Years ago in the lectures of Professor Don Trow at Victoria University we used to debate the merits of which profit in a set of accounts to look at.Companies presented three main documents, the profit and loss account, the balance sheet and the cashflow s
Years ago in the lectures of Professor Don Trow at Victoria University we used to debate the merits of which profit in a set of accounts to look at.
Companies presented three main documents, the profit and loss account, the balance sheet and the cashflow statement.
The balance sheet is a list of assets and liabilities. If a company was a person it would be the house and car weighed against mortgages and other debts. Assets minus liabilities leaves equity.
Cashflow statements are important because a lot of companies fail because they do not have enough cash. Most financial journalists do not spend much time on cashflow statements but when the meat company Fortex collapsed we nodded our heads knowingly and said you could see it coming in the cashflow statement.
The late great financial journalist Warren Berryman flicked straight to the notes in the accounts - where you find related party transactions, essentially deals with mates at mates' rates.
Also worth a look are contingent liabilities, like the court cases which cost Australian banks hundreds of millions of dollars that were contingent on a court judgment and references to banking arrangements, chief executives' salaries and other interesting things that might be "off balance sheet" as the accountants say.
But the profit and loss account, or operating statement, is the document journalists mostly look at.
It basically says a company made this revenue from making widgets. It cost this much to produce them, giving a profit. You then deduct tax to get net profit after tax.
If a widget maker also sold a building for more than the value in its accounts a one-time gain would appear before the bottom line profit, also known as profit attributable to shareholders.
There was a bit of debate in the old days about whether we should look at the profit before or after one time items to get a picture of how a company was travelling.
Prof Trow was of the opinion that the bottom line was the bottom line and I favoured this when reporting profits for many years in defiance of grumpy companies sensitive about which profit appears in headlines.
Then property companies presented an issue. The accountants decided that the value of their buildings went up and down a lot and the current market value of buildings should be included in the profit and loss to give a true reflection of their position each year.
So "unrealised" gains and losses started appearing in profit and loss accounts. It was a "paper" or accounting item, not real money made or lost from making widgets.
The move began toward looking at underlying earnings. The issue many financial journalists had with that is that there are a lot of them and companies tended to pick the one that makes them look best. "We had a really bad year, but it was a one-off." Yeah right. Wasn't last year a bad one too?
There are earnings before interest and tax, earnings before interest, tax, depreciation and amortisation and any number of things referred to as operating earnings. There are also normalised earnings, which is the profit from the business we now have compared with if we had it last year even though we didn't actually have it last year.
Accountants in an ideal world want the accounts to reflect what is really going on in very complex businesses. It is a worthy goal but hard to achieve. Generally there has been a trend toward reporting changes in the balance sheet in the operating statement.
This arguably more sophisticated approach is having unintended consequences and this week a group of company directors warned financial journalists against reporting the net profit after tax in company results because it is so distorted by accounting rules.
When the government decided to stop companies depreciating their buildings for tax purposes it created a difference between the tax value of a building and its book value.
International accounting rules require that these liabilities are reported in the profit and loss statement.
So more than $1 billion of deferred tax liabilities that get created in accounts and then are slowly run down but are never payable are eroding the reported profits of New Zealand companies this earnings season.
It is really bad timing because investors are nervous about earnings anyway in the wake of the global financial crisis.
We have ended up with a situation where the main financial document produced by a company is not useful.
The directors are worried that all investors see are headlines in the media of the net profit after tax. It is a sad day in business journalism when you get told off for highlighting a net profit after tax.
So until a lobby of international accounting bodies and of the government fixes it, we are being asked to look at underlying earnings because the net profit after tax is a nonsense.
