Christopher Niesche: Mind the GAAP when judging results

Alternative measures can be useful but accounting standards are key for investors to understand performance.
Woolworths made a A$1.2 billion ($1.25b) net loss. Photo / AFP
Woolworths made a A$1.2 billion ($1.25b) net loss. Photo / AFP

If you ever find yourself at a crowded party and want a little time alone, you could try uttering the phrase "accounting standards".

But, the fact is, accounting standards are important. They are standardised rules by which companies prepare their accounts so investors and analysts know what they're getting when they look at a company's results.

Investors know what's left in and what's excluded and so have a basis for comparison and measurement.

This profit season, where we have seen a dizzying array of profit measures by which to judge company performance, it is worth remembering these rules and asking which particular profit measure investors should heed.

Woolworths made a A$1.2 billion ($1.25b) net loss after slashing the value of its home improvement and general merchandise stores and recording weaker earnings from its Australia and NZ supermarkets.

But if we exclude net impairment charges and restructuring costs of A$2.6b, underlying net profit fell 64.4 per cent to A$803.5 million, still not great, but a lot better than a loss of more than a billion dollars.

Super Retail Group, which owns the Ray's Outdoors chain as well as Super Cheap Auto and Rebel Sports, posted a 22 per cent fall in net profit to A$62.8m in 2016.

But excluding restructuring costs, underlying net profit rose 2.2 per cent to A$108.6m.

Theme park operator and film business Village Roadshow reported a net profit of A$16.6m, down from A$40.2m for a 58.7 per cent fall. But underlying net profit was up marginally to A$50.9m, from A$50.1m in the previous year.

These companies aren't alone in reporting alternative profit measures and this is not to suggest their behaviour is untoward. They are part of an increasingly common trend in the Australian market, according to soon-to-be-published research by Stephen Taylor of the University of Technology Sydney Business School and his colleagues.

Australian companies are required to abide by what's known as the Generally Accepted Accounting Principles (GAAP) such as net profit, but more companies are promoting alternative profit measures in their results as well. These include "underlying profit", "cash profit", and "recurring earnings".

Often the results of using these measures is that the company's earnings look better, or at least not as bad.

Often the results of using these measures is that the company's earnings look better, or at least not as bad.

The researchers looked at the earnings reports of Australia's 500 largest listed companies. They found that in 2000, slightly more than 20per cent of them reported non-GAAP after-tax earnings measures. By 2014, more than 40 per cent of firms were doing this.

The alternative measures mostly worked in these firms' favour. Some 60 per cent of them disclosed non-GAAP after-tax earnings which were higher than the corresponding GAAP figures.

Non-GAAP reporting can be used to mislead rather than inform investors, although Taylor said it would be naive to say that this is always the motivation. There are times that the non-GAAP measures can help investors better understand the performance of a company.

However, the researchers didn't give what you would call a ringing endorsement to the use of these measures.

"Non-GAAP measures are at least incrementally informative relative to their GAAP equivalent," they wrote.

They conclude: "Non-GAAP earnings numbers may convey a difference view of firm performance to investors, since the disclosed non-GAAP figures are systematically and economically higher than reported earnings in compliance with accounting standards. However, the statistics also suggest that non-GAAP figures appear to be presented on a selective basis."

All of this raises the question of how much attention we should pay to the non-GAAP measures.

Take a company which has blown up a few hundred million dollars on a bad investment. What it is effectively saying with the alternative measures is "if we hadn't made this investment, our profit would have been this much better".

But the fact of the matter is that the company did make the bad investment and it did cut its profit by hundreds of millions of dollars. And it was the company's board and management which committed the funds to the investment.

Investors need to hold these companies to account and not let them hide behind accounting measures that let them shirk the responsibility for bad decisions.

Sometimes there are genuine one-off events outside a company's control and maybe then the underlying earnings measure is useful.

But at other times, companies exclude what could be considered to be a normal risk to their operations.

Take, industrial relations for instance. Should a company that has a highly-unionised work force and a fraught industrial relations environment exclude the cost of a strike from its results?

The research says the rising use of non-GAAP results "represents a significant challenge to accounting standard setters and more broadly, regulators of financial markets".

It also represents a challenge for investors.

- NZ Herald

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