Part 3: Reporting alternative performance measures such as "underlying profit"

Central government: Results of the 2010/11 audits (Volume 2).

Last year, we reported our unease with SOEs in the electricity sector disclosing alternative performance measures in their 2010 annual reports. In this Part, we:

Why we were uneasy

In our 2011 report to Parliament, Local government: Results of the 2009/10 audits, we noted that the electricity SOEs were disclosing an amount described as underlying profit in their annual reports.

Underlying profit is an alternative performance measure to the profit figure determined using approved financial reporting standards and included in the financial statements. Sometimes, different terms are used, such as "normalised profit" instead of "underlying profit", but they are essentially the same type of measure. The term underlying profit is not defined in financial reporting standards, but it typically excludes changes in the fair value of financial instruments and non-recurring transactions.

By presenting an underlying profit figure, entities intend to provide information that readers can use to better assess ongoing financial performance.

Normally, we encourage public entities to include information in their annual reports that is likely to be relevant to users. However, we were uneasy about the practice of disclosing underlying profit because:

  • there is no authoritative guidance about what "underlying profit" is or how to calculate it, so inconsistent practices are likely between different entities;
  • the underlying profit amount is often presented prominently in the annual report and could overshadow the financial information that was prepared in keeping with financial reporting standards; and
  • the underlying profit amount is not always clearly labelled as supplementary information that is additional to the information required by financial reporting standards.

Our expectations for reporting underlying profit

In early 2011, we carried out some research about underlying profit disclosures and set our expectations for such disclosures by entities in the public sector. Our research included looking at how regulators address the reporting of underlying profit, locally and internationally. In particular, we looked at the work on underlying profit completed by:

  • the Securities Commission (which was disestablished and replaced by the Financial Markets Authority in May 2011);
  • the Committee of European Securities Regulators; and
  • the Australian Securities and Investments Commission.

In March 2011, we provided our auditors with guidance about what they should expect when entities disclose alternative performance measures such as underlying profit. We said that, if entities in the public sector disclose alternative performance measures in their annual reports, then we expect those disclosures to:

  • be understandable;
  • relate to information based on generally accepted accounting practice in New Zealand (NZ GAAP13), preferably by reconciling the amounts;
  • be neutral and not used to remove "bad news";
  • be consistently calculated over time;
  • be less prominent than information based on NZ GAAP; and
  • include comparative information for the previous year.

For any alternative performance measure to be understandable, we said that we expect the disclosures to contain enough contextual information for a reader to understand what the alternative performance measure is (that is, the principles supporting it) and why it has been included in the annual report.

We generally expect the alternative performance measure to be disclosed outside the financial statements or in the notes to the financial statements, and for any commentary on the alternative performance measure to be balanced with commentary on information based on NZ GAAP.

Underlying profit disclosures by State-owned enterprises in 2011

We reviewed the underlying profit disclosures made in the 2011 annual reports of SOEs.14 Underlying profit disclosures are usually reported by entities with a commercial focus, and SOEs are the main entities in central government that have a commercial focus.

The purpose of our review was to gauge the level of reporting of underlying or "normalised" profit within the SOE sector and assess how clear those disclosures were.

About half of the SOEs reported underlying profit in their annual reports, using a range of reporting practices. Some included it in their financial statements, while others included that information in commentary accompanying the financial statements. In our view, these SOEs were trying to provide readers with some additional insight into how the SOEs' performance should be judged.

These SOEs did a reasonably good job of disclosing how they calculated underlying profit and how that profit related to the information in the financial statements. However, in our view, there is room for greater clarity.

What next?

We will continue to work with SOEs and our auditors, as appropriate, where we consider that improvements can be made to the disclosures about underlying profit (in keeping with the principles set out in paragraph 3.7).

We will watch developments with the reporting of alternative performance measures (such as underlying profit) in the private sector, where the practice is more widespread. If necessary, we will revise our expectations for "for-profit" entities in the public sector. We want to ensure that practice in the public sector is appropriately aligned to practice in the private sector, given that entities in the public sector making such disclosures have a commercial focus.

As well as keeping up with developments in reporting alternative performance measures in New Zealand, we will watch what is happening internationally, especially in Australia. We note that the Australian Securities and Investments Commission issued a regulatory guide (No. 230) in December 2011, entitled Disclosing non-IFRS financial information.

The Financial Markets Authority has said that it intends to consult on a draft regulatory guide on disclosing alternative performance measures and other information prepared other than in keeping with approved financial reporting standards. We look forward to seeing the draft regulatory guide.

13: NZ GAAP includes applicable financial reporting standards issued by the New Zealand Accounting Standards Board, which is a sub-board of the External Reporting Board. NZ GAAP establishes requirements for preparing financial statements in New Zealand.

14: We included Air New Zealand with SOEs for the purposes of our review.

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