, 2018
Executive Summary
Staff of the Canadian Securities Administrators (CSA staff or we) recently reviewed two important areas of disclosure for real estate investment trusts (REITs) and real estate operating companies (REOCs): distributions and non-GAAP financial measures. We reviewed distribution disclosures relative to National Policy 41-201 Income Trusts and Other Indirect Offerings (NP 41-201) and non-GAAP financial disclosures relative to CSA Staff Notice 52-306 (Revised) Non-GAAP Financial Measures (CSA SN 52-306). We sought to assess the quality and sufficiency of disclosure provided by real estate issuers relating to the sustainability of their distributions. For non-GAAP financial measures, we reviewed the following:
- adjustments made in arriving at non-GAAP financial measures,
- the prominence of non-GAAP financial measures, and
- the use and reconciliation of non-GAAP financial measures.
Given strong investor interest in this sector and the inherent pressure on issuers to pay distributions, the sustainability of distributions and the accompanying disclosures are important to investors.
The purpose of this notice is to share our review findings and to provide additional guidance for real estate issuers to disclose information that is more useful and transparent to investors.
1. Background and Disclosure Expectations
Distributions
REITs and many REOCs pay out the majority of their income in the form of distributions to their unitholders or shareholders. The opportunity to receive recurring distributions provides investors with an incentive to invest in real estate issuers, and distributions are an important component of the total return. Investors may compare distribution yields across issuers, and as a result, financial measures related to distributions provide important insights in analyzing both available returns and the variability of such returns. The industry uses a variety of financial measures of distributions, both GAAP and non-GAAP, to quantify the sustainability of distributions.
Distribution disclosures are outlined in NP 41-201[1], and also captured in the disclosure requirements for liquidity under the MD&A form requirements (Form 51-102F1 Management’s Discussion & Analysis).
Non-GAAP Financial Measures
Real estate issuers use a variety of non-GAAP financial measures to explain their operating performance and/or cash flows. These measures include net operating income (NOI), earnings before interest, taxes, depreciation and amortization (EBITDA), funds from operations (FFO), adjusted funds from operations (AFFO), adjusted cash flow from operations (ACFO) and related distribution payout ratios.
The chart below outlines the frequency of non-GAAP financial measures used by the real estate issuers we reviewed:
Non-GAAP financial measures can provide investors with supplemental information about an issuer’s financial position, financial performance or cash flows. However, investors must have sufficient information to understand what these measures represent, how they are calculated, and how they are useful to investors and management. Concerns arise when issuers present non-GAAP financial measures in a manner that is confusing or potentially misleading, such as when they are inadequately defined or when they obscure GAAP financial measures.
CSA SN 52-306 provides guidance to issuers that choose to disclose non-GAAP financial measures. Given the breadth and volume of non-GAAP financial measures used by issuers, we have recently renewed our focus in this area.
Given the prevalent use of non-GAAP financial measures in this sector, transparent disclosure of these measures is critical.
2. Our Review
We reviewed 47 REITs and REOCs[2] as part of this review. Our review excluded those issuers that did not use non-GAAP financial measures, did not pay distributions, or that had minimal market capitalizations.
We reviewed distribution disclosures and assessed the quality and sufficiency of disclosure provided about the sustainability of distributions. For non-GAAP financial measures, we assessed the disclosure with regard to the adjustments made, the prominence of these measures, and how they were used and reconciled by issuers.[3]
3. Findings
We sent comment letters to 72% of the issuers that we reviewed. Of the issuers that we reviewed, 6% were required to restate MD&A, and 62% agreed to enhance their disclosure prospectively.
Generally, REITs and REOCs provided adequate disclosure about their distributions, except when “excess distributions” were made and in those cases, many issuers did not disclose the sources of cash used to fund the excess.
For non-GAAP financial measures, we found a lack of transparency about the various adjustments made in arriving at non-GAAP financial measures, particularly maintenance capital expenditures and working capital. We also noted instances where non-GAAP financial measures were presented with greater prominence than the most directly comparable measure specified, defined or determined under the issuer’s GAAP. Lastly, we observed diversity in how non-GAAP financial measures, particularly AFFO, are used and reconciled by various real estate issuers. We are concerned that these issues have the potential to render non-GAAP financial measures not useful, confusing or misleading.
Part A sets out our findings with respect to “excess distributions” and the sustainability of distributions and Part B sets out our findings for non-GAAP financial measures.
Part A – Distributions
3.1 “Excess distributions” and the sustainability of distributions
We generally found that REITs and REOCs provided adequate MD&A disclosure about their distributions. When “excess distributions” were made, issuers generally followed the guidance in NP 41-201, although some issuers did not compare and discuss their distributions in relation to cash flows from operating activities, as outlined in NP 41-201. Some issuers with “excess distributions” provided boilerplate disclosure, particularly about the sources of funding.
We found that 45%
of real estate issuers had “excess distributions” in the interim reporting
period.
Of those issuers with “excess distributions”, 68% quantified the amount of the
excess relative to cash flows from operating activities.[4]
Issuers generally provided disclosure of the reasons for the “excess
distributions”, and for most, this was due to seasonality in the interim period,
the timing of certain payments or working capital fluctuations. The better quality
disclosures provided entity-specific explanations for the particular items of
working capital which led to the excess, such as leasing costs, taxes or
transaction costs. We remind issuers that they should clearly quantify the
amount of “excess distributions” relative to cash flows from operating
activities in each reporting period.
Some issuers discussed that there was no “excess
distributions” when the level of distributions was compared to ACFO or other
non-GAAP financial measures. While this type of distribution analysis on
a non-GAAP basis may be helpful, and provides insight into how management may
view distribution sustainability, issuers should still quantify and explain “excess
distributions” consistent with the guidance set out in NP 41-201, with equal or
greater prominence.
We found that 67%[5] of the issuers did not disclose a description of the sources of cash used to fund the “excess distributions”, or their description was boilerplate. Examples of boilerplate or vague disclosures include the following types of statements:
• These fluctuations could be funded from other sources such as credit facilities, or
• The issuer does not expect distributions to exceed operating cash flows on an annual basis.
When “excess distributions” exist in a period, issuers are reminded that it is not sufficient to simply state that they believe current distributions are sustainable.
The risk profile of an issuer that relies on sources other than operating cash flows to fund distributions, such as capital raising, debt financing or sale of properties, is inherently different than an issuer that funds distributions solely through operating cash flows. We expect the disclosure about distributions to address these risks.
Part B – Non-GAAP Financial Measures
We identified a significant number of disclosures pertaining to non-GAAP financial measures[6] that did not conform to the guidance in CSA SN 52-306 or NP 41-201. These included:
- a lack of transparency and lack of disclosure about the adjustments made in arriving at non-GAAP financial measures such as AFFO,
- a lack of clarity in how management uses each individual non-GAAP financial measure,
- a failure to clearly identify the most directly comparable GAAP measure, and
- non-GAAP financial information being presented more prominently than the GAAP information
We are also concerned that some issuers might understate the cost to sustain and maintain their properties.
3.2 Non-GAAP adjustments: maintenance capital expenditures and working capital
For a non-GAAP financial measure to not be confusing or misleading, it is important that investors understand the adjustments being made as part of the reconciliation to the most directly comparable GAAP measure. Issuers should ensure all adjustments are sufficiently explained, including why and how the adjustment was determined. Our review noted many issuers that did not provide sufficient disclosure about the adjustments made in arriving at the AFFO, ACFO and other non-GAAP financial measures presented in the MD&A.
In determining each adjustment, issuers either use amounts presented in the financial statements, or an estimated amount. In situations where an adjustment is an estimate, issuers should provide additional disclosures about how the estimate was determined.
When non-GAAP financial measures are used to describe cash available for distribution, NP 41-201 outlines the relevant guidance about the non-GAAP financial measure and the adjustments and assumptions underlying the measure[7].
Our review mainly focussed on adjustments related to maintenance capital expenditures and working capital. These two adjustments are often material and subject to significant management judgement. Furthermore, these adjustments can also have a direct impact on non-GAAP financial measures used to describe cash available for distribution (for example ACFO), including the related distribution payout ratios. Our review uncovered deficiencies in disclosures of these items, as detailed below.
Maintenance capital expenditures
The IFRS
accounting treatment for capital expenditures (i.e. the requirement to
capitalize or expense certain costs) does not address whether capital
expenditures are for sustaining existing capacity or are
for future growth (revenue-enhancing). To account for this, an adjustment for
maintenance capital expenditure was made by most real estate issuers in
reconciling certain non-GAAP financial measures. A maintenance capital spending
adjustment (or “maintenance capex” adjustment, as it is commonly known)
reflects the amount held back, and therefore not distributed, by the issuer to sustain
and maintain their real estate properties in their current state. Any
deterioration of a property resulting from not incurring sufficient maintenance
capex would impact the property’s ability to maintain the same level of
revenues, and would ultimately impact distributions.
We observed that there is diversity in practice amongst real estate issuers in how the maintenance capital expenditures adjustment is determined and disclosed. The majority of issuers deducted an estimate of capital expenditures using an estimate or reserve, while 38% of real estate issuers deducted actual maintenance capital expenditures in calculating AFFO. Maintenance capital expenditures estimates were determined in a number of different ways: percentage of revenues or net operating income, certain dollar amounts per square foot, independent estimates, or forward-looking using forecast amounts[8]. Of the 62% of issuers who used an estimate in determining the capital expenditures adjustment for AFFO, only 39% disclosed a comparison to the actual maintenance capital expenditures, as shown in the chart below.
For many of the issuers using a maintenance capital expenditures reserve, the reserve was not well explained and it was often unclear from the disclosure how the reserve was determined. In order to provide investors with insight into how the reserve was determined by management, issuers should provide additional disclosure[9] in the MD&A including:
• the method by which management determined the reserve,
• why that method was chosen in determining the reserve and why that method is appropriate,
• how the reserve amount compares to actual maintance capital expenditures in the period and historically, and
• explanation of why management’s estimate is more relevant than the actual.
The actual amount of maintenance capital expenditures incurred in a period may not be readily apparent from the issuer’s financial statements, as the financial statements do not distinguish between maintenance and growth capital expenditures. Disclosing a comparison between the amount of the estimate used in the derivation of the non-GAAP financial measure and actual historical amounts would provide useful information, and give investors a better understanding of the issuer’s business.
We acknowledge that, in some cases, an estimate of maintenance capital expenditures that is normalized or removes seasonality associated with the actual amount spent during a particular short term period may be more reflective of a sustainable amount. It is critical, however, that investors understand how the estimated amount was determined and why it is viewed by management as a more accurate or representative amount than the actual. Furthermore, where the maintenance capital expenditure estimate differs materially from the actual amount spent, there may be an impact on the sustainability of the issuer’s distribution, which should be discussed.
Some issuers grouped together their estimate for
maintenance capital expenditure with other amounts estimated by management,
such as tenant inducements, tenant expenditures or leasing costs or incentives.
This aggregation further obscures the amount of maintenance capital expenditure
from investors, both the actual level and what management views as the
appropriate normalized amount.
We expect issuers to disaggregate this information in their disclosure in order
to provide useful information on the capital expenditure requirements.
In the below example, the maintenance capital expenditure reserve has not been explained in sufficient detail for investors to be able to understand how it was determined (i.e. what percentage of net rental income was used), why this method was chosen or how the normalized amount compares to actual expenditures.
The below example provides more useful information for users in assessing how management determined what a “normalized” amount is, and provides transparency to a key input which investors may use to assess the issuer’s distribution payout ratio.
Working capital
Working capital
adjustments are often made in determining non-GAAP financial measures used as
measures of sustainable cash flow[10].
The intent of a working capital adjustment made by REITs and REOCs in this
context is to eliminate fluctuations due to changes in receivables, payables
and other working capital items that are not indicative of sustainable cash
available for distribution. The amount
of the working capital adjustment is subject to management’s judgement and the
appropriate amount depends on the nature of the business.
Issuers using non-GAAP financial measures other than ACFO as cash flow measures indicative of sustainable cash available for distributions should also be considering working capital adjustments.
A working capital
adjustment should be accompanied by the disclosures outlined in section 2.7 of
NP 41-201.[11]
We found that for a significant number (69%) of the issuers making a working capital adjustment, the adjustment was the same dollar amount as the change in non-cash working capital reported in the statement of cash flows. In the absence of clarifying disclosure, we questioned this adjustment, as it would appear unusual that the entire change in working capital from a prior period be considered to be inconsistent with sustainable cash flows.
We asked issuers to explain how they determined the working capital adjustment and the amounts that are not indicative of sustainable cash flows, and to explain the process undertaken by management in estimating the level of sustainable working capital.
Examples
of working capital items that were adjusted include working capital changes
related to: development, prepaid realty taxes and insurance, and accruals
related to acquisitions and dispositions.
As the nature of the working capital items requiring adjustment depend on the
issuer’s business, it is important to disclose the details of working capital
adjustments to allow investors to better assess and evaluate the impact on
sustainable cash flows.
The following
example illustrates disclosure which met CSA guidance.
As the working capital adjustment is often material, and subject to significant management judgement, issuers should provide additional disclosure in order to provide transparency to investors.
Non-GAAP Adjustments – Potential Impact
The table below
illustrates the potential impact on ACFO and the ACFO payout ratio for a REIT
under differing approaches to maintenance capital expenditures and working
capital. It underscores the importance of clear disclosure for maintenance
capital expenditure and working capital adjustments,
as these amounts directly impact the distribution payout ratio.
3.3 Prominence of disclosures of non-GAAP financial measures
Joint Ventures in MD&A
Several real estate issuers use joint ventures to both own and operate real estate assets. Under IFRS 11 Joint Arrangements, joint ventures are a type of joint arrangement[12] in which the parties have rights to the net assets of the arrangement. Joint ventures are accounted for using the equity method of accounting in accordance with IAS 28 Investment in Associates.
We observed that issuers with joint ventures sometimes present a full set of non-GAAP financial statements in the form of a columnar reconciliation[13] within the MD&A that shows separately their pro-rata share of the interest in joint ventures (non-GAAP pro-rata financial statements). This presentation of a full set of non-GAAP financial statements within the MD&A effectively creates a non-GAAP financial measure for each financial statement line item. This presentation effectively unwinds the equity method of accounting required by IFRS 11.
We issued comments when issuers did not present the most directly comparable GAAP measures with equal or greater prominence to the non-GAAP financial measures. In many instances, in addition to the numerical presentation and reconciliation in the form of full non-GAAP pro-rata financial statements noted above, the narrative discussion in the MD&A about the issuer’s performance, financial position, and liquidity that ensued was almost entirely focussed on the non-GAAP pro-rata financial results, with little to no discussion of the comparable GAAP metrics. In CSA staff’s view, this extensive and pervasive use of non-GAAP financial measures at pro-rata interest makes it difficult for a reader to interpret the financial performance and financial condition relative to the GAAP financial statements. In these situations, where the discussion in the MD&A was pervasively based on non-GAAP metrics at pro-rata interest, without a GAAP discussion presented with equal or greater prominence, we requested issuers to restate prior periods’ MD&As in order to provide greater prominence to GAAP measures.
We also issued comments relating to the naming of
these non-GAAP financial measures. CSA SN
52-306 states that in order to ensure that a non-GAAP financial measure does
not mislead investors, it should be named in a way that distinguishes it from
GAAP items. In most instances, issuers presenting non-GAAP pro-rata financial
statements did not explicitly name each line item (which is a non-GAAP
financial measure) in a way that clearly distinguished it from the comparable
GAAP measure. While these issuers did generally indicate elsewhere either
narratively or in a footnote that the column of pro-rata numbers are not in
accordance with GAAP, in CSA staff’s view, the use of GAAP terms in the
labelling of the individual line items is nonetheless misleading. This concern
is compounded when the MD&A is focussed on the non-GAAP pro-rata financial
statement line items which are labelled using the same terms as the GAAP financial
statement line items.
Lastly, we required certain issuers to include clarifying disclosure in their MD&A that the issuer does not independently control the unconsolidated joint ventures, and that the presentation of pro-rata assets, liabilities, revenue, and expenses may not accurately depict the legal and economic implications of the issuer’s interest in the joint ventures.
News Releases
We noted that several issuers gave more prominence to non-GAAP financial measures in news releases than the directly comparable GAAP measures. These news releases focussed heavily on describing the issuer’s performance in terms of NOI, FFO, AFFO, and other non-GAAP financial measures without disclosing and discussing the most directly comparable GAAP measures.
We also remind issuers that CSA SN 52-306 applies to disclosures made on issuers’ websites, investor presentations or other social media.[14]
3.4 Use of non-GAAP financial measures and reconciliations
Our review focussed on the use and reconciliation of AFFO and ACFO, however the observations may also apply to other non-GAAP financial measures.
There continues to be diversity amongst real estate issuers in how AFFO is utilized, with some using it as an earnings measure (35%), and others using it as a cash flow measure (21%), or both (44%). We noted that the MD&A disclosure about the purpose and use of AFFO was often boilerplate.
For greater clarity, the purpose and the use of AFFO
(and any other non-GAAP financial measure) is
an important factor in considering whether it should be reconciled to net
income or cash flows from operating activities, or other GAAP measures. Issuers’
disclosures should clearly explain why management calculates and uses AFFO, and
the reconciliation provided should be consistent with this intended use. For
example, where AFFO (or another non-GAAP financial measure) is discussed
primarily as a performance measure used to explain the cash generated by the
issuer, its distribution-paying capacity, or the sustainability of
distributions, the most directly comparable GAAP measure would be cash flow
from operating activities. In determining the most directly comparable GAAP measure, an
issuer may also consider the nature, number and materiality of the adjusting
items.
An issuer should also consider the most appropriate label for its non-GAAP financial measures. Labeling a measure as AFFO is misleading if the measure excludes normal, recurring operating expenses necessary to operate the issuer’s business because “from operations” is included in the acronym “AFFO”.
Use of non-GAAP financial measures other than AFFO
Our review noted that issuers are also using a variety of other non-GAAP financial measures such as NOI, adjusted funds available for distribution, normalized FFO, operating FFO, normalized AFFO, ACFO or free cash flow. Issuers should provide appropriate accompanying disclosure with these measures as set out in CSA SN 52-306.
Issuers should also carefully consider the number of non-GAAP financial measures used to “tell their story” in the MD&A, and avoid using multiple non-GAAP financial measures for seemingly the same purpose.
4. Conclusion and Next Steps
The findings of our review indicate that the quality and completeness of disclosure pertaining to non-GAAP financial measures and distributions in the real estate industry need improvement. We remind issuers to review the guidance set out in NP 41-201 and CSA SN 52-306. We also remind issuers to provide appropriate disclosures when they are distributing more cash than they are generating from their operations, and when they are discussing their operating and cash flow performance with non-GAAP financial measures.
We will continue to assess these areas in our continuous disclosure and prospectus reviews. We will also monitor certain issuers to ensure commitments to prospective changes and enhancements requested have been made.
Questions
Please refer your questions to any of the following:
Catalina Miranda Accountant Ontario Securities Commission 416-204-8965 cmiranda@osc.gov.on.ca
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Sonny Randhawa Deputy Director Ontario Securities Commission 416-204-4959 srandhawa@osc.gov.on.ca |
Alan Mayede Senior Securities Analyst British Columbia Securities Commission 604-899-6546 amayede@bcsc.bc.ca |
Michael Moretto Chief of Corporate Disclosure British Columbia Securities Commission 604-899-6767 mmoretto@bcsc.bc.ca
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Anne Bruchet Securities Analyst British Columbia Securities Commission 604-899-6778 ABruchet@bcsc.bc.ca
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Anne Marie Landry Senior Securities Analyst Alberta Securities Commission 403-297-7907 AnneMarie.Landry@asc.ca
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Cheryl McGillivray Manager, Corporate Finance Alberta Securities Commission 403-297-3307 Cheryl.McGillivray@asc.ca |
Wayne Bridgeman Deputy Director, Corporate Finance Manitoba Securities Commission 204-945-4905 Wayne.Bridgeman@gov.mb.ca
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Nadine Gamelin Senior Analyst Autorité des marchés financiers 514-395-0337 ext.4417 Nadine.Gamelin@lautorite.qc.ca |
Hélène Marcil Chief Accountant and Director Autorité des marchés financiers 514-395-0337, ext. 4291 helene.marcil@lautorite.qc.ca
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[1] Although the primary focus of NP 41-201 is income trusts, the principles can apply more generally to issuers that offer securities which entitle holders of those securities to the net cash flow generated by the issuer’s business or its properties. The policy rationale therefore applies to REITs and REOCs given their stated objectives to provide shareholders with stable dividends or distributions. Section 2.5 of NP 41-201 refers to “distributable cash”, a term which is no longer widely used in the industry. However, section 2.1 of the policy clarifies that the disclosures that should be provided about distributable cash extend to any other non-GAAP financial measure that a REIT or REOC may use to describe the amount of net cash it has generated during the period which is available for distribution (and therefore includes adjusted funds from operations or adjusted cash flow from operations, or any other non-GAAP financial measure of cash flows).
[2] This included the interim and annual filings, as well as the news releases of these issuers.
[3] We are aware of the existence of industry guidance relating to FFO, AFFO and ACFO. Our review was focussed solely on compliance with securities obligations.
[4] For the 2016 annual period, 19% of real estate issuers reviewed had “excess distributions”, and of those with “excess distributions”, 67% quantified the amount of the excess relative to cash flows from operating activities.
[5] For the 2016 annual period, 44%.
[6] Non-GAAP financial measures are generally found in the MD&A, news releases and investor presentations on issuers’ websites.
[7] Section 2.7 of NP 41-201.
[8] We remind issuers that forward-looking information is subject to the requirements in Part 4A of National Instrument 51-102 Continuous Disclosure Obligations (NI 51-102).
[9] Refer to section 2.7 of NP 41-201.
[10] In our review, working capital adjustments were primarily made in reconciling cash flows from operating activities to ACFO.
[11] The working capital adjustment should be supported by a detailed discussion of the nature of the adjustment, a description of the underlying assumptions used in preparing each element, including how those assumptions are supported, and a discussion of the specific risks and uncertainties that may affect the assumption.
[12] IFRS 11 defines a joint arrangement as an arrangement of which two or more parties have joint control.
[13] For example, a columnar reconciliation of this type may show the issuer’s statement of income as presented in the financial statements, an additional column with amounts related to equity accounted investees for each financial statement line item, and then a total column for each financial statement line item, which is often labelled “Proportionate Share” or “At Issuer’s interest”.
[14] Disclosures of non-GAAP financial measures made through social media are also covered by CSA SN 52-306. Refer to CSA Staff Notice 51-348 Staff’s Review of Social Media Used by Reporting Issuers, for additional details.