Free audio stream, including stories that are padlocked on our site. Listen on any device, anywhere. Updated twice daily. The audio stream takes several seconds to start on Android devices.Launch Radio player
The head of the global body responsible for setting accounting standards says he scratches his head over companies using an Ebitda measure of earnings but he understands why some prefer not to focus on net profit as a performance measure.
Hans Hoogervorst, chairman of the International Accounting Standards Board, is visiting New Zealand seven years after companies here were required to adopt the New Zealand equivalent to international reporting standards, known as NZ IFRS. The rule change filled gaps in the nation's existing standards including recognition of financial instruments, share-based payments to executives and directors, and the treatment of mezzanine financing.
Forcing companies to recognise changes in the value of financial instruments in their profit and loss statement brought transparency to the use of products such as derivatives, which Warren Buffet once called 'financial weapons of mass destruction', and which triggered the 1994 bankruptcy of California's Orange County.
But pushing more items into the P&L has also encouraged companies to present extra, non-standard measures of profit, including 'underlying earnings' and earnings before interest, tax, depreciation and amortisation.
"Ebitda I don't understand at all," Hoogervorst told BusinessDesk. "Why don't you want to know about depreciation and interest, which tells you a lot about the leverage of a company."
"If I was an analyst and I saw underlying earnings, I would always want to know what is on top," he said. "What are underlying earnings? They usually look better than total earnings. So those are reasons for scepticism."
The Financial Markets Authority set out its expectations on the use of alternative earnings measures under 10 principles that became effective on Jan. 1, 2013. They include a requirement to show how the measure is calculated and to provide reconciliation to GAAP profit. They also require companies to use such measures consistently from period to period, consider their prominence and avoid bias.
Hoogervorst, a former Dutch finance minister and financial markets authority chief, says he understands that annual statements have become "very long and tough to read" but to some extent that was inevitable as companies become more complex, including the use of derivatives, complicated pension arrangements and merger and acquisition activity.
But he also said there is "too much of a tick the box mentality by both companies and their auditors and regulators", leaving the investors "swamped by disclosures."
A Deloitte survey of 100 New Zealand companies released last year on the use of underlying profit in 2012 found that 90 of them had provided a total of 253 alternative profit measures. That was the year before the new FMA guidelines kicked in. Of the 253, 81 percent were reconciled with GAAP profit and 63 percent provided a clear explanation of how the measure had been calculated.
"I think that the logic of the markets is that one number is always dominant and it should be the P&L," Hoogervorst said. "In the long run that number gives the least surprises because it includes everything.
I recognise that P&L is a rough number."
The IASB recently completed a new revenue recognition standard that will take effect in the next couple of years, installing a standard top-line definition around the globe. More than 100 countries now use IFRS. The body is now working on a standard for the insurance industry, which "has a huge lobby" and as major buyers of government bonds is a voice governments tend to listen to, Hoogervorst said.
In a speech in Sydney this month, Hoogervorst said he is "still shocked as we continue to stagger from scandal to scandal in the financial markets."
He said at the root of these problems was "the enormous extent of moral hazard in the financial markets", including agent-principal conflicts and "the asymmetry of information."
The IASB's role was to "keep capitalism honest," he said, quoting his predecessor David Tweedie. The body had battled vested interests in its efforts to combat moral hazard. Successes included having stock options treated as an expense and bringing pension liabilities on balance sheet. It is currently battling to get lease contracts included.