Accounting Theory - Policy Guidance, Underlying Profit - Essay Example

354551 - Accounting Theory Underlying Profit For the Financial Services Institute of Australiasia (FINSIA) and the Australian Institute of Company Directors (AICD) the term ‘Underlying profit’ is defined to mean: The statutory profit figure when adjusted in order to arrive at an amount which reflects the result for ongoing business activities and is a sound basis for the estimation of future operating results of the enterprise. (FINSIA, AICD, Aug 2008) AICD and Finsia both support use of the term “underlying profit” in preference to other terminology to describe an adjusted profit figure. In the past, companies have used a variety of terms including: profit before exceptional items result excluding exceptional items result before non-recurring items result before significant items result before special items result before specific items normalised result underlying result current operating result underlying earnings. A 2007 PwC survey of 2,800 European financial statements, “result excluding exceptional items” is the most popular term in the United Kingdom. In the years 2004-05 there was a significant increase in the number of companies using “underlying profit” after the introduction of International Financial Reporting Standards (IFRS). In 2007, an survey carried out by Ernst and Young showed that many Australian companies choose to describe their varied financial adjustments as either “underlying, normalised and cash profit” and at other times as either “underlying EBIT” or even “underlying EBITDA.” AICD and FINSIA are both of the opinion that certain terms like “normalised” or “adjusted” are popularly used all over the world in general and specifically in Australia. But they agree that the term “underlying profit” has the following advantages: It does not give specifics about future expectations when put in contrast to “sustainable earnings” “Normalised profit” give an impression of a general “smoothing” of profit based on the management’s judgments As it uses existing financial terminology, it does not go against the grain of the IFRS On the other hand ‘Statutory profit’ is defined to mean: The net profit after tax (NPAT), as derived from statutory financial statements compiled in accordance with the Corporations Act 2001 and Australian Accounting Standards. (FINSIA, AICD, Mar 2009) The statutory profit figure is the most popular start up point when assimilating and reporting financial information. It is also often used to understand and study the true and comparative economic and financial performance of any company. For now, all the financial reports that are prepared and audited are in complete accordance with the Corporations Act. These are definitely the primary economic accountability mechanism for Australian companies. But more information is definitely needed. According to both ASIC and FINSIA, showing both statutory profits and underlying profits on financial reports will clearly show their relationship in communications to shareholders and the general public. They will then be ale to determine, with all certainity, about the profit result. This includes financial reports, reviews, analysts’ results and other management commentaries. Selecting adjustments The statutory profit figure needs adjustments that are subjective on a variety of factors like the company and industry size and the standard operating procedure. For example, a manufacturing company may carry out a mark to market revaluation by adjusting and calculating underlying profit, this will not help out a financial institution. Directors need to make very subjective decisions as to which adjustments are appropriate and these have to vary between companies and also industries. However, there are certain policies that will help companies so that they in turn can reach out and aid the investment community. This aid will be necessary in making an informed decision about the relevance of each adjustment that finally arrives at the underlying profit figure. Listed below are the items that are appropriate adjustments. This list is not exhaustive, but is intended as more of a guideline about the kind of adjustments that can be included in the tables so as to derive the underlying profit. Significant transactions or events — While “significant” may be seen as a subjective term, any transaction either on its own, or when combined with other similar transactions, may be considered significant if it affects the statutory net profit after tax figure by more than five per cent. Identify and adjust these items if they are may not be consistent or significant in the coming years. For example: Transactions that give rise to adjustments would include divestments of other operating businesses or assets. Another example is any failed takeover attempts. Financial effects of unprecedented such as floods, fire should similarly be noted. Where these events are covered by insurance, include the net amount. One-off provisions — Definite and one-off provisions that will not be an recurring expense can also affect profits. These provisions may in certain cases include redundancy and restructurisation costs. Fair value adjustments — The unrealised profit or loss arising from revaluing assets (such as derivatives, financial instruments, property or agricultural assets) is not usually reflected in financial reports and may be included as an adjustment. Including a fair value adjustment may be contentious at certain times, and therefore caution should be exercised. Impairment losses — Impairment testing of assets may result in a large write-down to non-recurring but recoverable amounts. Income tax settlements — If a company has received a tax refund or paid a tax penalty that is not related to the current year’s operating profit, this can easily be an appropriate item to be added in the reconciliation report. Defined benefit pension plans — While not common in Australia, several companies have needed defined benefit plans and this may be an appropriate item as an adjustment. Revaluation of long-term liabilities — Some companies have long-term legal obligations. If the revaluation of the long-term obligation is included in the reported profit, this should be itemised. This is not to be considered in the case of long-term liabilities that exist in the normal course of a companys operations. For example: This is expressively true in the case of land rehabilitation for mining companies. The following items may also need to be considered by some companies: Items for which an adjustment should not be made Scott Marshall, chairman of Finsia’s financial markets advisory group and head of industrial research at Shaw Stockbroking, says analysts and the management of companies routinely adjust their profits for various non-cash and significant items in an effort to make it easier to determine next year’s profits. (Boyd, 2009) Even AICD is of the view that some companies are adjusting their statutory profit against items that do not add up as significant financial items. Some of them are: Employee share schemes — They are actually a legitimate and real impost on the business from the shareholders’ perspective. Amortisation and depreciation — These should not be included in the reconciliation table in the routine course of things, but rather be noted clearly elsewhere in a management discussion and analysis of the profit result. Where the depreciation has been impressively changed because of a significant event, this change may be disclosed as an adjustment in the reconciliation table. PGP recommendations can help ASIC is worried by the complete inconsistency in the various reports of normalised or underlying profits. There have been numerous cases of companies that have used the underlying profit to cover up for their handling of those aspects of the report that give the best company-oriented results. This shows them in a great light and helps the company to be valued higher then it should be. In other cases, companies have shown their fair value adjustments and problems without revealing the pre-tax effect on their company. The International Accounting Standards Board had long recognised a need to prepare a new reconciliation schedule that aims to provide greater clarity about the underlying financial performance. Their reform process is extremely long-winded, so industry-based attempts that attempt to show clarity in profit reporting is necessary. Therefore both FINSIA and AICD have together released a Policy Guidance Paper (PGP) that can help to provide the first template for presenting the ‘underlying profit’ in a consistent manner. This aims to be of immense help to shareholders, analysts, companies and even the financial media. Proper financial reporting where it is done in accordance with the general duty of companies and their officers. They are not to provide any information that is false or misleading to their stockholders, their customers or the general public. Scott Marshall, chairman of FINSIA’s financial markets advisory group and head of industrial research at Shaw Stockbroking says that recently many profit adjustments have not been consistent between various companies and industries. While some companies have made adjustments without providing comparable figures for previous years; others have amended their adjusted profits without disclosure of the changes. (Boyd, 2009) The AICD/ FINSIA principles for underlying profit recommends reconciling the underlying profit figure with the statutory profit and presenting the adjustments in tabular form. Also, it recommends that both positive and negative adjustments to the statutory profit be disclosed. All of these attempts show that the industry is taking action to vigorously help users of financial statements to understand the underlying financial performance. Practical Difficulties: The major difficulties that companies may face with implementing the recommendations in the PGP and in interpreting are in terms of the adjustments that need to be made. Adjustments that are made to arrive at the underlying profit have to be separately itemised if they are “significant” and this will vary from company to company. The utter subjectiveness of the situation leaves it open to various interpretations and misunderstandings. In preparing the table, companies should take into consideration the needs of shareholders, markets, customers and others. The objective is solely to provide a transparent, logical and justifiable reconciliation between the statutory profit figure and the underlying profit. But while doing this, the resultant reconciliation may not really assist analysts and others who may wish to carry out valuations. The tax associated with each adjustment has to be clearly identified. This is true even in the case of one-off or non-recurring gains or losses. These taxable items will usually be significant and adjustments for these have to be individually itemised. Smaller items that are not individually significant may be aggregated for adjustment purposes, but still have to be disclosed and explained. Transparency requires that companies include adjustments whether they or not they have any positive or negative impacts on the underlying profit figure. This complete disclosure of underlying profit should not be seen as an opportunity to “window dress” the financial result and make the company look of greater valuation. Some companies cherry pick items they wish to emphasise. But this only leads to the reduction of the long-term confidence of the market in that specific company and then slowly, in the market in general. Bad situations that have a contra-effect on the valuation of the company also have to be disclosed completely and companies may resist this in the name of brand-building. The types of adjustments should be consistent between reporting periods. If, for example, a company makes an adjustment for foreign exchange impacts in the current year, it should disclose similar adjustments in following years (even if the adjustment is insignificant in those future years). Financial reporting A 2007 Ernst & Young study examined financial reports and media releases of the top 20 Australian listed companies to determine, amongst other things: If there is a distinct trend of communicating different earnings from those reported in statutory financial reports; and if there is a trend, whether there is any consistency in this approach. The study showed there was a trend towards reporting adjusted earnings to the market and, while these results were reported in various ways, there was a consistency in the nature of adjustments being made. The study also revealed two types of common adjustments: Significant one-off transactions and events – made to indicate what a stable earnings base for the company should be. IFRS-related matters – that are also made for the above purpose and for additional reasons that indicate dissatisfaction with how IFRS reflects the company’s business in that certain adjustments The AICD/ FINSIA project team suggests that the increase in the financial reporting of adjustments shows that many users of financial statements are simply not receiving, or are perceived to be not receiving, all the information they need. This has led to an increased demand for underlying profit disclosure and a heightened desire for greater consistency In November 2006, FINSIA conducted a survey on the quality of financial reporting in Australia. Respondents, mostly quality analysts were generally positive about the quality of such reporting, but noted that the “normalising” of earnings was one area that could benefit from greater consistency in the reports. (FINSIA, AICD, Aug 2008) 82 per cent agreed when asked whether a “separate and consistent disclosure of a normalised profit would be useful”. The importance of the underlying profit figure especially to the investment community does not diminish the importance of companies that are preparing financial statements according to the law and applicable accounting standards. Furthermore, this guidance is not based on a view that financial reporting under IFRS is incorrect or misleading. This actually aims to recognize that users of financial reports have a variety of information needs, these principles are therefore intended to lead to a presentation of additional explanatory information that are not otherwise readily available. Both FINSIA and AICD believe that companies should try and think about the various supplementary information that they could provide to help their shareholders. In fact the whole investor community could use some help in understanding the company’s financial position and performance. This is where the concept of Underlying profit comes in. Analysts are always studying financial statements to determine the health of companies and organisations. This is especially true about cases where analysts need to put a value on the company and/or its assets. At this point, all valuations are usually based on expected future profits and cash flows. Experts go beyond looking at just the past statutory profits as the starting point when doing any such valuation, in fact they choose to make adjustments and aim at being able to derive an underlying profit. Then various calculated assumptions are made about the rate of the company’s growth or the projected cash flows and the underlying profit is then ready to be used as a futuristic market projection. This in turn can help understand a company’s financial health and valuation both in the present and future. Scott Marshall, chairman of FINSIA’s financial markets advisory group and head of industrial research at Shaw Stockbroking, says the media plays an important role in communicating profit results and for this reason it would be useful if wire services and other media more rigorously reported underlying profits as well as statutory profits. (Boyd, 2009) Reference: FINSIA and AICD, Underlying Profit: Principles for reporting of non-statutory profit information, March 2009 FINSIA and AICD, Preliminary Views on Financial Statement Presentation, October 2008 http://www.iasb.org PricewaterhouseCoopers, Presentation of income under IFRS: flexibility and consistency explored, 2007 http://www.pwc.com Ernst & Young, Reported earnings - Trends, analysis and predictions, May 2007. FINSIA and AICD, Underlying Profit: A discussion paper on the reporting of non-statutory financial information, August 2008 http://www.companydirectors.com.au/NR/rdonlyres/326A7E61-2BCA-4CB2-88F3-B750D8048E1E/0/FINAL_FinsiaAICDUnderlyingProfitsdiscussionpaper.pdf Tony Boyd, Business Spectator, Mar 2009 http://www.businessspectator.com.au/bs.nsf/Article/Profits-$pd20090310-PYSW2?OpenDocument Read More