- Truthfulness, Transparency and Incentives: Making Financial Reporting More Honest
- What are affecting earnings quality
- HK opens doors to Chinese Accounting Standards
- Mind the GAAP
- SOX Section 404 - is it really effective ?
- Are Foreign Issuers Shunning the U.S.?
- Sarbanes-Oxley: A price worth paying?
- Value is in the Eye of the Beholder
- Sarbanes-Oxley: A Price Worth Paying? - Sumesh
- The Sarbanes-Oxley Act-Is it Worth Paying the Price?
Monthly Archives: September 2010
The chief accountant of the SEC has described pro forma earnings as “earnings before the bad stuff.” In their study, “The Predicitive Value of Expenses Excluded from Pro Forma Earnings,” Professors Doyle, Lundholm, and Soliman prove there is some truth to that claim.
Companies issue pro forma earnings reports because they feel US GAAP rules penalize them for “unusual and nonrecurring transactions.” In some cases, they have a point. Unusual events that are unlikely to effect future cash flows can distort a company’s bottom line and investors’ perceptions thereof. However, as the authors show, too many corporations are using pro forma earnings reports to excite investors with rosy projections that don’t match reality. These pro forma reports are often trumpeted in press releases, while any mention of the bad stuff is buried at the end, such as AT&T’s 2001 fourth quarter release. Worse yet, the evidence shows that the gap between GAAP and Pro Forma is widening, as demonstrated by Bradshaw and Sloan.
As a student studying accounting for the first time, I find this disturbing. So far, the more I learn about accounting, the more I learn about ways corporations can cheat. I’m glad to know about these methods, legal, borderline, and otherwise, but a part of me wants to return to the days where ‘ignorance is bliss.’
Pro forma earnings do not include unusual or infrequent transactions. Items excluded include amortization, depreciation, goodwill, and other expenses. The usual intention of these exclusions is to present a clearer picture to investors. But really, is doing so beneficial or potentially detrimental to the statement user who is not cautious? Pro forma figures typically make a firm look for profitable than GAAP figures. Simply put, it is the “earnings before the bad stuff.” The study explores the company’s defense that pro forma earnings provide a better picture for forecasting and if it causes a stock market reaction.
In 2001, General Motors opted to exclude legal settlement costs. In my opinion, it is fair to exclude legal costs as it is not part of a company’s future cash flows/potential, even though the event can reoccur. Regardless, it is up to management whether to include it or not, and it is up to the user to effectively make their decisions.
Since a company is free to use pro forma calculations over that of GAAP, I feel that so long as that is clearly emphasized, it is up to the user to “use” and invest accordingly. I don’t see it as manipulative since an investor should be educated enough to know of the risks involved, and that footnotes are not to be ignored. If not, perhaps he should not be investing, and/or rather paying someone who does know how to properly read the statements to do the reading for him.
The study, however, concludes that exclusions can predict lower future cash flows, and in turn, has a negative effect on stock returns. Earnings announcements cause reactions. But parallel to my thoughts above, it was also concluded that the market can simply be fooled. It may not actually be due to negative implications of future cash flows depending on the excluded expenses.
This article enlightened me—a novice in the investment world—to a few things:
1) In regards to earnings, companies release either/both of two figures to the public: 1. “as reported earnings” which conform to GAAP, and 2. “operating earnings” which exclude one-time items (and allow management a bit more flexibility in what is reported).
2) Historically, the gap between “reported” and “operating” earnings has been wide, illustrating a fundamental and philosophical divide between how FASB and businesses define earnings. Why can’t the two camps figure out one standard for reporting earnings? Subjective judgments from company to company make them non-comparable over time.
3) Regardless of which camp you’re in, two earnings figures translates to investor confusion. So, don’t make an investment based on “earnings,” unless you’ve first read the financial statements and determined exactly what those “earnings” report.
On the businesses side of things, “operating earnings” are calculated to the exclusion of one-time events, presumably reflecting a more accurate account of “business-as-usual” earnings. The article points out that since 1995, “operating earnings” have topped GAAP earnings by an average of $2.47 per share—showing that the “business-as-usual” outlook has historically been brighter than what has actually occurred in any given year (how optimistic!). But recently (June 2009), the gap between those earnings figures narrowed to $0.31.
The author interprets this narrowing as a sign of market stability. I speculate that a major cause for this narrowing is investor skepticism (a mark of instability). On the heels of the Madoff scandal, and in response to public outrage, I think Wall St. reported earnings more conservatively, and closer to their GAAP earnings, in the name of transparency and in attempts to restore investor confidence. Honestly, I think that we’ll need to deem one consistent, less prone-to-manipulation method for reporting earnings (among doing many other things), to restore my confidence. But in the meantime investors, it pays to mind the GAAP gaps.
“Investors, It Pays to Mind the GAAP Gaps”, is a great article that shines a light on the increasing gap between non gaap operating earnings and gaap conforming operating earnings among companies within the Standard & Poor’s 500. Before expanding on the significance of this gap, first, let me briefly explain the reasoning behind announcing non gaap operating earnings along with gaap earnings. Management teams inside of corporations as well as some analysts believe that non gaap operating earnings can be a better indicator of the performance of a corporation. This alternative method of reporting operating earnings removes any one-time charges or any one-time gains as opposed to gaap conforming operating earnings which account for the impact of one-time items. Executives and analyst will argue that the impact of these special items skews or blurs a company’s true financial picture.
The Microsoft case is a great example of this occurrence. Microsoft in the quarter ended June 30th 2007, reported gaap operating earnings of $4 billion while also providing investors with non gaap operating earnings of $5 billion. The difference in the two figures is related to a $1.06 billion Xbox warranty enhancement charge. According to management and probably most of the analyst community, this charge is a one-time occurrence and is not expected to reappear. Looking at this example it is understandable why some investors would prefer non gaap earnings as they believe it is a better depiction of Microsoft’s operating performance for the quarter.
The article’s author, Mark Gongloff, raises a number of legitimate concerns. When looking at the past 14 years, the gap between gaap and non gaap operating earnings numbers has risen by $2.41. When the averaging the gaps between these earnings over the past 10 years to eliminate any spikes or dips, non gaap operating earnings were almost 24% higher than gaap earnings. After reading the article, I thought to myself, “What does this signify?” Why has the gap between gaap and non gaap earnings grown so much over the last decade or so? Is it simply that executives are managing today’s corporations more differently than before or could there be an underlining cynical reason that’s causing one-time charges to increase when compared to one-time gains.
A critical look inside the Microsoft case might provide some answers to these questions. As mentioned, Microsoft took an Xbox related charge of $1.06 billion. Part of the charge was related to warranty claim payments to customers who bought the Xbox, experienced problems with the device, then turned to Microsoft for a fix. Microsoft, in an attempt to ensure customers who were interested in the Xbox that it stood behind its product, enhanced the existing warranty policy. Thirty five percent of the charge was also “attributable to inventory valuation adjustment” or, in other words, Microsoft looked at its Xbox and realized that some of its chips did not work properly and had to replace them.
It is very possible that when Microsoft’s management team was setting the budget for its latest innovative product that the team was more interested in supporting Xbox’s profit margin, therefore, cutting cost and corners. This cost cutting strategy might be the reason that Xbox did not perform as expected by customers thus forcing Microsoft to pay high warranty claims. It would not be the craziest idea to think that executives would push today’s cost to tomorrow in the form of one time charges to help please Wall Street and most importantly to help pay for the new home in Hawaii. This strategy and others that compromise product quality across America’s industries might be just one reason for the increasing gap between gaap earnings numbers and non gaap earnings numbers.
I believe the article “Investors, It Pays to Mind the GAAP Gaps” does an ok job in explaining why there is a difference between GAAP numbers and Non-GAAP numbers in terms of operating expenses for income statements for different companies. According to the article, many companies will have higher Non-GAAP numbers than GAAP numbers because many companies will not include one time costs/revenues in their income statements in the Non-GAAP numbers. Of course the reason for doing this is because they want their investors to see what their “normal” operating earnings usually are under normal circumstances. I say the article does an ok job because it doesn’t really say why the Non-GAAP numbers have been higher on average for the past 10 years, even when we weren’t in the recession. It is highly unlikely that more one time costs have occured than one time revenues every single year. I believe it is always higher because companies will try to be as optimistic as possible, especially when things are looking bad. This is evidenced in the article when it states that companies with a larger difference tend to do worse in the long run.
Additionally, the article goes on to discuss how over the past few years, the recession has caused the gap between GAAP and Non-GAAP numbers to increase because due to the recession, more bad events have occurred than good ones. Therefore one time losses have increased and one time gains have decreased. However, according to the second quarter numbers, the difference between GAAP and Non-GAAP decreased significantly. I believe this could be for three reasons: Either the economy is recovering so there is less incentive to inflate numbers, the one time bad events are no longer one time events, but have been continuously recurring, or people are starting to realize that heavily inflated Non-GAAP numbers is actually a sign of weakness. Personally, I think our economy could get a lot worse, but for the time being it has been somewhat stable, which has decreased the number of one time costs and decreased the need for companies to feel like they have to inflate their numbers in order to have a better image. Regardless of why, it is still important to follow both numbers because in general, an analyst may want to leave out extraordinary events when projecting a companies future growth. However, I also believe it’s important to take one time factors into account when making investments because although they are very rare and extremely difficult to predict, they DO occur, and if one is prepared, he/she can make a healthy profit or in some cases, save a lot of money.
The article “Confused About Earnings” from the November 26, 2001 issue of Business Week, discusses the discrepancy between corporate earnings as reported according to GAAP rules vs. other earnings numbers published by companies according to their own methods of accounting. As you would expect, companies use their own methods for calculating earnings in order to portray a better financial picture than what would have otherwise been displayed by the GAAP earnings. I do not fault the companies for choosing numbers that paint them in a better light as long as the methods are fully disclosed and the GAAP numbers are also available to the public. I believe that fault can be found with the investors and the analysts on which they rely who are pressuring the companies to “perform” better and better so that they can “sell” them to investors, even if they are a bad investment choice.
I do agree that more oversight in terms of how earnings are reported would greatly benefit investors that are truly looking to objectively evaluate a company and a standard for reporting this information should be the goal of any new legislation on the issue of financial reporting.
Until such a standard can be successfully developed and adopted by corporations, Investors should stop contributing to the problem by refusing to invest in a company that can not clearly explain how their earnings figure into the standardized GAAP reporting and exactly how and why they were calculated if they differ from the GAAP standard.
People, however, will continue to invest in companies that portray higher and higher earnings regardless of whether the earnings can be substantiated. They will only cry foul once the company goes under, and they will certainly not blame themselves for not properly investigating the company before investing.
How do we determine the value of a company? What do investors need to know? Companies provide financial statements; these financial statements are designed to show how well a company is doing, how well they are performing, how much money is being generated or lost, and what we can expect from the future. Investors look at financial statements. Without investors a company wouldn’t exist. Therefore it’s obvious that a company try’s its best to appeal to investors and to make them want to continue investing their money. If people don’t invest then the company loses money, if the company loses money then people get fired, bonuses go away, funding is cut…etc. This puts a lot of pressure on managers to keep their investors happy. Managers must show positive numbers on financial statements. Companies have different opinions what standards should be used in creating these financial statements. On one hand we the GAAP. Some companies feel that by applying GAAP investors aren’t getting the real sense of what company is producing. Many analysts and accountants consider GAAP to be inconsequential because under GAAP many noncash and one time charges are included. Because of the effects that following GAAP has many companies prefer the pro forma approach. The pro forma approach is a method that a company uses to create its financial statements according to its own discretion. However pro forma methods vary from company to company. The ending numbers using GAAP and pro forma end up being very different. So now how does an investor really know what to expect? GAAP doesn’t leave much room for change, even if specific issues were to arise that affect accounting it can take years to changes to be implemented within GAAP. On the other extreme pro forma calculations allow so many changes and eliminations that numbers could be changed completely. Should GAAP with all the included figures be used as a reliable source for investors or should a company’s pro forma calculations be deemed more reliable?
I say that both methods should be used as a baseline for investors. If you have a GAAP based report and pro forma based report you can see both spectrums of the financial statements. With both reports you can see the difference in the numbers and depending on how extreme they are you can prepare the right questions. If the statements are slightly off then you know small adjustments were made and the reports will probably stay consistent in the future. Now if according to GAAP the company is losing money and according to por forma numbers a company is making great profits then you know there are explanations needed. By using both reports you can have a better insight on what to expect from companies.
This article raises several interesting issues about how revenue is calculated under GAAP and under pro forma calculations, and the issues with both numbers. On the one hand, GAAP can be too conservative because it includes one-time and noncash expenses; for this reason, the author mentions that many investors disregard this number, as they do not feel it gives them an accurate sense of a company’s prospects for success. Also, FASB has proven itself to be too slow to make changes to the GAAP standards in the face of events such as the attacks of 09/11/01 and the intricacies of accounting in the software sector.
However, pro forma calculations also are far from perfect, as they are not audited and are therefore subject to abuse. While GAAP requires that a company calculate its earnings similarly from one quarter to the next, pro forma calculations can change quarterly. I think that the authors are on the right track when they mention that it would be best for investors to be provided with two separate numbers – the GAAP figure and the operating earnings, as this would allow investors to use both an audited figure and one that excludes numbers that are not relevant to the ongoing running of the company. Although there is currently a large gap between these two figures for many companies, by standardizing the way operating earnings are reported investors could be assured that both number provide accurate and relevant information about a corporation’s financial health.
Although Accrual Based Accounting methods bring with them great benefits like allowing the management to exercise better management of assets, gives a fair description of the financial position of a company at any given point of time and more importantly in today’s times of complex business transactions allows them to be recognized fairly. It had allowed managers the ability to present to shareholders a much better picture of how the company is doing over a long period of time.
The author touches upon how the introduction of “estimates” complicated and increased the problems the industry already faced. Since Lanxin and Anelisa have already touched upon the points pertaining to how estimation can be sometimes misused by corporations to manipulate and misreport earnings and how its is necessary for the investors to be careful and conduct their own research before making any investing decisions.
I would like to elaborate and talk about a topic that the author briefly mentions about “Fair Value Accounting.” I would like to elaborate about this form of accounting and how it has over the last few years been come to blame for one of the biggest economic crises we have seen in our lifetimes.There are proponents who blame fair value accounting for our current economic crisis since it valued a lot of the assets that financial institutions held to pittances. Detractors of this form of accounting suggested that it led to many banking institutions failing and which further led to fall in the value of assets.
However not marking to market would also mean that institutions and corporations were in essence trying to shy away from the problem at hand until it got manageable/ or probably worse and is not often the best approach. The solution to this issue could be a middle way out and an accounting practice that would segregate how assets are valued and carried on books based on their purpose.They could also be categorized based on the possibly predetermined length of investment and purpose of investment. But panning either method of accounting is not a solution to the problem on our hands and the FASB in collaboration with governments and corporations should work towards coming up with the most effective and transparent accounting practices.
I believe Accrual Based Accounting is an inevitable accounting practice in today’s times of complex business arrangements. But addition of Footnotes and specific directions on Assumptions made by management of corporations and increased investor awareness will make the reporting system foolproof and the markets more efficient.
Every one of us is familiar with the adage honesty is the best policy. In business honest behavior can be profitable in the long run. The only question that remains is how to quantify honesty and ethics. Till not so long ago, investors used the financial statements and the history to measure a firm’s future performance. However, as stated in the article investors lost billions of dollars by using this measure because the numbers on the financial statements were easy to play with. Accrual accounting was adopted so that the financial implications of a transaction were reflected on the statements as soon as the transaction took place. However, I believe it is the fair value accounting (FVA) that made comparisons and future estimations more reasonable.
The article sights that the reason people do not advocate FVA is because they believe it will add to accounting inaccuracies. May be FVA predicts future performance inaccurately but is estimation the only thing for which FVA is useful. I don’t think so. For example, as an investor I would prefer to have a current value of all the assets and liabilities for the firm I choose to invest and FVA definitely serves my purpose. FVA also helps the managers to divert a firm’s working capital appropriately according to current market conditions which in turn would reduce operational risks. Irrespective of what the antagonists say, I would consider myself as a proponent of FVA. Fair value accounting is the best method to determine future performance of a firm if the subjective factors associated with it are taken care off. Subjective factors include but are not limited to analyzing risk characteristics and return on investments. There are many cases in which the managers used FVA as a tool to inflate financial statements but it’s due to lack of internal controls. This could be avoided with proper auditing.
I think FASB‘s decision to devise a hierarchy for FVA is crucial. David Bianco’s concern could be alleviated if firms explicitly add footnotes stating their assumptions while calculating the fair value for instruments of lower hierarchy. Finally I consider accounting to be highly subjective but this should never be a reason for not using FVA. On the other hand, objective factors such as production costs, inventories should be strictly monitored to get closer to actual estimates.