Finding meaning in the profit and loss statement

By in Accounting and Finance

Managing the chasm between financial reporting under accounting standards and earnings guidance, to meet your stakeholders’ needs.

An audited statutory report typically is not the document a shareholder will seek as they eagerly await to see how their listed and unlisted investments perform come reporting season. This has now been replaced by an Earnings Guidance Statement, which is typically released concurrently with the audited statutory report.

Why so?

Shareholders have long perceived the audited statutory report as overly long, complex and filled with accounting jargon that doesn’t meet their financial reporting needs.

Yet, the chasm between these two reports need not be so large. In this article, I will focus on the humble statement of profit and loss, to demonstrate how current approaches to statutory reporting have become so misaligned with shareholders’ expectations.

Take the examples of Pact Group Holdings Ltd (Pact), an Australian packaging and logistics enterprise, and the Food Revolution Group (FOD), and their results for the half year ended 31 December 2017 (available on the ASX).

Both statements are designed to meet accounting standards requirements, but do so in ways that confuse the underlying profitability of the business. For instance:

  1. Both have employee benefits expense (or employee costs), but is not possible to identify whether those employees are used in costs of production, selling marketing and distribution, research and development or corporate and administrative services;
  2. Both have been involved in significant transactions, but the amount of costs attributable to that transacting activity, be this due diligence or costs of executing the transaction, is not obvious;
  3. Both do not use subtotals to disaggregate their result (for instance, the result before transaction costs, depreciation and amortisation and finance costs) with the exception of the delineation between profit before tax and net profit for the period; and finally
  4. Some line items seem to be obscure, like operating costs, or strangely aggregated, like occupancy, repairs and maintenance, administration and selling expenses.

The fact is that the Accounting Standards require entities to be explicit in their classification of revenues and expenditures that have meaning for investors.

AASB 101 (IAS 1) Presentation of Financial Statements requires that revenues and expenses should be classified by either their function or nature. So, a preparer of financial statements may ask these questions when thinking about this specific requirement in order to contemplate alternative ways these statements could be read:

  • Is that really employee benefits expense, or is it the payment to employees performing marketing, selling and distribution activities?
  • Is that really consultants’ costs, or are they transaction costs taken to the profit or loss in-connection with the due diligence and execution of a transaction? or even
  • Is profit or loss before income tax the only relevant subtotal, or could a subtotal be included showing profit before finance costs, depreciation and amortisation, transaction costs and income tax expense?

In other words, the accounting standards already permit the presentation of a statement of profit or loss that is commercial and tailored for shareholders, and in-turn curate meaningful and powerful information for their analysis, for instance:

  • How much effort does it take so attract and retain customers (ratio of marketing, selling and distribution expense to sales)?;
  • What expenses were incurred in performing due diligence and executing a transaction (transaction costs)?;
  • How much did it cost to restructure an entity following a change in management in order to elevate profitability levels (restructuring costs); and
  • After reclassifying so many of the other expenses, what, really, is left in corporate and administration expenses that are an unavoidable sunk cost of managing and operating an entity?

Taken in this light, the dry and draconian sounding jargon in AASB 101 takes on a new commercial relevance – all with the added benefits of harnessing management’s goal of achieving value for investors.

This, in theory, should facilitate a more efficient pricing of the entity by its shareholders, particularly in their need to understand underlying earnings quality. And that, really, is the essence of financial reporting.

 

 

 

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