Weird profit benchmarks
I have been wondering for a while how auditors fix their materiality limits so I read eight audit reports of four large audit firms [1] to see if I could find anything amusing on this Oh so serious and boring subject.
Their approaches to the subject are quite different. Some auditors choose a percentage against a profit to choose their materiality benchmark, others choose an amount and measure it against a profit. But auditors create a constant. None of them use the same calculation of profit as their base. They go from simple to bizarre as I show below:
Adjusted profit before taxation (Ernst &Young, Associated British Foods)
No information on what is adjusted.
Normalised Group profit before taxation (KPMG, Unilever)
Not sure what normalised here means.
Adjusted profit before tax from continuing operations, including net pension finance costs (Deloitte, Tesco)
No information on adjusted.
Three-year average of the Group adjusted operating profit before tax attributable to shareholders’ profits from continuing operations. (Pricewaterhouse Coopers, Aviva)
I wonder why they chose a three year average. Profits must be jumping around so to keep their percentage and the materiality amount stable, they decided on a three year average.
Statutory profit before tax, Adjusted profit before tax, Revenue and Net cash flows from operations (Deloitte, GlaxoSmithKline)
This is what Deloitte call delightfully “metrics used by investors and other readers of the financial statements,” (whatever that might mean) which makes it all the more justified to use as a benchmark. Using their professional judgement, Deloitte choose a materiality number, in this case £210 million, and then measure it against these different benchmark calculations.
Adjusted EBITDAal (Ernst &Young, Vodafone)
Please note the ‘adjusted’ with a capital A. Now most people, even accountants, have no idea what EBITDAaL means let alone Adjusted EDITDAaL. They do not explain what Adjusted is either. For the ignorant like me EBITDAaL represents EBITDA after Leases. This has recently become fashionable is some industries and as Ernst &Young state it “provides us with the most relevant performance measure on which to determine materiality given the prominence of this metric …” Of course EBITDAaL covers materiality so much better than EDITDA on its own.
PBTCO normalised to exclude this year’s investment and other variances and losses attributable to non-controlling interests (KPMG, Legal and General)
If you don’t know PBTCO represents profit before tax from continuing operations. KPMG choose the trendy accounting convention of using initials instead of stating clearly what they mean. We all know they are competent auditors, so there is need to show off in this way.
Too long for the table [see 2 below] (Pricewaterhouse Coopers, AstraZenica)
Pricewaterhouse Coppers calculate this weird profit benchmark and then apply a percentage to fix their materiality limit. I am certain nobody outside the firm has ever heard of this profit calculation, but they claim quite naturally, perhaps though tongue in cheek, that “these amounts are prone to year on year volatility and are not necessarily reflective of the operating performance of the Group”.
As you can see all this is nothing but inventive. But why do audit firms not choose a recognised measure of profit, for instance, profit before taxation, EBIT or EBITDA? To emphasise their independence, to show their originality in auditing or simply as they all state somewhere in their audit reports: by applying their “professional judgement”?
Percentage
So what is the percentage that auditors choose as their materiality amount? The favourite is 5% and percentages close: 4.8%, 4.7% or 4.6%, for six out of the eight companies. KPMG do own up to having an internal guideline for fixing a maximum materiality limit in their Unilever audit report:
“When using a benchmark of Group profit before taxation to determine overall materiality, KPMG’s approach for public interest entities considers a guideline range of up to 5% of the measure.”
And this seems to be followed by the others much of the time. There are two exceptions with low percentage choices: 2% in Vodafone and 3.7% in GlaxoSmithKline. Ernst &Young go wild with only 2% in Vodafone and justify and explain nothing. I guess they felt worried by 5% which would have meant a very high limit of €725 million and little audit work to carry out. But they go back to the norm of 5% in their Associated British Foods audit report.
Only Pricewaterhouse Cooper consistently choose 5%, but with different profit bases. KPMG do not believe in rounding up to 5%, they consider 4.8% and 4.7% to be more accurate.
I then had a look at the absolute materiality limits to see if there was a trend, but sadly I found nothing to muse about.
Finally, this rather bland statement from Deloitte in their GlaxoSmithKline audit report made me smile:
“Given the importance of the above metrics used by investors and other readers of the financial statements, we concluded `Statutory profit before tax` to be the primary benchmark.”
They claim that ‘statutory profit’ is a recognised and important metric used by investors and readers of financial statements. However it only comes up in their audit report. In the other annual reports there are statutory tax rates, statutory allowances, statutory deadlines, even a statutory audit fee, of course statutory auditors and many other statutory items, but never statutory profit. How important does that make it as a primary benchmark?
[1] From a list of the 50 largest UK based companies, I chose two companies audited by the four large audit firms Pricewaterhouse Coopers, Deloitte, Ernst &Young and KPMG from the 2022 annual reports of the companies named above.
[2] “Profit before tax after adding back intangible asset impairment charges (Note 10), fair value movements and discount unwind on contingent consideration (Note 20), the discount unwind on the Acerta Pharma share purchase liability (Note 3), material legal settlements (Note 21) the unwind of the fair value adjustment to Alexion inventories (Note 2) and restructuring charges relating to the Post Alexion Acquisition Group Review (Note 2).”