Underlying earnings: a checklist for boards
Over the last five years, proxy advisers and institutional investors have increased their focus on the earnings measures used for assessing and payments of executive incentives.
Many ASX-listed companies report an underlying earnings measure in addition to their statutory reporting obligations (a recent analysis of the ASX 50 by KPMG showed that 39 of the 50 top companies in the ASX reported an alternative profit result in addition to the statutory result). There is a good reason for this. Generally, it is because they consider the accounting basis does not provide the investor with a good understanding of the performance of the core business – looking through revaluations, impairments and one-off transactions to really assess what sort of return the business is making on the invested capital.
It is useful to, firstly, consider the pros and cons and then a checklist to ensure against traps.
- Underlying earnings are typically drawn from management accounts and are the basis of budgets on which management is focused and assessed
- They are generally the measures within management’s control, or line of sight
- They better reflect the basis of market value
- Strip out one-off transaction costs that may otherwise discourage value adding acquisitions
- Are the measures typically used internally for reporting of operating segments of the business and on which the business leaders are assessed
- Non-cash adjustments, like impairments, are often excluded on the basis the asset cost has been recognised
- Can be the basis on which guidance is provided
- Can be a better and more consistent comparison with competitors
- Can be less volatile by removing mark to market adjustments
- Accounting measures are just as prone, if not more so, to manipulation
- Underlying earnings can be inconsistent within the company and between companies
- Underlying earnings has no basis in law or standards and relies on judgement
- Can exclude items for which management should be accountable
- Is treated skeptically by some investors and proxy advisers if used for paying incentives
- Requires judgement to refine what is in the definition and what is excluded
- Requires an explanation of why it is used in the remuneration report, whereas an accounting measure requires less explanation, even if less valid
- Underlying measures are not subject to accounting standard audits
One of the criticisms of underlying earnings is they are often used for performance measurement of managements’ incentives and are not necessarily aligned with shareholder outcomes. For example, excluding a significant loss on disposal of a business unit impacts shareholders but may not be reflected in the executives’ incentive outcomes.
The following checklist may help boards to work through how they use the underlying earnings measure in their remuneration frameworks.
- Prepared a policy/guideline setting out the basis on which underlying earnings is to be determined?
- Is it the same basis for reporting purposes as for remuneration purposes?
- Has the basis of calculation been agreed with the auditors, necessary to sign-off incentive payments?
- Defined what will be included and excluded from underlying earnings?
- And the rationale for the inclusion or exclusion?
- Is the basis consistent from year to year?
- Listed the criteria that are the bases for identifying an item for inclusion/exclusion?
- Are all items of the same nature identified for the board’s review and consideration?
- Are impairments of assets acquired by current management excluded?
- If so, why? Management who acquired assets that are impaired should be accountable for that impairment.
- If the earnings of acquired businesses are included, have the acquisition costs been excluded? If so, why? If the earnings are included in the underlying results, what of the costs of acquiring the business? Some say they should be included as they are part of the acquisition cost. Others say they should be excluded because acquisitions are often opportunistic and cannot be planned for, and that the costs could be a disincentive to management for undertaking a value accretive acquisition.
- Is management responsible for foreign exchange movements? If so, why have they been excluded from underlying earnings?
- What is the rationale for excluding business closure costs?
- What action could management have taken that would have ameliorated the items being excluded? If there were actions within management’s authority and control, why are the items being excluded?
- Will the investors recognize that management should not get the benefit of revenues being included, or costs being excluded on the basis the item(s) was outside of their control?
- Do the underlying earnings reward shareholders on a basis that is consistent with managements’ reward outcomes?
Directors should be expecting a continued focus throughout 2017 on the disclosure of underlying earnings and the extent to which executives’ rewards are greater than would have otherwise been the case.
© Guerdon Associates 2022
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