A focus on 'real' results must not be at expense of reality
Andrew Buchanan | Thursday, 19 June 2008
PHRASES such as 'headline earnings', 'core results' and 'underlying profit', often accompanied by 'adjusted' or 'record', are common features in many financial reports.
At a time of nervous markets and uncertain economic prospects it seems increasingly popular to exclude certain items from profit in order to highlight and communicate the 'real' results, particularly in narrative reports accompanying financial statements. But look behind the adjustments and you will find that most relate to removing debits; adjustments that take out credits are conspicuous by their absence.
The use of non-GAAP measures (or alternative profit measures) has not escaped the attention of regulators. The US Securities and Exchange Commission (SEC) has placed restrictions over their use, while in Europe the Committee of European Securities Regulators has issued its own recommendations. In the UK, the Financial Reporting Review Panel has pointedly noted that international accounting rules permit additional line items and descriptions in the income statement - but only where really necessary.
Companies often argue that adjusting entries are 'non cash', such as share-based payment expenses or the amortisation of intangible assets. Shareholders and analysts focus on cash flows, they claim, and in the absence of cash it is not a 'real' expense. But I would argue that these expenses, although non cash, represent real transfers of value.
Without share options (which often dilute shareholders' interests and so are a real cost to them), an increased cash bonus would often be needed to attract and retain good quality staff. And where a new business has been acquired, it is right to include a charge for the use or realisation of the intangible assets acquired, as well as a credit for the income.
Companies reporting in accordance with International Financial Reporting Standards (IFRS) often add back amortisation charges for relatively newly identified intangible assets, such as order backlogs and customer relationships. While investors and analysts do not always focus on these seemingly 'fluffy' intangibles, I believe that separate identification reflects commercial reality.
Under old rules, companies often recognised large goodwill balances which were amortised over a 'default' period of, say, 20 years - which told investors nothing. Under IFRS 3 'business combinations', companies have to identify more clearly the components of what has been acquired and their useful lives. If an acquired business has substantial unfilled orders, it should attribute value to them and recognise an expense as the orders are fulfilled, since the profit they will generate will be included in the deal price.
The current reporting season has also highlighted that 'volatility' is this year's unwelcome guest. IFRS requires companies to include all derivatives on their balance sheets at fair value, with changes in value - unless tough hedge accounting tests are met - being recorded in profit or loss. This is another favoured item to exclude from 'core' earnings, but 'derivative' is really just another word for 'bet' and fairly substantial profit wrecking debits have appeared as the credit crunch has bitten. Why should a bad bet be excluded from a company's results when good ones were not? And why, if the actual value of an asset or liability is volatile, should the reported results be shielded from that volatility?
At the time of the dot.com crash a spoof article extolled the virtues of earnings before bad stuff, showing how a company could report consistent increases in EBBS while its operations crashed around its ears. In the current economic climate companies might do well to tell it as it really is.
The writer is technical partner at BDO Stoy Hayward.
FT Syndication Service
At a time of nervous markets and uncertain economic prospects it seems increasingly popular to exclude certain items from profit in order to highlight and communicate the 'real' results, particularly in narrative reports accompanying financial statements. But look behind the adjustments and you will find that most relate to removing debits; adjustments that take out credits are conspicuous by their absence.
The use of non-GAAP measures (or alternative profit measures) has not escaped the attention of regulators. The US Securities and Exchange Commission (SEC) has placed restrictions over their use, while in Europe the Committee of European Securities Regulators has issued its own recommendations. In the UK, the Financial Reporting Review Panel has pointedly noted that international accounting rules permit additional line items and descriptions in the income statement - but only where really necessary.
Companies often argue that adjusting entries are 'non cash', such as share-based payment expenses or the amortisation of intangible assets. Shareholders and analysts focus on cash flows, they claim, and in the absence of cash it is not a 'real' expense. But I would argue that these expenses, although non cash, represent real transfers of value.
Without share options (which often dilute shareholders' interests and so are a real cost to them), an increased cash bonus would often be needed to attract and retain good quality staff. And where a new business has been acquired, it is right to include a charge for the use or realisation of the intangible assets acquired, as well as a credit for the income.
Companies reporting in accordance with International Financial Reporting Standards (IFRS) often add back amortisation charges for relatively newly identified intangible assets, such as order backlogs and customer relationships. While investors and analysts do not always focus on these seemingly 'fluffy' intangibles, I believe that separate identification reflects commercial reality.
Under old rules, companies often recognised large goodwill balances which were amortised over a 'default' period of, say, 20 years - which told investors nothing. Under IFRS 3 'business combinations', companies have to identify more clearly the components of what has been acquired and their useful lives. If an acquired business has substantial unfilled orders, it should attribute value to them and recognise an expense as the orders are fulfilled, since the profit they will generate will be included in the deal price.
The current reporting season has also highlighted that 'volatility' is this year's unwelcome guest. IFRS requires companies to include all derivatives on their balance sheets at fair value, with changes in value - unless tough hedge accounting tests are met - being recorded in profit or loss. This is another favoured item to exclude from 'core' earnings, but 'derivative' is really just another word for 'bet' and fairly substantial profit wrecking debits have appeared as the credit crunch has bitten. Why should a bad bet be excluded from a company's results when good ones were not? And why, if the actual value of an asset or liability is volatile, should the reported results be shielded from that volatility?
At the time of the dot.com crash a spoof article extolled the virtues of earnings before bad stuff, showing how a company could report consistent increases in EBBS while its operations crashed around its ears. In the current economic climate companies might do well to tell it as it really is.
The writer is technical partner at BDO Stoy Hayward.
FT Syndication Service