Equities – non-GAAP reporting sugar coats earnings figures and investors need to beware.

How do you read earnings releases? It’s a question often asked by traders and one that is not as easy to answer as it might seem.

Far from simply checking headline profits/earnings versus estimates, the picture is clouded by the increasing use of atypical reporting conventions and methods that seek to paint a rosier picture of financial health than may be entirely accurate.

So called non-GAAP (generally accepted accounting principles) reporting is being used more and more by companies releasing earnings reports. But companies should be on notice as lately this practice has grabbed the attention of regulators.

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More than 88 per cent of S&P 500 companies disclose non-GAAP metrics in their earnings release. Of those releases, says Hans Hoogervorst, Chairman of the International Accounting Standards Board, 82 per cent show increased net income and are “clearly designed to present results in a more favourable light”.

Typically, non-GAAP reporting is used to present what boards see as a more accurate and representative view of their company’s underlying earnings and profits. It usually strips out noncash and nonrecurring items, but the worry is that these figures could be misleading.

 ‘Detached from reality’

 

Hoogervorst  notes one study showed that the popular metric ‘core earnings’ was, on average, 30% higher than GAAP earnings.

According to data from S&P Dow Jones Indices and Thomson Reuters quoted by the WSJ, GAAP earnings companies listed on the S&P 500 were “virtually unchanged” last year compared with 2012. However, non-GAAP earnings rose nearly 14%.

“While these are numbers for the American market, securities regulators in the world of IFRS Standards are also concerned that non-GAAP numbers are getting increasingly detached from reality,” commented Hoogervorst.

Shareholder spring?

 

“In this light it is rather unnerving that most management remuneration packages are based on adjusted earnings. Knowing that even GAAP numbers can be vulnerable to earnings management, remuneration committees should be extremely wary to base their policies on earnings adjusted by management itself,” adds Hoogervorst.

A recent spate of mini-revolts by shareholders in the City suggests that investors are starting to take note.

Hoogervorst notes one case where the non-GAAP metric was more than $12bn different from the IFRS version – a $6bn loss was turned into ‘underlying profit’ of $6bn. The happy CEO’s remuneration was based on the underlying profit.

“Clearly, both shareholders and remuneration committees need to be much more aware and critical of the role of non-GAAP measures in remuneration formulas,” adds Hoogervorst.

Examples are plentiful. Alcoa recently reported a GAAP net income loss of just over $500m over the last 12 months, but was able to magic this into a $532m profit with a little bit of non-GAAP reporting wizardry.

Crackdown

 

Now, regulators are on the case. The Securities and Exchange Commission (SEC), the US watchdog, has taken exception to the use of non-GAAP reporting by Valeant.

It’s accused the Canadian pharmaceutical giant of being “potentially misleading” in its reporting to investors.

SEC Chairman Mary Jo White has said she wants to “rein in” non-GAAP reporting, while SEC staffer Mark Kronforst told some news outlets recently that the regulator will “take exception” to the practice.