Reporting financial performance

What are the types of accounting abuses?

• Reserve accounting
• Extraordinary items
• Earnings management
• Big bath accounting
• Recognising income too early
• Deferring recognition of expenses/costs
• Pro forma earnings

What is reserve accounting?

Excluding certain items from profit and loss account, and reporting them as reserve movements

What are exraordinary and exceptional items?

• The term “outside the ordinary course of business” was vague and open to interpretation

As a result:

• Many one-off material losses were classified as extraordinary

– Excluded from EPS

• Many one-off material profits were classified as exceptional

– Included in EPS

What is earnings management?

• No single accepted definition

– Accounting choice

– Income smoothing

– Earnings management

– Earnings manipulation (violate GAAP)

• Information perspective

– Better communicating inside information to external stakeholders

• Opportunistic perspective

– Managers manipulate earnings to achieve personal gains

what are the motivations for Earnings Management?

What is big bath?

• one time large write-offs

• to boost future profits

What is anticipating income?

Recognising income before it is earned.

What is delaying recognition?

Choosing to delay your recognition of costs/expenses

What is Alternative Performance Measures?

• not audited

• “earnings without the bad stuff”

Examples of non-GAAP metrics

FRS 3 Reporting Financial Performance

• Extraordinary items were eliminated

• Most items previously classed as extraordinary now treated as exceptional

• Up to three exceptional items permitted to be highlighted on face of profit and loss account

• Other exceptional items to be disclosed in notes

• All realised gains and losses to be shown in profit and loss account

What items need to be seperately disclosed?

• Write downs of inventory to net realisable value (and reversals)

• Write downs of property, plant, equipment to recoverable amount (and reversals)

• Costs of, provisions for, restructuring (and reversals)

• Profit / loss on disposal of property, plant and equipment

• Profit / loss on disposal of investments

• Profit / loss on discontinued operations

• Litigation settlements

• Other reversals of provisions

What is material?

• Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the decisions of primary users.

• The size or nature of the item, or a combination of both, could be the determining factor

• Users are assumed to have reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence.