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Judging a firm by its profit & loss account
September, 10th 2007
The profit and loss statement of a firm is an essential tool, both for evaluating the firms management in its stewardship function, and estimating the future earnings of the company for the purposes of valuing it. On the one hand, the profit and loss statement tells us whether the actions of the firms management created or destroyed shareholders wealth in the past reporting period. And on the other hand, it allows us to analyse the sources of the firms cash flows in the current period so that we can better extrapolate what its future cash flows would be.
Since the information that would be the most relevant for evaluating the performance of a firm will vary with the nature of its business, one would have expected the format of the profit and loss statement to vary from industry to industry. This expectation is, however, belied by actually published profit and loss statements which are all too uniform and seem to be produced from a template drawn from some outmoded law. Yet, in fact, it is the lack of management interest in transparency rather than restrictive regulation which is to blame for the rigidity of profit and loss statements.
Both Indian and international regulations actually allow a great deal of flexibility in the preparation of financial statements. In India, it is Schedule VI of the Companies Act rather than the accounting standards which governs the presentation of the profit and loss statement. This law does not specify any particular format for the statement at all. It only stipulates the principles which should be applied in presenting the profit and loss account. The International Financial Reporting Standards (IFRS) are equally flexible. It is the responsibility of the board of directors to ensure that this flexibility provided by regulators is used for the benefit of users of financial statement.
One way in which the profit and loss statement can be made more useful is by providing a functional classification of expenses. The usual natural classification groups transactions according to their types. For example, all salaries and wages or all depreciation is grouped together. A functional classification, in contrast, might classify a particular wage payment as cost of goods sold, administrative expenses or selling and distribution expenses depending on the activity for which the wage is paid. Since such a classification is better correlated to a firms decisions and its external environment, it is often more informative than the natural classification. While the Indian Companies Act requires firms to produce the profit and loss statements on the basis of a natural classification of expenses, it does not prohibit them from providing additional information based on a functional classification. The IFRS goes further by allowing firms to use either the functional or the natural classification for the profit and loss statement, though it requires firms using the functional classification to make some additional disclosures.
However, companies seldom pay attention to the requirements of users of financial statements. For example, analysts are interested in the gross profit ratio of a company engaged in retail business. Gross profit is the difference between the value of sales net of excise duty and the cost of goods sold. The cost of goods sold is the total cost of producing or purchasing the units sold and bringing them to the location and condition of sale. For example, in a merchandising business, this includes procurement price and expenses on logistics to procure and transport the goods to the store which sells the product and also the cost of primary packaging. In the case of a manufacturing business, the cost of goods sold includes the manufacturing cost of units sold and the cost of transporting those items to the location where those units are sold. The cost of goods sold does not include operating expenses. Published profit and loss accounts presented by companies engaged in retail business do not provide details of the cost of goods sold. Therefore, an analyst has to make significant assumptions in calculating the gross profit ratio using information provided in published accounts.
The gross profit ratio is not meaningful for companies that spend significant amount on, say, advertisement or on product development. For example, a mega store may provide significant free space to create a shopping experience that helps it attract more customers and charge a premium compared to other retail stores. The rent or depreciation of this space and furniture and fixtures is not a part of the cost of goods sold. They are included in operating expenses. Therefore, the gross profit ratio computed as above would be misleadingly high since the premium charged by the mega store is reflected in the value of its sales while the development expenditure which allows that premium to be charged is not included in the cost of goods sold. An analyst who wishes to correct this can do so only if the profit and loss statement provides a break-up of operating expenses. Similarly, for a company engaged in manufacturing activities, analysts are interested to know the detailed break-up of manufacturing expenses. However, such break-ups are seldom available.
While the fundamental principles which govern the preparation of profit and loss statements are the same in Indian and international standards, in some matters of detail the IFRS specifications make for more relevant statements. For example, the IFRS requires a statement of changes in equity to be presented in addition to the profit and loss statement and the balance sheet. This statement shows the comprehensive income in a period, i.e., the net change in shareholders equity arising from all transactions and events other than those with owners. This redresses the fact that the bottom line of a profit and loss statement does not give a measure of clean surplus since certain items of income and expenditure such as revaluation reserves are excluded from the profit and loss statement to reduce the volatility of reported incomes.
The Indian GAAP recognises the concept of extraordinary items and requires that extraordinary items be presented separately. The IFRS does not recognise the concept of extraordinary items. Often it is difficult to distinguish extraordinary items from ordinary items. For example, it was debated whether losses arising from the 9/11 event were extraordinary items. The FASB finally concluded that those losses were ordinary items because businesses are ordinarily exposed to such risks.
The IFRS also provides for a better treatment of prior period adjustments arising from errors or changes in accounting policy. Consider a company that changes some accounting policy, say the method of depreciation, in 2007. Suppose that, together with the statements for 2007, it also presents the financial statements for 2006 as comparative figures. The IFRS requires that it calculates the net effect of change for periods up to 2005. The general reserve as on January 1, 2006, is adjusted for this net effect. Each element of the profit and loss account for the period 2006 affected by the change in policy should be adjusted while presenting the comparative figures. The Indian standards, on the other hand, require the entire effect of the retrospective change to be recognised in the period 2007. In this case, the IFRS produces a more comparable set of financial statements.
We can expect the continuing process of review of standards to address these anomalies. The more serious problem remains that of the reluctance of companies to take advantage of the flexibility already provided by the current regulations. Its only pressure from the users of financial statements which can compel managers to move towards greater transparency and informativeness rather than merely a formal and minimal conformance with the standards.

Asish K Bhattacharyya
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