Experts: Adjusting earnings gives rosier view of profits, but practice puts investors at risk
In the early 2000s, investors' confidence in U.S. stocks was shaken by the bursting of the dot-com bubble and the high-profile accounting scandals that took down Enron and WorldCom.
The government responded with regulations to beef up accounting rules, making it more difficult for publicly traded companies to obscure results that might raise red flags for investors.
More than a decade later, some regulators and analysts are worried that too many companies once again are accentuating the positive in their earnings and risking confusion among the investing public. A huge swath of corporate America, including several Pittsburgh-area companies, regularly adjusts quarterly profit figures to leave out expenses they consider one-time, non-recurring costs — a once-infrequent practice limited to a few exceptional instances.
Critics contend some companies are trying to make their results look better than they are.
“Nothing works out perfectly all the time. Companies don't always have up earnings,” said Jack Ciesielski, publisher of The Analyst's Accounting Observer, a Baltimore-based investment research service that has been critical of the widespread use of adjusted earnings.
Concerns within the SEC
Adjusted earnings are becoming more common in financial reports as more corporations pursue acquisitions, which often result in integration and restructuring costs. They show up often in some industries, such as energy, where depressed oil and gas prices have forced drillers to write down the value of their assets.
Last year, 401 companies listed in the Standard & Poor's index of the 500 largest American companies reported adjusted earnings, up from 269 in 2009, according to an analysis published by Ciesielski in March. The Securities and Exchange Commission has noticed the trend and said it is considering strengthening regulations around reporting finances outside the standards of Generally Accepted Accounting Principles, known as GAAP reporting. The SEC requires companies to follow GAAP for all quarterly financial reports, but it allows them to include non-GAAP results.
James Schnurr, chief accountant at the SEC, told accounting professionals gathered in Philadelphia in March that the agency had noticed a “troubling increase” in the number of companies using non-GAAP metrics and was concerned that the media is giving too much prominence to adjusted results.
“Non-GAAP measures are intended to supplement the information in the financial statements and not supplant the information in the financial statements,” Schnurr said. “However, when the financial news networks report quarterly earnings, they very frequently report the non-GAAP measure of earnings with no reference to the actual GAAP earnings.”
Schnurr said he was “particularly troubled by the extent and nature of the adjustments to arrive at alternative financial measures of profitability.”
Adjusted earnings can be confusing for individual investors. Unless the average investor can decipher complex financial statements, it could be easy to miss problematic results that are buried in a quarterly report, said Matthew Karr, manager of investment research at Fragasso Financial Advisors, Downtown.
“There's so much headline focus on (the earnings number), and the management of these companies, they understand that,” Karr said. “I think what the SEC is obviously doing is trying to protect the independent investor from the bad actor.”
More flexible interpretation
SEC regulations of non-GAAP reporting go back to the Sarbanes-Oxley Act, passed in 2002 in the wake of the accounting scandals and tech sector implosion. The law — named for former Sen. Paul Sarbanes, a Maryland Democrat, and the late Rep. Michael Oxley, a Republican from Ohio — called for a host of new rules on publicly traded corporations. The SEC published regulations in 2003 that were widely viewed as discouraging non-GAAP reporting and the practice waned, said Denny Beresford, executive in residence at the University of Georgia's Terry School of Business and a former chairman of the Financial Accounting Standards Board, a private organization that establishes accounting standards.
Beresford said a 2010 update of the non-GAAP regulations was interpreted by accountants as less restrictive.
“The parameters of the (updated) guidelines were considered much more flexible,” he said.
Companies are allowed to report adjusted earnings in addition to results that follow GAAP standards as long as they clearly label non-GAAP results as such and provide a reconciliation between the two.
Many investors and analysts appreciate adjusted earnings and other non-GAAP financial information because it can help them better understand how a company is performing, Beresford said. There are instances when it makes sense to remove an unusual expense that will lower profit only once, such as from losing of a lawsuit.
“The key is that the information companies provide can be very informative and useful to investors as long as they read the fine print and see what adjustments companies are making,” he said.
Acquisitions drive exclusions
Several Pittsburgh-area companies — including Mylan NV, Alcoa Inc., EQT Corp., Kraft Heinz Co. and Bank of New York Mellon Corp. — are among the hundreds of corporations in the S&P 500 index that regularly report adjusted earnings alongside GAAP measures. The companies have generally excluded expenses related to acquisitions, restructuring and litigation.
Mylan, one of the world's largest manufacturers of generic pharmaceuticals, has focused quarterly earnings reports on its adjusted profit since announcing in 2012 that it would achieve earnings of $6 a share by 2018.
Fueled by a string of acquisitions, Mylan pushed the goal to 2017. But eliminating expenses related to those acquisitions is key to the company hitting its target. Mylan officials declined to comment.
Last year, for instance, net income was $1.70 a share, while adjusted income was $4.30 a share. In the first quarter this year, Mylan reported net income of $13.9 million. But after removing costs related to deals, litigation, restructuring and a number of other items deemed by the company to be non-recurring, it reported adjusted profit of $386.3 million.
Tech, health firms lead the way
Twenty of the 30 companies listed in the widely watched Dow Jones Industrial Average reported adjusted profit last year, with non-GAAP earnings being an average of 31 percent higher than GAAP net income for 18 of those companies, according to research firm FactSet.
Technology firms and companies in the health care industry have been the most common users of adjusted earnings, but many other corporations recently have adopted the practice, said Ciesielski of The Analyst's Accounting Observer. The growing gap between adjusted income and GAAP profit has been caused by declines in the energy industry and the high number of acquisitions.
For the S&P 500, combined adjusted earnings totaled $804.2 million last year, 43 percent higher than the total GAAP net income, according to Ciesielski's analysis. While combined net income dropped 11 percent in 2015 compared with the year before, total adjusted income rose 7 percent in the same period.
Companies achieved that gain by leaving out nearly $242 billion in expenses that they considered non-recurring, Ciesielski said.
“It's hard to shake the feeling that more of these (excluded expenses) are being found just to make things look better,” Ciesielski said.
Bryan Routledge, an associate professor of finance at Carnegie Mellon University's Tepper School of Business, said investors are sophisticated enough to understand the difference between adjusted and GAAP income. As long as both measures are disclosed and clearly labeled, Routledge said he didn't think anyone will be misled.
“Investors as a whole are relatively smart and it's hard to fool them with accounting,” he said.
Companies aren't able to hide poor results without running afoul of SEC rules, even if they focus their statements on adjusted earnings.
“If you feed (investors) nonsense information, they discard it.”
Alex Nixon is a Tribune-Review staff writer. Reach him at 412-320-7928 or email@example.com.