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Excessive adjustment of corporate earnings to exclude supposedly one-off costs is a warning sign of a management team over-confident or under pressure, says Jane Fuller

This article was first published in the February 2014 UK edition of Accounting and Business magazine.

After a bumper 2013 for equity markets in the developed world, companies will be under pressure to repeat the trick this year.

They may try to buy growth, hence excitement (among potential fee earners) about the revival of M&A activity. Or they may pursue the organic path: recent surveys from Deloitte and BofA Merrill Lynch show a renewed appetite for capital spending among both CFOs and investors.

But this spending could dent profits in the short term, which is not such good news for the keenly watched price/earnings ratio. With high expectations baked into the P, companies will be under pressure to keep up the E.

Pressure can lead to rule-bending. One way companies do this is to invite investors to ignore certain costs because they are ‘exceptional’. Management motivation is all the more questionable if adjusted earnings are a key factor in performance-related pay.

The UK’s Financial Reporting Council politely drew attention to the earnings manipulation problem in a December note entitled FRC seeks consistency in the reporting of exceptional items. Its Financial Reporting Review Panel had found that some exceptional charges incurred in the downturn had since been released to pre-exceptional profits. It set out guidance to discourage bias and obfuscation in ‘underlying’ profits.

Also know as ‘non-GAAP’ numbers, this more flattering view of performance is often emphasised at the expense of the International Financial Reporting Standards (IFRS) numbers. (No, they aren’t perfect, but they are more objective.)

In the US, Jack Ciesielski, publisher of research service The Analyst’s Accounting Observer, has produced a less polite commentary on the non-GAAP shenanigans of technology and healthcare companies. In both sectors, four out of five S&P 500 companies report non-GAAP numbers. The net effect for the tech cohort was to add back more than US$40bn to net income in 2012 – about 60% more than in 2011.

Ciesielski points out the drawbacks in various non-GAAP numbers, including EBITDA (earnings before interest, taxes, depreciation and amortisation) – the ‘lazy analyst’s cashflow’. As for restructuring charges, instead of the old abuse of ‘big bath’ provisions, they are now ‘much more like “serial sponge baths”’.

Adjustments to IFRS numbers are not all bad. The absence of IFRS guidance on operating profits, for instance, does leave a vacuum for users of accounts, who are seeking a ‘clean’ platform for profit forecasts. Data providers such as Morningstar, which produces the E number for UK share prices in the Financial Times, have formulae to exclude genuinely one-off gains and losses – on the disposal of a discontinued business, for instance. The Johannesburg Stock Exchange bravely lays down in its listing rules a consistent way to calculate ‘headline earnings’.

But it is a bit like herding cats. Many users of accounts pride themselves on their judgment of what should be counted in or out. Others go along too easily with the management’s smoothed version.

Amid the anarchy of adjustments, what can be read into excessive use of non-GAAP numbers? In the US tech sector, maybe arrogance. Elsewhere, stress: witness the £1bn difference between ‘core’ and statutory interim operating profits last year at RBS.

At two simpler companies, Next and EasyJet, the cleanness of the reported numbers looks like a symptom of the no-nonsense management behind their success. By contrast, Autonomy, in its last annual report before HP massively overpaid for it, started adjustments at the gross profit level and ended up with earnings per share 35% higher than the IFRS number.

Until IFRS revisits the statement of profit or loss, it is good to see at least one regulator paying attention. And managements should bear in mind the risk to their underlying reputation.

Jane Fuller is former financial editor of the Financial Times and co-director of the Centre for the Study of Financial Innovation think-tank

Last updated: 6 May 2014