Is financial transparency dead?

On the topic of adjusted earnings, Warren Buffett noted in his February 2016 letter to shareholders that it has “become common for managers to tell their owners to ignore certain expense items that are all too real,” and that “Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring ‘earnings’ figures fed them by managements.”

You heard that same complaint in our January 2016 AER column, “Why to watch a company’s adjusted earnings.” The prevalence of the topic indicates a major problem. Adjusted earnings numbers are largely unregulated, and they’re not audited or comparable among companies. Based on multiple sources, the vast majority of large-cap U.S. companies report adjusted numbers. FactSet puts the figure at greater than 90% of S&P 500 companies. And, turns out the adjusted numbers make companies look better more than 80% of the time, according to research company Audit Analytics.

Anecdotal evidence of this also abounds. In Canada, Valeant is the worst recent example. In 2015, the company reported adjusted EPS of US$8.14. But, according to the audited income statement, the company actually lost US$0.85 per share over the same period. Many healthcare firms, both here and abroad, are guilty of the same sin. So advisors have to be attuned to the relative gap between regular and adjusted earnings.

GAAP is short for Generally Accepted Accounting Principles.

Canadian public companies had to switch from GAAP to IFRS (International Financial Reporting Standards) as of January 2011.

In the U.K., annoyance has boiled over most recently in the energy sector, specifically regarding BP. The company reported adjusted earnings of US$5.9 billion versus an income statement loss of US$6.5 billion. As we noted before, a significant risk for advisors is when management bonuses are based on meeting targets for their own numbers, or when poor GAAP-based results are ignored when handing out executive raises, as is the case with BP.

Adjusted revenue

It’s not only adjusted earnings that are a problem. Changes to top-line revenue are becoming more common. Aimia (parent of Aeroplan) used to report wide differences between gross billings and standardized revenue. In the U.S., Tesla reported 2015 non-GAAP revenue of US$5.29 billion, versus standardized revenue of US$4.05 billion.

The U.S. SEC is becoming more concerned over the issue, commenting in May 2016 that “revenue adjustments do more than just adjust from GAAP: they change the very starting point from which other performance analyses flow […] If you present adjusted revenue, you will likely get a comment [letter]; moreover, you can expect the staff to look closely, and skeptically […].”

The SEC also issued its standard warning that it may implement new rules to curb any practices it deems offside.

U.S. securities regulators have always tried to tamp down on reporting abuses, but they ultimately have not prevented a stampede of companies turning to adjusted earnings measures. That’s why regulators look for help from other sources, and periodically push corporate audit committee members to exert a more sober influence on adjusted results.

Unlikely ally

Unexpected support for reform recently came from the chair of the International Accounting Standards Board.

In May 2016, the makers of Canada’s IFRS accounting rules gave a speech highlighting the need for the board to do more to standardize the income statement.

Previously, the accounting standard-setters seemed content to allow management leeway in terms of accounting rules. There’s recognition now that they may have gone too far, with the IASB chair noting, “We have to acknowledge that non-GAAP measures are also popular because we provide too little guidance in terms of formatting the income statement. The enormous flexibility under existing accounting standards is an open invitation for non-GAAP to step in.”

The board is contemplating standardizing EBIT (operating income), EBITDA, or other subtotals in the income statement that analysts and investors are keen to base share price on. It would be even more beneficial to investors if they extended the concept to the cash flow statement, and standardized commonly misconstrued measures, such as free cash flow.

Heed the warning

But advisors can’t wait for accountants to improve the situation. If history is any predictor, it will be a long time before any new rules are put into place. And stats show the current financial reporting environment is quickly deteriorating. The easiest route is not to examine adjusted earnings, revenue and cash flows from the ground up, making sure every company includes the same items. Instead, focus on what is being excluded. For instance, be skeptical when companies completely delete recurring expenses or cash flows, as opposed to merely smoothing them out. Most important, heed the uncharacteristic warning from the accounting standard-setters. They know better than most where the bodies are buried.

By Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE. They run Accountability Research Corp., providing independent equity research to investment advisors across Canada.