Normalising profits to bury the bottom line shouldn't be the norm.
New Zealand has a serious accounting crisis - and it is getting worse.
It has arisen because most of our largest listed companies have rejected the country's IFRS accounting standards.
Their audited accounts are consistent with the standards, but directors are amending audited numbers and reporting "normalised" or "underlying" profits. Twelve of the 19 NZX50 Index companies with June balance dates have adjusted their earnings from audited to normalised.
The combined June year normalised earnings of these nineteen companies was $1806.6 million, or 28.8 per cent higher than the audited figures of $1402.6 million.
Company directors are beginning to look like golfers who go around in 85 but put a 76 on their card because that is what they normally shoot.
Adherence to rules and regulations is non-negotiable in sport, but the majority of our companies believe they can report adjusted or normalised profits if they don't like the audited numbers.
The disregard for our IFRS accounting standards has serious implications for investors, as was clearly evident after the 1980s sharemarket boom and bust and recent finance company debacles.
These show that individuals will invest their money in the wrong companies when accounting practices give an overly optimistic impression of performance.
There can also be serious conflicts of interests if senior executives are paid on the basis of normalised, rather than audited profits. There is clearly a strong incentive for executives to focus on the higher normalised profits if their bonuses are based on these figures.
Nine of the 19 companies had normalised earnings higher than their audited figures.
Telecom reported normalised profits of $388 million, 133.7 per cent higher than the audited figures of $166 million.
Three big items account for the differences between the audited and normalised figures - the exclusion of natural disaster costs, the omission of ultra-fast broadband and de-merger costs and asset value write-downs.
Different companies have treated natural disasters, particularly the Christchurch earthquakes, differently.
Skellerup includes Christchurch quake costs of $2.7 million in its net profit of $20.2 million, yet Telecom excludes natural disaster costs of $42 million from its normalised earnings.
Why does Telecom exclude disaster costs? Why does it also exclude expenses associated with ultra-fast broadband when benefits from this are expected to accrue?
The largest item in Telecom's adjustment from audited to normalised profits is the exclusion of asset write-downs of $257 million. The exclusion of these raises the normalised profits but also gives a boost to future earnings if these assets were subject to depreciation, because this depreciation will not have to be deducted in the years ahead.
Telstra also has a large number of write-downs and impairments in its June 2011 year audited result but the Australian group produced no normalised earnings.
The difference between Telecom and Telstra is ironic because one of the main reasons for the introduction of IFRS was to enable investors to compare the performance of companies in different countries.
Fletcher Building reported normalised earnings of $359 million against an audited $283 million.
The normalised figure includes a one-off gain of $16 million from the sale and leaseback of an Auckland factory, but excludes asset and inventory write-downs.
Abnormal inventory write-downs were a problem in the 1980s. For example, if a company wrote down an item of stock from $100 to $50, this unusual loss of $50 was excluded from normalised earnings. But if the item was then sold for $70 the following year the company booked a $20 profit to both its audited and normalised earnings.
There is no suggestion that Fletcher Building is planning to do this, but less scrupulous companies will copy the larger groups and adopt inventory revaluations that deceptively inflate future earnings.
The huge difference between NZ Oil & Gas' audited loss of $75.9 million and its normalised profit of $30.6 million is due to the exclusion of the huge write-down of its Pike River Coal investments and foreign exchange losses.
The boost in Auckland International Airport's normalised earnings is mainly due to the exclusion of a write-down in the value of property, plant and equipment, and Sky City's higher normalised profit was primarily due to the exclusion of the Christchurch casino impairment.
As well, SkyCity includes earnings from its international or high roller business at a normalised or theoretical rate rather than the actual figure.
Only seven companies - Ebos, Heartland, Michael Hill International, Nuplex, PGG Wrightson, Skellerup and SkyTV - made no adjustments from audited to normalised profits.
Ebos included $8.2 million of profits from discontinued operations in its net earnings of $31.6 million whereas other companies exclude discontinued operations, particularly if they are a negative figure.
PGG Wrightson, which has reported a loss of $30.7 million for the June 2011 year, is probably the most interesting of the 19 companies.
Twelve months ago, the company announced normalised June 2010 year earnings of $25.3 million, compared with audited earnings of $23.3 million.
The difference was because of the exclusion of a one-off tax provision due to the removal of depreciation on property from normalised earnings.
PGG Wrightson's June 2011 result contains no adjustments for normalised items so the net profit is now $23.3 million instead of the $25.3 million highlighted 12 months ago.
The June 2011 year loss of $30.7 million contains non-operating losses of $22.0 million and negative fair value adjustments of $25.8 million.
The rural company is now adopting the correct approach, but why the sudden change in emphasis from normalised to audited earnings?
Is it because the Chinese recently acquired a 50.01 per cent controlling interest in the company and want to adhere to our IFRS accounting standards, or is it because the new controlling group wants the profit figures to look as bad as possible so that they can make a full takeover offer at a low price?
Only three of the 19 companies - Cavalier, Port of Tauranga and Vector - had lower normalised earnings when compared with the audited figure.
Vector's audited profit has been adjusted down from $201.4 million to $171.3 million because of the exclusion of a one-off profit of $30.1 million from a share services deal with Transpower.
Accounting issues are extremely important, particularly in light of the Crown's proposed sale of shares in Mighty River Power, Meridian Energy, Genesis Energy and Solid Energy.
How are individual investors going to know whether share offerings are fair value if privatised entities emphasise highly normalised earnings instead of the lower audited numbers?
Professional investors and investment analysts will be able assess the difference between normalised and audited earnings, but individual investors will not.
Yet again, we will be sending individual investors into an accounting minefield with few detectors to help them navigate a safe course.
Surely it would be far better to clear up our accounting mess before embarking on another round of privatisations that will be aimed at investors with little understanding of our complex accounting standards and practices.
* Disclosure of interest: Brian Gaynor is an Executive Director of Milford Asset Management.
Bgaynor@milfordasset.comBy Brian Gaynor Email Brian