Financial statements and the Annual Report should be an important part of how companies communicate with their shareholders about performance and prospects. Performance has many aspects – cash, earnings etc – but investors can reasonably expect financial statements to communicate financial performance. A measure of profit seems an essential component of this.
Why, then, is it so hard to find “profit for the year” in the front end of an annual report? You’ll also rarely see that number presented in the financial statements’ segmental disclosures, which are prepared “through the eyes of management”. In contrast, companies are likely to explain segmental and group financial performance based on an alternative profit measure such as “Profits before …”. It’s worth asking why preparers of financial statements do this and whether it’s a problem.
Some measures are widely published across an industry or sector, based on industry-agreed definitions.
Many company-specific adjusted profit measures are driven by good intentions - an attempt to disaggregate performance based on the frequency of occurrence or nature of particular events or transactions. The rationale for separating out exceptional gains and losses might be that performance is best understood from a baseline of earnings that are more likely to recur in future periods. Properly presenting one-off, unusual or exceptional items, can therefore help companies to communicate financial performance more clearly.
Other adjustments to IFRS measures of profit seem to be a recurring annual occurrence intended to approximately reconcile IFRS profits to operating cash, for example by stripping out non-cash expenses such as depreciation, amortisation, impairments and share-based payment expense, while a few seem to stem from a dis-satisfaction with how accounting requirements affect performance – perhaps because it is inconsistent with how the directors view performance.
Adjusted profit measures predate IFRS (profit before exceptional items being the obvious example), but the number and sheer variety of adjustments seems to be growing. My purpose is not to debate whether specific adjustments are right or wrong; but to ask why companies feel the need to make them.
However much financial statements are derided as being too long and too late (itself worthy of separate debate), the Annual Report remains an important part of corporate stewardship – a key conduit for communication from executives to investors and other users; for many investors perhaps the only communication.
We use generally accepted accounting principles (GAAP, for example IFRS) - in financial statements for a reason. Without GAAP, what’s to stop a company using a language that no-one else understands, or, more dangerous still, communicating in a way that fails to meet the stewardship objective? Every company has the potential to be the biggest, best or most profitable, if it were allowed to measure performance in a uniquely favourable way. The problem is that if GAAP ceases to provide a sensible language, companies are rightly incentivised to use their own.
I’m concerned that IFRS is in danger of losing touch with executives’ and investors’ needs, becoming a language that executives fear to speak, at risk of being perceived as losing focus on the true performance of the company, or just being misinterpreted.
Meanwhile, the International Accounting Standards Board (IASB) continues to adopt a balance sheet focus to its proposed standards, adding profit and loss fudges to try to alleviate the undesirable consequences – volatility in earnings that does not reflect performance. The proposed straight-lining of lease costs in the ongoing, and flawed, leases project (PDF 394.36 KB) is a case in point . Some would describe these fudges as pragmatism. I am a pragmatist, but the IASB should not rely on the pragmatism of preparers and auditors to overcome the challenge of applying accounting standards that have a weak conceptual basis.
Crucially, the IASB is at risk of missing a huge opportunity to make progress on the issue of financial performance. The ongoing Conceptual Framework project doesn’t attempt to define financial performance or to answer thorny questions about, for example, unintended volatility in earnings. Instead, the current discussion paper seems to seek concepts that will justify existing fudges, rather than digging the foundations for a future of clear, principles-based standards that will be generally accepted as the basis for communicating financial performance. As a result, we’ll still face an income statement that is little more than the difference between two balance sheets, and two balance sheets that increasingly fail to measure assets and liabilities in a way that results in “performance” that either executives or users can relate to.
If this is the case then there will be no end to the steady growth of “adjusted earnings”.
To me, the prevalence of Key Performance Indicators (KPIs) based on adjusted earnings measures is a warning that GAAP measures are missing the mark. I believe standard setters should consider again the question of what financial performance is and how to measure and present it. What do you think?
Mark Summerfield is a Partner at KPMG in the UK
Thank you for your comment. I think we’re in agreement as to the problem. One way forward is for GAAP to better distinguish the type of volatility. For that, GAAP needs to better define what financial performance is. Be interested to hear ideas for other solutions?
Mark Summerfield, Partner - KPMG in the UK.
3. IFRS creates some very strange results. While it helps to have an international standard we also need to be wary of the risk of group compromises that create animals that no one truly understands. It would be a large and long exercise to create a new version of IFRS; however, it's needed.
2. Non-GAAP measures can be a really useful tool in helping to describe periodic performance but should never be more than an adjoint to explaining the GAAP performance.
1. I'm really interested in the issue of volatility in earnings. IASB members have frequently seen volatility as a virtue: volatility, we're told, means that the accounts have more value relevance. Yet when plotting a graph with volatile data points, we learn from an early age to ignore each individual point and draw in a trend line. How do we know what sort of volatility we have in IFRS? Is it so unreasonable to seek to draw out a non-GAAP trendline if it's useful to investors?_______________________________________________________________
This article represents the views of the author only, and does not necessarily represent the views or professional advice of KPMG in the UK.