Are all profits equal?

Companies are increasingly adding alternatives to statutory profit

New research into pro forma earnings disclosures since the advent of IFRS in New Zealand has revealed some significant trends.

By Jack Crowley, Professor David Lont, and Dr Tom Scott

Because they allow investors to assess and compare the business performance of companies, profit measures are a vital part of financial reporting. However, companies are increasingly adding alternatives to statutory profit (net profit after tax) to annual reports and other forms of corporate communication, such as quarterly press releases.

These include so-called “pro forma”, “adjusted, “underlying” or “headline” earnings, which are often unaudited. As a result, regulators, auditors and industry observers have become concerned that extensive use of such non-GAAP (generally accepted accounting principles) metrics may cause confusion and even mislead investors.

On the other hand, some companies contend that pro forma earnings (PFE) actually provide a more comprehensive insight into overall corporate performance. They blame overly rigid International Financial Reporting Standards (IFRS) for decreasing the information value of financial statements, and increasing the need to present alternative earnings figures.

Whatever the case, clear and reconcilable alternative performance measures would likely be able to not only mitigate concerns around the use of PFE, but provide richer insights into operating performance than statutory profit alone.

IFRS and PFE

To facilitate better understanding of the issue, CPA Australia funded research to determine whether the IFRS regime, introduced in 2005, is associated with a rise in alternate profit reporting in New Zealand. We also cast light on the types of adjustments that have typically been made by companies, and whether they have changed post-IFRS. Finally, we sought to answer the question: do companies provide clear reconciliations between alternative profit measures and statutory profit?

The research was based on reporting by NZX-listed companies over the period 2004–2013. It resulted in 1067 observations, 688 of which were post-IFRS adoption.

We first examined the frequency of PFE disclosure and found a statistically significant increase after the implementation of IFRS. Indeed, 47 per cent of sample companies disclosed a PFE measure in 2004, rising to 58 per cent in 2013 (see Figure 1). The most common adjustments related to tax, interest, depreciation and amortisation (see Figure 2) – confirmation that companies are now regularly reporting adjusted earnings before interest and tax (EBIT) PFE results.

FIGURE 1: Frequency of pro forma earning disclosure by year and pre- and post-IFRS

However, the next most common adjustments, which relate to fair value, acquisitions and disposals, one-off, other and unknown adjustments, are somewhat troubling. Notably, while adjustments to fair value, asset impairments and other assets have become significantly more commonplace post-IFRS, one-off adjustments have declined.

FIGURE 2: Frequency of adjustments pre- and post-IFRS

In particular, the frequency of fair value adjustments increased from just 14 per cent to 33 per cent following the introduction of IFRS. Although consistent with an increase in the use of fair value accounting under IFRS, the trend clearly indicates pushback from companies which prefer to emphasise what they believe to be a more useful measure of performance – a view not necessarily shared by critics of adjusted GAAP earnings numbers, who in some cases label many pro forma earnings disclosures as little more than an attempt to portray overly optimistic financial performance.

Of course, the increase we identified in adjustments to asset impairments may be due to IFRS requiring more disclosures of impairment losses relative to New Zealand Financial Reporting Standards (NZ FRS).

In contrast, the reduction in adjusting for one-time items, which frequently have a negative impact on operating earnings, could well stem from changes in rules around special or extraordinary items.

Higher quality disclosures

As mentioned, reconciliations of popular voluntary disclosures such as pro forma earnings with statutory profit can help alleviate concerns that some companies’ PFE disclosures are designed to mislead, with unsophisticated investors especially vulnerable. In this respect, we see not only a significant general upwards trend in the number of reconciliations, but also a higher proportion of higher quality reconciliations. Whereas in the pre-IFRS period just 68 per cent of the sample provided reconciliations, this rose to 75 per cent post-IFRS.

Key conclusions

The study has confirmed several important issues. First, we documented the prevalence of pro forma earnings in New Zealand, determining that their frequency increased post-IFRS. Second, the frequency of the type of adjustments made to calculate PFE across 15 categories was researched, with the results linked to changes in accounting rules.

Specifically, we conclude that the marked increase in fair value adjustments is likely caused by a greater propensity towards fair value accounting under IFRS.

Third, although disclosure of PFEs has increased post-IFRS, so too has the quality of reconciliations. Again, this is an important caveat, as higher quality reconciliations may offset concerns about pro forma earnings being used to opportunistically mislead investors. In addition, they allow investors to more easily recognise any “red flags” in a company’s financials, and to undertake appropriate due diligence.

FIGURE 3: Reconciliation of pro forma earnings by year and pre- and post-IFRS

Unintended consequences

Even after controlling for a range of company characteristics through regression analyses, an important overall finding of the study is that corporates have responded to changes in accounting standards by providing additional information tailored to offset them. In other words, the provision of statutory information based on accounting standards may have had unintended consequences.

Users of such unaudited financial information need to be aware of its potential shortcomings. While higher quality reconciliations certainly help, changes in methodology or emphasis could, over time, further muddy the water. Equally, we note that a significant minority of companies do not, in fact, provide high-quality reconciliations, which in turn could raise red flags with regards to investment.

Need for ground rules

The findings are particularly timely in that the International Accounting Standards Board (IASB) recently considered alternative performance measures as part of its longer-term Disclosure Initiative. Although it said there are no problems with companies providing additional information to investors, it emphasised the need for some ground rules to be established to prevent the presentation of misleading information.

The IASB further noted that it can be difficult to tell whether such disclosures are or are not required under IFRS, but asserts they “should not be given so much prominence in financial statements that they overshadow the IFRS numbers”.

So, are investors confused or enlightened by PFEs? This is an issue that will be addressed in the next phase of our research. In the meantime, a full report on our just-completed study is available on request.

Jack Crowley is a University of Otago master’s graduate.

Professor David Lont is the Head of Department  for Accountancy and Finance, University of Otago.

Dr Tom Scott is a Senior Lecturer at the Graduate School of Management, University of Auckland.

TOP TRENDS

  • Pro forma earnings disclosures have increased after the adoption of IFRS.
  • Overall, reconciliations have also increased in quality, but a significant minority of companies still do not provide adequate reconciliations.
  • Fair value, asset impairments and other adjustments are more common post-IFRS, whereas one-off adjustments have declined.

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