The objective of this section is to bring to the reader’s attention the difference that prevails between reliable and unreliable financial statements in connection to earnings. Typically the former are following rules established, or at least approved,
Box 12.1 (Continued)
Writedown of goodwill, if impaired Total operating expenses
Operating profit before tax and minority interests Tax expense
Net profit before minority interests Minority interests
Net profit
Basic earnings per share Diluted earnings per share
Box 12.2 Supplementary list with off-balance sheet and other items
● Litigation
● Fair value of financial instruments (required by IAS 39)
● Financial instruments risk position
● Interest rate risk
● Credit risk
● Currency risk
● Liquidity risk
● Pledged assets
● Contingent liabilities
● Operating lease commitments
● Retirement benefit plans and other employee benefits
● Equity participation plans
● Additional disclosures required under US GAAP and SEC rules (for a non-US company listed in the US)
by supervisory and regulatory authorities of the Group of Ten (G-10) countries. US GAAP and IFRS are examples.
The not-so-reliable statements are mostly ad hoc inventions of different firms, which might have fitted better into Chapter 10, which addressed creative account- ing and other practices designed to misinform investors. On the other hand, it is always a good policy to present the reader with a contrast between what consti- tutes:
● Dependable financial reporting, and
● Partly or fully unreliable statements of operations which are essentially traps.
Starting with the fundamentals, the more classical way to measure a company’s performance over the year is net income. Also known as reported earnings, or the bottom line, this is highly regulated by means of officially set accounting prin- ciples. In the United States net income is the number the Securities & Exchange Commission accepts in its filings.
An alternative measurement, the operating earnings, is an adjustment of net income that excludes certain costs deemed to be unrelated to ongoing business.
Operating income, however, can be misleading both because of these exclusions and for the reason that, to the untrained eye, it looks very much like a GAAP fig- ure: the operating incomestands for revenue, minus the costs of doing business.
Nearly synonymous to operating earnings is another metric: core earnings.
Neither of the two is calculated according to rules established by the Financial Accounting Standards Board (FASB). Therefore, when they find their way into forward-looking statements, they bring to them an aura of creative accounting along the lines discussed in Chapter 10. Investors beware:
● Operating earnings and core earnings are more or less defined by the com- pany reporting them.
● As such, they can include or exclude anything the management of that company wishes.
The net result is that they cannot serve for a serious analysis, let alone predic- tion of financial health. Even more liberal in interpretation is another reporting scheme, to which reference has been made in Chapter 10: EBITDA (earnings before interest, taxes, depreciation, and amortization). It does not really mean much, yet it is widely used. EBITDA can reach a level of absurdity by leaving out of the equation all costs. Why only ITDA and not ITDAML, where M stands for all material costs and L for all labour costs.
Like proforma, EBITDA practices were originally developed and used by indus- try sectors that carried high debt loads, and wanted to hide them – like cable TV (CATV). The easy solution has been to simply leave them. When the stock mar- ket curiously accepted this, other industry sectors found it a convenient means for financial misinformation. EBITDA is a curious financial reporting ‘standard’:
● Unacceptable to the regulators
● But acceptable to some investors who risk their money with unreliable metrics.
Notice that over the years other industry sectors developed their own form of earnings statements which suited better their reporting needs. An example is the real estate investment trusts (REIT), a pioneer of engineered earnings with its funds from operations (FFO) reporting. FFOs, however, seem to have backfired and by now some REITs have begun to revert to plain US GAAP earnings reports.
Sometimes with nonregulatory financial reporting even the form of presentation may give rise to uncertainty regarding the meaning of contents. An example is the earnings press release. This consists of an earnings number flashed in the head- line, which may or may not be calculated according to rules: Press releases are by no means financial statements reviewed by regulators. They are mainly for pub- lic relations reasons:
● Aimed to catch investors who don’t do their homework, and
● They usually employ pro forma numbers which, as we have already seen, are unreliable.
In contrast to what has been outlined in the preceding paragraphs, the statement of operationsfocuses on regulatory reporting of net income, and it is audited by certified public accountants (CPAs). Hence, barring Andersen-type risk, it is reli- able. Another piece of financial reporting is the statement of cash flows, to be found in quarterly reports filed with SEC:
● It provides a good measure of a company’s financial health, and
● It is much less vulnerable to massaging than press releases, proformas, FFOs, and EBITDAs.
Of course, the master piece of reliable financial statement is the balance sheet(see Chapter 13), when prepared according to IFRS, US GAAP, or other official stan- dards which respect their readers. The balance sheet highlights an entity’s assets and liabilities and its cash in hand, and it can be accompanied by footnotes.
I always read the footnotes of companies in which I invest (or plan to do so), but consider them to be a questionable practice. Sometimes they address huge items which turn the balance sheet on its head; as, for instance, derivatives risk. And most often they are skipped by investors because:
● They are cumbersome, and
● In many cases the message they convey is unclear.
Yet, footnotes have their fans, including regulators and standards setters (see Chapter 10). For instance, under US GAAP Footnotescan be found only in SEC filings, particularly in the annual report. Quite interesting also is the disclosure under reversals, because it indicates that:
● A company overestimated how much it would have to spend, and
● It is crediting that excess back into its earnings, sometimes also restructur- ing its reserves (more on this later).
In this and similar cases, not only have the earnings figures been manipulated in such a way as to become unrecognizable, by leaving out whole chapters of items such as costs, but also costs still being included are subject to massaging. A case in point is special charges. This is a general term for anything a company wants to highlight as ‘unusual’ – therefore, something to be supposedly excluded from future earnings projections.
As we will see in section 5, an overused term is goodwill, written in the assets side of the balance sheet; and with it, goodwill impairment. Goodwill is a way of writing down the premium a company paid over the fair market value of the net tangible assets it acquired. As such, it has been regulated in different ways by dif- ferent accounting standards, in different jurisdictions. For its part,
● Goodwill impairment has a very liberal definition, and
● This is often used to downsize the exorbitant price paid for acquisitions.
The alter egoof goodwill impairment is asset impairment. It stands for charges taken to bring goods a company paid a high price for down to their current mar- ket value. In terms of financial reporting, asset impairment should have been a much more dependable figure than goodwill impairment, but it is not necessar- ily so. Several companies that bought Internet and other stocks during the late 1990s at highly inflated prices are taking these charges on venture-capital funds.
Another of the major cost articles confronting a going concern is reserves for restructuring. It stands for an accrued expense to cover future costs of closing
down an operating division or plant – also for downsizing the personnel. These are usually projected costs (of forward statement type) and do not necessarily represent current cash outlays. The trick is that:
● Restructuring reserves are often overstated, and
● When this happens, they become a boost to earnings in following years because they are reversed.
Finally, still another key component of the top list of reported costs is write- downs. It stands for lowering the value of an asset, like a plant or equity invest- ment. Write-downs are usually seen as bookkeeping exercises that take care of a real cost incurred long ago, that now proves to be unwise. Frequently, behind a write-down is money spent unwisely. But they may also represent reductions because of banking or some other fees.
It does not take a genius to realize that analysts and investors are at a loss because of the earnings chaos which results from the disturbing trend among companies of calculating according to their own idiosyncratic ways. What is sur- prising is an increasing willingness among financial analysts and investors to accept nonstandard computations in financial reports, trusting them as repre- sentative of an entity’s real earnings and true balance sheet values – altogether forgetting about the myths behind some of the figures.