The company reporting season can be tricky for unsophisticated investors. Firms try to put their performance in the best light. Managers dress up figures to emphasise the positive and even to boost their performance bonuses.
One way a loss can be transformed into a profit is by using non-standard measurements. If company earnings are falling overall, you can separate out the good parts and issue a press release trumpeting 'underlying profit' is rising.
Underlying profit can exclude inconvenient numbers as 'extraordinary' or 'one-off' items that need to be included in the Generally Agreed Accounting Principles (GAAP) measure of earnings in quarterly, half-yearly and annual reports.
Expert financial analysts don't usually fall for misleading headlines but retail investors can be sucked in. In the US, increasing use of non-GAAP earnings' measures to meet analysts' profit forecasts caused regulators to crack down in 2003.
As a result, US investors are reported to be getting more accurate information to price shares. By comparison, Australia, the UK and Europe remain comparatively unregulated.
There has been a consistent growth in the extent to which Australian firms promote such alternative non-GAAP income measures, according to a survey co-authored by Jeff Coulton, a senior lecturer in the school of accounting at UNSW Business School.
And yet, non-GAAP information can increase investors' understanding of a company. GAAP standards tend to be one-size-fits-all, to allow comparison with other companies, but there are cases where they are not always as relevant as non-GAAP measures, such as with comparing start-up technology companies making initial losses.
So investors beware – the usefulness of non-GAAP measures can depend on the motives of company managers. In The rise and rise of non-GAAP disclosure: A survey of Australian practice and its implications, Coulton and co-authors Andrea Ribeiro, Yaowen Shan and Stephen Taylor warn:
"There are competing objectives underlying these disclosures (that is, self-interest versus better information for stakeholders), and the resulting consequences of these disclosures will also vary in line with the dominant motivation for their supply."
I think that financial statements tend to do a reasonable job, but that
increasingly company-made adjustments tend to improve the information provided
to investors’ – jeff coulton
The non-GAAP measurements that should ring alarm bells for unsophisticated investors include 'underlying profit', 'cash profit', 'recurring earnings', 'adjusted results' and 'cash earnings'.
For example, a recent JB Hi-Fi half-yearly results presentation highlighted a measure labelled 'underlying earnings before interest and tax', as well as 'underlying net profit after tax'. The underlying results excluded the transaction fees and implementation costs of the acquisition of The Good Guys chain of consumer electronics retail stores in November 2016.
According to Coulton, if investors think The Good Guys acquisition was a 'one-off' event for JB Hi-Fi, then excluding costs relating to the purchase can provide investors with a more useful performance measure. That is, the underlying earnings are more likely to be representative of future earnings than a bottom-line GAAP measure (net Income).
However, Coulton notes that if companies regularly have the same type of 'one-off' exclusions in their non-GAAP measures, then investors need to be more cautious in taking the non-GAAP number at face value. Investors should compare 'underlying profit' with net income, or with operating profit after tax.
"One important thing for investors to examine is the trend in these performance measures over time. Is 'underlying profit' consistently lower or higher than a GAAP measure? One key problem that investors face with non-GAAP numbers is that they are not measured consistently by the same company over time, nor by different companies in a given year," Coulton says.
He also notes that the Big Four banks each highlight a 'cash earnings' performance measure, but that it is not at all clear that 'cash earnings' is calculated the same way by each bank, or consistently over time by each of the banks.
Managers may believe that non-GAAP measures can provide a better indication of the company's underlying performance, and thereby better inform investors about the 'true' performance and/or economic position of the firm.
Globally, non-GAAP reporting has become increasingly common, with earnings figures higher than the corresponding GAAP earnings number and by excluding not only transitory 'one off' expense items but also recurring items.
The most commonly excluded expense item in the US is depreciation and amortisation (21%), followed by stock-based compensation, such as options to incentivise managers (17%), mergers and acquisitions' costs (10%) and research and development costs (7%).
"A lot of evidence suggests that the usefulness of GAAP 'earnings' has declined over time," says Coulton.
"Overall I think that financial statements tend to do a reasonable job, but that increasingly company-made adjustments tend to improve the information provided to investors."
The researchers looked at actual non-GAAP disclosures in Australia during 2000–14. More than 40% of companies used non-GAAP measures in 2014, though in 91% of these cases this was reconciled with GAAP's statutory earnings, to provide context and be less misleading.
Still, half the companies disclose a higher value of non-GAAP earnings than equivalent GAAP earnings. Financial companies led the way, where non-GAAP results were pumped up by an extra 50%.
Overall, the evidence is that the non-GAAP result exceeds its GAAP equivalent more frequently than otherwise, but the difference is not as large as some anecdotes would suggest.
The researchers found non-GAAP measures were substantially less volatile than their GAAP equivalents, with substantially fewer extremes in year-to-year comparisons. There was also a convergence in terminology, with more companies favouring the use of terms such as 'underlying profit' or 'underlying earnings'.
Only 2% of the 250 reports from a mixture of Australian Securities' Exchange (ASX) top 100 firms and others investigated by the Australian Securities and Investment Commission (ASIC) were found to have used non-GAAP profit disclosures in a "disruptive" manner. However, 58% of the reports were identified as not fully complying with ASIC's draft regulatory guide.
'The harder task is for investors to try to determine how well the company will perform in the future'
– jeff coulton
Managers determining bonuses
Managers and firms have incentives (bonuses and higher share prices) to beat earnings benchmarks and/or analysts' forecasts. Coulton says there is an issue here of transparency.
"It is typically the managers that get to decide what goes into or out of non-GAAP numbers, so managers are getting to determine what number is used in determining their bonus. A sensible remuneration committee should be aware of this, and if necessary, make adjustments."
Company reports are only one factor for investors wondering if they should buy or sell shares in a company, says Coulton.
"They are important in explaining firm performance, but they are not particularly 'timely'. By the time Qantas releases its full year results we already know the half-year performance, we already have passenger numbers for much of the financial year, we know what the price of aviation fuel has been, and so on. The harder task is for investors to try to determine how well the company will perform in the future."
The International Accounting Standards Board (IASB) is presently updating the conceptual framework of financial reporting. It believes that investors' expectations about company returns depend not only on their assessment of future cash inflows, but also on their assessment of management's stewardship of the company's resources.
While recognising that a single measurement basis for all assets and liabilities may not provide the most relevant information, the IASB is considering a limit on the number of measurement bases used in financial statements, to help investors better understand and compare.