RegulationCorporate GovernanceWhen is a profit not a profit?

When is a profit not a profit?

The current debate among analysts and standard setters is centred around how 'profit' and 'earnings' are defined. Just what is the bottom line?

When is a profit not a profit?When is a profit not a profit? That is the
question taxing analysts, standards-setters and those in charge of corporate

A row has erupted over the future of the ‘bottom line’, over what companies
report as their ‘earnings’ or ‘profit’ and whether it should change. How should
companies explain how their fortunes have changed in the last year, by totting
up this year’s and last year’s balance sheet, or through a highly stripped down
‘underlying’ figure?

Is it even a row? Richard Barker, a research fellow with the International
Accounting Standards Board and a Cambridge academic, says some of the discussion
of the issue is ‘alarmist’ in suggesting the bottom line as we know it is to
disappear. Richard Sexton, no less a figure than the head of assurance at the
biggest audit firm, PricewaterhouseCoopers, says that ‘radical change’ is on the
cards and that it is important to have a full discussion sooner rather than
later. The UK Society of Investment Professionals advises analysts to get their
‘retaliation in early’.

At issue is how a company reports how it has done over the preceding year.
There are proposals to move to a ‘comprehensive’ income statement that
represents all balance sheet movements, and analysts and investors, in the form
of the Corporate Reporting Users’ Forum, have written a letter to
standards-setters warning them off.

Analysts want to know what the ‘underlying’ profit is for a company, so they
can make assessments of whether it is worth investing.

That means a profit figure that strips out things like currency movements or
fair value movements, issues that do not explain how well the management is
doing rather than just market fluctuations.

In the face of such compelling arguments for clear and uncluttered numbers
representing the position of a company, who does support a comprehensive income

‘I’m tempted to say everybody,’ says Ken Wild of Deloitte.

Wild says that whichever accounts preparer you ask will give you a different
answer as to how profits should be recorded.

‘People say you shouldn’t include finance costs, because it goes up or down
with interest rates. But others say that’s an ongoing cost,’ he says.

The same is true of selling a factory. One factory sale might seem an
exceptional item to many, but what if the company has 30 of them and sells two a
year routinely?

Even so, the analysts and investors look to be a powerful lobby. And they
have struck at a time when the IASB is vulnerable on its conduct of the
standards debate.
The segmental reporting row raised accusations from MEPs that the body was
undemocratic, and that it made decisions before consulting.

The standard-setter, which along with the FASB is pushing the earnings
debate, has yet to issue a discussion paper on the issue and has only mooted
possibilities. But suggestions that no decisions have been made are likely to
fall on deaf ears given recent history.

Jan Engström, an IASB member, says that the ‘comprehensive income’ proposals
are the most radical on the table and that the bottom line will not disappear.
But analysts and investors were scared given the IASB’s lofty and academic

Wild has a tale, though, about the markets that would make most a little wary
of trusting the analysts and investors too much.

A retailer 15 years ago had a £90m charge to put through its books after
buying a rival.

But instead of putting it in as an extraordinary item it put it through the
profit and loss account, saying that as it planned to make more acquisitions it
would be a recurring cost.

‘The shares fell 35p, a big chunk of their price, and the whole of the retail
sector was marked down. Lex [the FT investment column] said there were fears of
an outbreak of prudent accounting,’ Wild says.

The issue really is that a stripped down profits figure might tell you
something about the underlying business. But it might disguise big balance sheet
movements too that are just as integral in judging the company.

The IASB is due to report in 2008 on its views on the issue. Whatever it
does, it had better tread carefully.

What they said

Bill Hicks, director of external financial reporting, AstraZeneca:
‘The issue of reporting performance is part of a wider debate, which goes to the
heart and soul of financial reporting, and is characterised by standard-setters’
apparent aspiration to move from the current “parent style” of financial
reporting (based on a focus on performance as directed by management that is
attributable to the parent company shareholders) to an “entity style” (where
there is no distinction between those gains and losses that are earned and those
that arise outside the control of the company or management, and no distinction
between parent company and minority interest shareholders).’

Richard Barker, Judge business school, Cambridge University: ‘The
issues…are not radical, they are not proposals and they are certainly not cause
for alarm.’

Richard Sexton, head of assurance, PricewaterhouseCoopers:`The
discussion paper should not be the starting point. Rather than being prepared by
the standard-setters prior to consultation, it should be a reflection of a full
and open debate amongst the key stakeholders in the reporting model. Now is
exactly the right time for all stakeholders to come together, while the
discussion paper is being drafted and before views become entrenched.’

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