Brian Gaynor: Crisis of accounting's double standards

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New Zealand investors are facing an accounting crisis. This is because domestic companies have rejected many of the new international financial reporting standards (IFRS) and are declaring "adjusted", "underlying", "operating", "excluding non-trading" and "from continuing operations" profits that vary significantly from audited IFRS-compliant profits.

Many of these re-stated profits are justified, but they reflect a disturbing lack of confidence in the new accounting standards, which are supposed to give a more realistic interpretation of the performance of companies.

This lack of confidence in IFRS is probably best summed up by Delegat's Group, which has reported an "operating" profit of $18.9 million for the year to June, compared with an audited IFRS-compliant profit of $200,000.

Delegat's chairman, Robert Wilton, wrote in the company's annual report: "The board considers that the results reported under IFRS do not provide adequate insight into the group's underlying operational performance, primarily due to the number of fair value adjustments that are required to be reported on.

"To better understand the operational performance, the group presents the operational performance report, which eliminates from each line in statement of financial performance all fair value adjustments.

"Also eliminated are the one-off non-cash accounting adjustments resulting from the impairment of assets and one-off non-cash accounting adjustments required as a result of the Government announcing changes to company tax legislation in the 2010 Budget."

In other words, Delegat's made nearly 10 adjustments to its net profit of $200,000 to get to its "operating" net profit of $18.9 million.

These adjustments reflect the serious concerns of many New Zealand companies over the appropriateness of IFRS.

Government tax changes, particularly the removal of depreciation on property and the requirement to make a deferred tax provision as a result, have opened the flood gates of opposition to IFRS.

This is a potential problem for investors as unscrupulous companies could take advantage of a situation where accounting standards have been discredited and develop their own "creative" accounting.

This would be yet another disaster for New Zealand investors because inadequate auditor oversight and "creative" accounting were major contributors to the 1980s sharemarket boom and bust, as well as the finance company debacle.

The main objective of IFRS is to create a common worldwide accounting standard so companies in different countries can be compared with one another.

IFRS has had a big impact on accounting policies relating to several areas, particularly impairment of assets, employee benefits, intangible assets, investment properties and financial instruments.

The problem is that many of these items are important as far as New Zealand companies are concerned, and domestic directors, management, analysts and investors believe that these IFRS accounting standards do not give an accurate view of company performances.

As a result, there is now a wide gap between IFRS accounting profits and the figures companies use when communicating with shareholders.

The table, which shows the difference between audited IFRS-compliant and company promoted profits for 15 listed companies, illustrates this trend.

Twelve of the companies display higher earnings than the audited profits and three report lower earnings than their audited ones.

The boards of the 15 companies consider their companies to have had combined net profits after tax of $1140 million for the 2010 year, compared with IFRS-compliant profits of $846 million.

Many New Zealand annual reports now contain two separate sections with totally different profit figures.

The front part has the directors' net profit figures, and the financial section at the rear has the IFRS figures approved by auditors.

The financial sections also include the earnings per share, which is based on the IFRS profit, and statements by the auditors that the accounts "comply with International Financial Reporting Standards" and "give a true and fair view of the financial position of the company and group and their financial performance and cash flows for the year just ended".

The difference between the accounting profit and the company's figure was raised at Cavalier's annual meeting.

The carpet company had an IFRS-compliant net profit of $11.4 million for the year to June, and earnings per share of 16.8c.

But managing director Wayne Chung wrote in his review that the group had "normalised" earnings of $16.6 million and earnings per share of 24.6c.

The difference was due to the impact of tax changes in the Budget.

Auditors KPMG were asked at the meeting if they had any oversight of the managing directors' figures and, if so, how could they endorse a net profit of $16.6 million when they had signed $11.4 million as being "true and fair".

A KMPG representative said he was quite comfortable with the use of $16.6 million even though the IFRS profit, which he had approved, was nearly a third lower.

Although all 15 companies in the table can justify the difference between their adjusted profits and the audited figure, there seems to be far more of this in New Zealand than in other countries.

This is a serious worry because inadequate accounting compliance usually plays a large role in any financial boom and bust, and New Zealand has a particularly sorry history in this regard.

The committee of inquiry into the sharemarket after the 1987 crash, had this to say about New Zealand's accounting practices:

"One of the major disclosure deficiencies identified by the committee was the level of non-compliance with the New Zealand Society of Accountants' statement of standard accounting practices (SSAPs).

"Despite a requirement in the listing requirements for companies to comply with SSAPs, it is apparent to the committee that these standards were not adhered to by all listed companies."

Audited financial statements now comply with IFRS standards, but a large number of companies have found ways to adjust these figures and report higher earnings.

These adjustments include:

* Previous year figures are revised downwards, compared with last year's annual report, enabling companies to report higher percentage increases compared with the previous year.

* Discontinued operations are excluded when they reported a loss but included when they are profitable.

* Changes to tax provisions are excluded when they are negative but included when they are positive.

* Unusual items are excluded when they are negative and included when positive.

* Asset impairments and write-offs are often excluded

* Real earnings are adjusted to theoretical earnings.

These developments are extremely disturbing for those of us with a long exposure to New Zealand's capital markets, as investors can be easily misled when accounting standards are not followed.

The problem is that we don't have strong leadership in the accounting profession.

Public issuers should be required to follow accounting standards in all aspects of their communications with investors, and if the accounting profession believes that these standards are inappropriate then they should be changed.

The road we are heading down, which is where companies reports their own adjusted profits to shareholders, inevitably leads to tears as far as investors are concerned.

* Brian Gaynor is an Executive Director of Milford Asset Management.