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Financial statements often warp the numbers

28 June 2018 by John Stittle

Financial statements often warp the numbers

Alternative performance measures, and even EPS, can distort financial statements

Company financial statements are increasingly bursting with accounting, legal and other regulatory requirements, so much so that many readers lack the time, patience or technical knowledge to wade through them.

Thus, investors and analysts often seek the magic number that can capture a company’s performance. To the annoyance of regulators, many companies disclose an array of often confusing and highly selective financial performance indicators to meet this need – but this may be changing.

Earnings per share

For many companies, the magic performance indicator has traditionally been the earnings per share (EPS). Initially popular in the US in the 1950s, its popularity soon spread across the Atlantic, with the key UK accounting regulator, the Accounting Standards Steering Committee (ASSC), adopting EPS in the 1970s. The committee specified how the EPS should be determined and where it should be displayed for public companies.

The basic EPS is a company’s profit or loss attributable to ordinary shareholders, divided by the weighted average number of ordinary shares. The definition of profit is standardised to mean profit from continuing operations after deducting all expenses – including taxes, minority interests and preference dividends – but before deducting ordinary dividends. Any dilution of the earnings potentially caused by share options or convertible debt must also be shown. In other words, it is the company’s ‘bottom line’ profits. Although some technical modifications have been made to the calculation of the EPS over the years, it is now an international requirement to show it under IAS33 rules.

Quite often EPS – specifically, the year-on-year growth in EPS figures – is picked up by the financial media, as it is easier to explain than the intricacies of annual results. Likewise, many companies base directors’ and executives’ incentive and bonus schemes on the annual growth in the EPS.

Distorted figures

Despite its wide usage, the IFRS EPS indicator is increasingly distorted. The concern arises because more listed companies are adopting aggressive share buy-back policies. In the US, the financial services group JP Morgan estimated that share buy-backs could exceed $800 billion this year. Other analysts are confident the $1 trillion target may be broken.

Even without this, many firms increasingly present alternative performance measures (APMs) to give a better impression. In addition to the basic EPS, companies are flagging their earnings before interest, tax, depreciation and amortisation (EBITDA), sometimes excluding restructuring costs
and rental costs, too.

Other APMs refer to ‘underlying’ profits, ‘headline’ earnings, ‘recurring’ items, ‘like-for-like’ basis and ‘organic’ growth – the list is almost as confusing as it is lengthy. Professional services firm PwC has expressed concern about companies increasingly using and misusing APMs. It highlighted there were increasing levels of ‘scepticism from the investment community about the quality and reliability of APM disclosures’.

Carillion

More topically, the half-yearly financial results published last autumn by Carillion, the outsourcing group, illustrated the use of many different APMs. In its last financial statements before it went bust, the firm used various performance measures to paint a more attractive picture.

Under the required IFRS standards, disclosed at the end of the results, Carillion’s H1 2017 numbers were little short of appalling. The company reported a loss before tax of over £1.1 billion – a loss per share of 261.2p.

To distract from these IFRS-based losses, Carillion produced self-selected and adjusted indicators. By using a range of voluntary non-IFRS APMs, Carillion conjured an ‘underlying profit’ of £82 million.

“APMs are highly selective, carefully chosen figures that can lead to serious distortion and sometimes even be misleading”

These figures arose from their ‘underlying’ operations, but only if they then added back adjustments of impairment write-offs of over £1 billion for contracts and goodwill, while ignoring other non-recurring expenditure. In other words, the company pretended these impairments and non-recurring costs never happened in the financial year.

Carillion directors tried to justify these APMs by saying it gave ‘decision useful information’ about underlying performance. Otherwise, its performance ‘can be distorted by non-recurring items’ or by ‘market factors outside the control of the group’.

Nevertheless, these excluded items can (or will) have severely adverse cash consequences for the group. They have not disappeared just because they have been excluded in APMs.

FRC probe

As such, more regulation for non-IFRS APMs may be in sight. At the end of 2017, the Financial Reporting Council issued the results of a second APM review, having sampled companies from the FTSE 100 and the FTSE 250 alongside some smaller listed companies.

APMs were used by all sampled companies. Most firms also followed recent European Securities and Market Authority (ESMA) guidelines and gave ‘equal prominence’ to APMs and IFRS measures. Generally, compliance with these ESMA guidelines was considered ‘generally good’ and ‘very much improved’ on the previous years’ annual reports.

Although the ESMA guidelines do not apply to any APMs in financial statements that conform to IFRSs – but do impact on the narrative reporting aspects, such as strategic reports and chairman or chief executive statements.

The FRC pointed out conforming to these guidelines will help ensure APMs are of ‘best practice’ and the APMs support a ‘fair, balanced and comprehensive’ strategic report. The council expects companies ‘to provide definitions and explanations of all APMs’.

The regulator added it was ‘not always clear’ if a performance measure being used was an APM rather than an IFRS measure. It noted only two companies stated their APMs were the ‘most meaningful’, failing to explain further.

Overall, the FRC’s main concern from the review was there was still some evidence of misuse of terms used in APMs, such as ‘non-recurring’, ‘unusual’, ‘infrequent’ and ‘one-off’ used with items such as restructuring costs and impairment charges. In turn, it recommended companies avoid descriptions like ‘non-recurring’ and adopt more precise labels.

In addition, the regulator was unimpressed with the use of ‘adjusted profit’ to eliminate amortisation of acquired intangibles, removing restructuring costs and losses on asset disposals. Unsurprisingly, in most cases, the council found the ‘adjusted profit’ almost always gave a more favourable figure than its IFRS equivalent.

Tread cautiously

Overall, users of financial statements should study any accompanying performance indicators with due caution. Even the EPS that is required by regulators can be modified in practice.

But the major problem is the use of APMs. These highly selective, carefully chosen figures can lead to serious distortion and sometimes even be misleading. And none of these indicators – either IFRS-based or APMs – are a substitute for a comprehensive analysis of a company’s financial statements.

John Stittle is a senior lecturer at the University of Essex

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