by John Hughes
A recent article in The New Zealand Herald provides an additional interesting perspective on the topic of “non-GAAP” or “adjusted” earnings measures. Here’s how it sets out the issue:
The article reports: “Many New Zealand annual reports now contain two separate sections with totally different profit figures. The front part has the directors’ net profit figures, and the financial section at the rear has the IFRS figures approved by auditors.” The following table sets out the differences between these two figures for fifteen entities:
The broad issue is entirely familiar to Canadian entities and users, and I’ve written about it several times in this space (most recently here). At one end of the spectrum, sound reasons exist why an entity might present some kind of adjusted earnings number – for instance, a one-off gain or loss might truly not be relevant to forming an expectation about future performance, providing a strong motivation for management to promote a principled focus on core ongoing operations. At the opposite extreme though, an entity might make so many adjustments to its IFRS-compliant earnings that the adjusted number represents little more than a fictionalized version of what might have transpired in an alternate universe. The concern here seems to be that some New Zealand entities are at or approaching that extreme – the article says for instance that in some of the adjustments, “real earnings are adjusted to theoretical earnings.”
It’s difficult though, for me anyway, to know what degree of outrage to summon up here. To construct another spectrum, the greatest accounting crimes might be those where some recognition or measurement wrongdoing is buried within the numbers and there’s no possible way for anyone to know it’s there or to adjust for it. In this case though, the issue is sitting right in plain sight. The article says “all 15 companies in the table can justify the difference between their adjusted profits and the audited figure,” which I take to mean they provide a reconciliation between the two. So while the adjusted presentation may invite a reader to deemphasize the IFRS-compliant numbers, it doesn’t compel them to. If the IFRS numbers are confined to the rear of the annual report, it must increase the risk that an investor will only see the adjusted numbers and not realize these provide an incomplete picture. But then an investor who takes any numbers at face value without digging deeper into the attached accounting policies, risks, measurement uncertainties and so on is just asking for trouble anyway. In other words, you might read the article as an implied plea to save investors from their own lapses, which I’ve come to think is a hopeless endeavour.
But on the other hand, the writer is suggesting that the magnitude of practice in New Zealand amounts to a pollution of the entire reporting atmosphere and culture. One of the commenters sums this up as follows: “I feel there is value in a company adjusting for abnormal items so to highlight the ‘real’ performance but I think you have correctly identified that it is a slippery slope! The scope of what is ‘abnormal’ appears to be growing.” I think you’d have to be sympathetic to this, but just because a slope is slippery, it seems to me, doesn’t mean you stubbornly lock yourself down at the top of it.
This is why I can’t quite agree with the article’s conclusion: “The problem is that we don’t have strong leadership in the accounting profession. Public issuers should be required to follow accounting standards in all aspects of their communications with investors, and if the accounting profession believes that these standards are inappropriate then they should be changed. The road we are heading down, which is where companies reports their own adjusted profits to shareholders, inevitably leads to tears as far as investors are concerned.” I don’t think the use of EBITDA is an indication that bottom-line profit is “inappropriate” – it’s just that engaging with an enterprise is complicated and it may make sense to draw on various perspectives. Banning the use of such measures (not that I’m sure how you could ever practically do that) would have the flavour, to draw on another cliche, of cutting off your nose to spite your face.
And on the last point, I certainly agree that investors are all too often led to tears, but again, suppressing the practice being discussed here would barely make a dent in the mountain of reasons why people make bad asset allocation decisions. Still, this is a serious article on something that’s clearly an escalating concern down there. Even if one doesn’t necessarily fully agree with the diagnosis, this kind of commentary in the mainstream media can only help sensitize investors and others to the limits and pitfalls of financial reporting. I wish we had more of it here in Canada.
The opinions expressed are solely those of the author.
PS Still looking for gift ideas? How about my IFRS literacy book? It’s every kid’s dream!