Beware of potential bottom line confusion

With the reporting season for the first half of the financial year over, a Southern Cross University researcher is warning investors to be aware of the way companies report their profits.

Elisabeth Sinnewe, a PhD candidate with the Southern Cross Business School, believes there is scope for investor confusion over the way Australian companies differ in reporting methods between adjusted earnings and income statement profits.

“A good example of adjusted earnings was with Webjet on February 7. They reported an increase in core earnings with normalised net profit after tax rising to 24 per cent from $5.9 million in 2011 to $7.3 million in 2012, while net profit after tax on its income statement decreased by 4.04 per cent from $5.9 million in 2011 to $5.6 million in 2012,” she said.

“The difference is due to one-off start up and acquisition costs, which Webjet appears to discount as not relevant to its core business. But Webjet is not the only one. From 2006 to 2011, 56 per cent of the top 500 ASX listed companies reported adjusted earnings.”

As part of her PhD, Ms Sinnewe has collected 15,000 earnings announcements of the top 500 ASX listed companies over a six-year time period to analyse the drivers and market reaction to adjusted profits.

Her research shows that companies, on average, report adjusted profits larger than the income statement profits, in particular if the later are decreasing or even negative. Despite this, short-term market reaction shows that investors find adjusted profits more useful than their income statement counterparts, as adjusted profits are also better suited to predicting future operating cash flows.

While Australian companies have to follow a regulatory guide, introduced in 2011, to minimise the risk of issuing misleading information, Ms Sinnewe argues that this regulatory reform should provide conformity across the sector in regards to reporting.

“In the United States, reporting adjusted earnings figures coincided with large corporate collapses such as Enron, which reported earnings on an adjusted basis just six weeks before the company went into bankruptcy,” she said.

“The potential risk of misinformation led to a radical reform of regulation in the US, which came into effect in 2003.

“By contrast in South Africa, companies have to report adjusted earnings and Australia is kind of sitting in the middle. It would make sense for investors to see the same sets of numbers for all companies to avoid potential confusion.”

However, there is a trade-off. For example, during 2008 to 2009 when the market highly volatile, financial analysts provided more favourable earnings forecasts for firms with stronger adjusted profit figures suggesting that professional investors relied on adjusted profits disclosed by firms when market uncertainty was high. Conformity may therefore limit management’s ability to signal important information to the market.

Photo: Elisabeth Sinnewe.