Fantasy Math Is Helping Companies Spin Losses into Profits
nytimes.com
nytimes.com
1. GAAP, which is a man-made set of social conventions for how to present financial results, does not accurately reflect Company X's economic reality and continuing future earnings power, while the pro forma results do. (Or, less strongly, GAAP is informative, but the pro forma numbers are also informative, about a different aspect of the company's situation.) Investors know that it is a useful discipline to hold all companies to the GAAP social convention, but appreciate Company X's efforts to provide them with more insight into its real economic position, and use the non-GAAP numbers to inform their own models.
2. The GAAP numbers are more or less right, the non-GAAP numbers are just fake and flattering, but investors, whose job it is to make intelligent decisions about the future earnings power of the company, ignore the non-GAAP numbers and focus on the GAAP numbers, which are after all reported prominently in the same press release.
3. The non-GAAP numbers are fake and flattering and all the investors are chumps who believe whatever management puts in the big font at the top of the press release.
Pretty much every discussion of non-GAAP accounting focuses exclusively on Possibility No. 3, which, as both an efficient-markets fundamentalist and an accounting post-modernist, I find by far the least plausible of the three possibilities. Anyway, here's a column by Gretchen Morgenson with the pleasingly archetypal title "Fantasy Math Is Helping Companies Spin Losses Into Profits."
http://www.bloombergview.com/articles/2016-04-25/investing-r...
4. Companies increasingly occupy Extremistan, where a large portion of their financial performance comes from one-off, Black Swan events. Both the GAAP and non-GAAP numbers are true but useless; the future cash flows of the company depend upon unforeseeable events in the future.
The description that the article gives of the non-GAAP results supports this. Take, for example, a lawsuit against the company that results in a $5B judgment, payable out over many years to survivors of an environmental disaster. GAAP results include this lawsuit, non-GAAP results exclude it. Which more closely represents the future financial performance of the company, from the POV of a long-term value investor? Well, that depends whether there will be future lawsuits like this one. It depends whether the verdict will be reversed on appeal. It depends how many survivors survive.
The same goes for things like severance pay and patent lawsuits. Increasingly, it also applies to "normal" business, things like product introductions and the price of oil.
In Zero to One, Peter Thiel mentions (and decries) that an increasingly large portion of America is adopting an "indefinite" worldview, where the future cannot be known and it's futile to try to predict it. I'm not sure folks really understand the potential implications of this shift. Does "investing" have any meaning when the assumption is that returns will be dictated by large, random events? Does "meaning" have any meaning? What does it even mean to be rational, when reason is a tool we use to predict and our assumption is that events are unpredictable?
The BP oil spill, shortcuts were made in the safety of the drilling equipment emergency cutoffs, in the Los Angeles methane leak, the company had put off maintenance to try to make rate payers pay for improvements instead of out of profits to the company. The Northern California San Bruno pipe explosion - safety funds had been diverted to executive bonuses.
Smart investors (and insurers of these companies) should be digging into long term risks. It is not that we cannot predict it - we are too cheap and profit oriented to pay to mitigate it.
5. The companies are incontinent. The rank and file neither know what GAAP or non-GAAP really are within their limited scope. To appease bosses that themselves have bosses, etc, they don't 'cook' the books, they rely on numbers that are fudged or optimistic from 3 divisions down the ladder and across the world and then fudge them some more.
Simple Example: If you have a 90% 'truthfulness' data transmission rate things get bad quickly. Say I tell my 10 underlings to go get staplers. They then go tell their 10 underlings to go buy staplers, etc. If the transmission rate is 90%, then at the first step down I get 9 staplers, not 10. The next layer down I get 81+9 = 90 staplers from 110 folks. The next layer down I get 729+81+9 = 819 from 1,110 people. By layer 8, I am below a 50% data transmission rate to go get staplers. Granted there are now over 111,111,110 people working at the company then, but you get the idea.
Now bubble that upwards instead. Do you think that the folks there are giving a 90% truthfulness rate in what they tell their bosses? I know the situation is a lot more complicated and layers get jumped and the chain of command is not nearly so nice. Still, I think the point stands that the companies maybe are just dumb and it may just be their fate to be so.
... or are they? At least, will they have data breaches every few years? What's the annual cost of doing all the work needed to prevent data breaches? If it's less than the averaged-out cost of cleanup, why weren't they doing it all along? If it's more, and they're accepting data breaches as a cost of doing business, shouldn't they be reporting that cost?
And if they don't think it's going to happen again, why not?
If you think that is a valid assumption, perhaps this risk is not mitigated entirely, but it would certainly change the risk profile of such a black swan event, would it not?
This isn't extreme good fortune, which would appear in both numbers.
It is futile to predict the future. GAAP is just there to try and make it easier to interpret the past, by applying some rules to compare companies against each other.
Although, I never really was able to reconcile Thiels' criticism of an 'indefinite' worldview. It appears to me if the factors that influence things are not only the unknowns but the are unknown unknowns (i.e. you don't even know what you would need to know that will determine the fate of the company/country/whatever). In that case, how could you be anything but uncertain and just try to structure your life to benefit from convexity or as Taleb coined, anti-fragility?
Companies as varied as Bank of America, Groupon, and Kinder Morgan all find creative and fascinating ways to assert that their bullshit financial metrics are more meaningful than GAAP.
Generally speaking, companies that aren't a shitshow and are actually making money don't bother cooking up new accounting schemes. Their CFOs focus on counting the profits, not heating air.
The number 1 is more or less true for a good number of companies. Number 2 and 3 applies to the rest of the companies depending on the investor you are looking at. The number of gullible investors is non-zero. Throws in that many companies are in option 1, and distinguishing between 1 and 2/3 became a complex problem.
So, we have a subset of companies whose price is determined by the ratio between good and bad investors. Obviously, good investors will fly away from these companies. But these companies could make you a lot of money if you leave soon enough. And then in finance classes, they use to say: "the market could stay irrational longer than you could stay solvent."
The results? Inflated Pro-forma statements stay around for enough time to do damage.
Chumps, no. Humans, yes.
Experienced investors never take GAAP at face value - most of them will work with both the GAAP and pro forma (as well as any other public releases) and try to reverse engineer the individual lines in order to tease out more pertinent (in their opinion) factors that affect the value of the business. different investors value risks differently but the pro forma is created by management for a general set of investors in order to bridge the gap between GAAP and exact economic reality.
As a side note, GAAP definitely isn't industry agnostic. For example, FASB (the financial accounting standards boards) issues guidance on revenue recognition for all sorts of companies and the guidance for a software company is very different than the guidance for your generic widget manufacturer.
Where's the Morgenson article?
And some business about talking to a lion, I think.
The biggest issue I see is that often the company will clearly spend more time with their proforma results than their GAAP results.
The outcome from this is that often when analyst or data companies try to put together metrics on a company they'll use GAAP results but if a ratio they want isn't present they'll substitute the ratio from the proforma results.
This means many of the data you get on google finance or even Bloomberg is an amalgamation of the two, which leads to garbage in-garbage out.
Side note: if you can clean data, you'll have a job for life!!!
Tech companies tend to be big users of pro forma results. Facebook famously turned a $700 million loss (GAAP) in 2012 into a $400 profit (Pro forma) by not using Black Scholes to calculate the cost of employee stock options.
Groupon was another poster child for pushing pro forma results vs GAAP results and that turned out about as well as you'd expect. Just google "Groupon pro forma vs GAAP".
Can these really be considered to be one-time events though? I would hypothesize that a company which has seen at least one lawsuit settlement is more likely to see another one down the road than a company which has never seen a lawsuit. Thus, the existence of a settlement should be a reasonable prediction of more losses to occur in the future. So why ignore them?
It seems like it would be at least more reasonable to consider the past M GAAP results than the past M non-GAAP results when analyzing a trend. The latter will consistently overestimate growth, whereas the former will have more noise, but averages out to being more representative of the actual growth. And the analyst at least has the necessary data to reasonably calculate error-bounds on his/her estimate.
It boggles my mind that this is written off as acceptable, just another way of looking at the results. I own a business. I understand its accounting. Turning a $700m loss into a $400m profit is a $1.1b lie.
Edit: if you'd like to put recurring profits and expenses on a sheet and show it to me, fine. But if you omit one-off expenses when representing your financial position (and let's be honest, there are always one-offs) you've fraudulently represented yourself.
The problem is 15-17 years ago, the income statement got "political" and congress / nasd/finra/ accounting standards boards started inserting accounting lines in the income statement that neither the companies or the analysts wanted. Cost of stock compensation being the primary one.
Look, when an investor looks at the numbers they want to dig down to the core operations economics and the health there of to create his valuation.
The investor/analyst isn't going to blindly say "oh they have negative GAAP Net Income ergo company value = 0"
You might think just avoid in investing in companies that are so crazy as to do that (in their promoted non-GAAP numbers) because that must be a sign they are not so bright and why rely on them to make wise investing decisions for your company. But you would find yourself ruling out many technology companies. It isn't that they don't know this is wrong, they just realize it is in their executives (CFO, CEO etc.) interests to promote the false earnings because many people will accept it.
My blog post from last week
http://investing.curiouscatblog.net/2016/04/21/buybacks-giveaways-to-executives-and-non-gaap-earnings/[1]http://www.npr.org/2016/02/18/467253394/why-did-americas-ceo...
-- environmental disasters are the result of under investment in preventing environmental disasters.
-- security breaches are the result of under investment in security.
-- restructuring is the result of under investment in continually adapting the organization to a changing reality
-- layoffs are often the result of under investment in hiring to make sure you don't hire bad performers and under investment in cleaning out poor performers continuously. The only layoffs that aren't like technical debt are those caused by external forces like a recession.
There is nothing wrong with under investing over time and then paying the piper when the time comes, but any one off expense that could have been prevented if things had been managed differently should not be excludable.
The litmus test should be along the lines of asking, "Is this cost our fault?"...
Or sometimes they're caused by management playing the "Let's cut costs to increase returns so we earn more from our shares" game.
Big layoffs are a management failure, not a hiring failure. Realistically, how likely is it that a company that's been running profitably for years suddenly discovers that thousands or tens of thousands of staff were a poor hire?
Tech companies in particular are annoyed by accounting methods developed for completely different types of businesses and are often frustrated that net earnings, for example, doesn't accurately reflect their situation.
However, combine that nugget with investor's willingness to be swooned by the latest growth company, and said company's desire to hit wall street growth targets and you get a dangerous combination.
The whole basis for normalizing earnings is to get to the real economic numbers you can expect a company to generate in the future. That means taking out what you believe are one-time costs, but again if you keep seeing the same adjustments every quarter, then something is up.
Owners, sharing the profits of the businesses they own, rather than making a levered bet on central bank money printing.
Crazy, I know.
I vote we make dividends deductible for the corporation, and treat capital gains as income, since it is.
Like, if I invest $10k for a year in the hopes of getting 6% return, that's a thing! I could've gone on a really swank vacation for that $10k, or I could've bought a really nice TV or whatever. Instead, I took that $10k and I said, okay, maybe this will give me $600. Or maybe I'll lose $1k instead.
But let's say it pays off, and I get $600. But it's taxed. If it's taxed at 20% (current cap gains), I get $480. If it's taxed at ordinary income (and my income is high), I get $360.
That's not irrelevant. I might pretty reasonably say "Man, in order to get a chance at $360, I'm tying up $10k for a year? And maybe I lose some of the $10k instead?"
And it's particularly relevant if this belief that cap gains should be taxed as ordinary income is paired with a belief that the top marginal tax rate for ordinary income should be higher than it is.
We've seen, all over the place, recently, that the financial sector responds to incentives. When it becomes hard to generate a return through traditional means, the financial industry chases returns no matter what. Sometimes the consequences of that are kind of scary. Now, if someone understands all that and has a considered opinion that none the less capital gains should be taxed as ordinary income, well, okay. But I've never actually seen anyone tackle all that. Instead, it's always one pithy sentence like "it should be treated as income, since it is."
There isn't some magical ethical category open to capital. I risk my life commuting to work to perform labor. What of it?
In any event, even if I can't convince you that there shouldn't be a distinction between income and capital gains, I hope I can convince you that there shouldn't be a taxation difference between dividends and capital gains. We need to make the way company ownership works much more like an LLC, where profits flow through to owners by percentage of ownership. Capital gains are easily manipulated with creative accounting, the madness of crowds, central bank money printing and, most significantly, leverage fluctuations. If anything, I would want tax capital gains more heavily than dividends, which do not lie.
A steady return of profits to owners would enforce the discipline our corporations so desperately need. Wall Street, of course, doesn't want that, and neither do most boards, because it would force them to give up cash that they would rather use for bonuses and stock grants. And that would be great.
Lets say a company buys another company for its SAAS product, customers and revenue. GAAP rules state that anything paid above "book value" for the company must be called "good will" and be depreciated. This might have made sense in a world where the value of a company was the equipment it owned and the value in a brand name but doesn't make as much sense for a SAAS company. That is why companies are often valued on "EBITDA" - earnings before interest, taxes, depreciation, and amortization
Goodwill is not subject to amortization since 2001 (depreciation is the term for tangible assets, amortization for intangible assets). It has to be tested for impairment, though. For example, HP bought Autonomy for $11.1bn in 2011 and took an impairment charge of $8.8bn in 2012 (the goodwill and a good chunk of the book value as well).
1. SEC rules require GAAP results to be presented with equal prominence to non-GAAP metrics. This is why reports usually have "Core" and "As Reported" metrics.
2. Starting mid 2014 to early 2105 we saw a large increase in the value of the dollar relative to other currencies. GAAP accounting requires that currency hedges be marked to market with fluctuations in non-realized gains/losses. This creates a lot of noise, hence the increase in non-GAAP reports.
When was the last time you saw an "extraordinary item" in a footnote that was excluded from making the earnings look better? Have you ever seen one?
EBDITA is called "earnings before all the bad stuff" by value-oriented analysts.
We should be using these fantasy math innovations to help the poor. There is a lot of fantasy profit that could really help people.
Some of the presidential candidates have actually good proposals about this idea.
First, all publicly traded companies are legally required to disclose financial statements that have been prepared according to GAAP and audited by an outside firm who ensures the financial statements are a "faithful representation" of the firm's financial position. Companies are also legally prohibited from suggesting that GAAP numbers are somehow insufficient or don't count in their official financial statements. This system is not perfect - Arthur Anderson had certified Enron's financials and it is known that the need to get continued business as well as form relationships with the companies' can mean that they don't always get the level of pushback that they should from audit firms. Additionally, traditional audit methods aren't really meant to detect outright fraud.
The claim that 90% of financial statements were prepared under some method other than GAAP is absurd and the link the author provides does not actually lead to an analysis for that number.
Accountants prepare financial statements for the benefit of investors and the rules and principles that form GAAP take into account people's willingness to abuse them, selectively apply them, and otherwise subvert them. There's also a great deal of genuine ambiguity where two reasonable people can look at the same situation and disagree as to the proper accounting treatment. None the less, any investor who would ignore those numbers in favor of some fictitious, back-of-the-envelope calculation in the Management Discussion & Analysis is a fool.
However, GAAP also requires that you discuss your company's financial situation, your strategy, your risks and special considerations beyond what is just in the book-keeping calculations. A typical financial statement has more notes and text to it than it does actual tables of accounts and balances. This is necessary because whereas accountants prepare their financial statements for the benefit of outside investors, we try to be as objective as we can and let the debt and equity holders be the ones to actually assess and estimate the meaning behind those numbers according to their own economic theories and financial needs.
So what exactly is the problem then? The author briefly gives three reasons that financial statements may not be as faithful as we'd like, but describes none of them in detail: restructuring and acquisition costs, stock-based compensation and write-downs of impaired assets.
First is the most obvious one, a write down of an asset due to impairment is an expense. As for executive compensation, that used to be a bigger problem than it was, but the accounting rules were changed to address that and we've seen a massive decrease in fishy compensation deals. There could well be issues about compensation that are emerging, but I don't happen to know about them and the author doesn't bother to mention them. Finally, there's restructuring and acquisition costs. Thankfully, this portion does get a one or two line explanation, but I don't see what this has to do with "hidden expense." The author says that future costs of restructuring are not recorded in the balance sheet. If you did, then you'd record the future cost as a liability and you'd match the expense with the actual work of restructuring. The expense would be the same in either case, but you'd have a liability on your books earlier. Except that you're not actually obligated to continue to spend money on restructuring, so there's no reason to accrue that cost anyway. This is a perfect use-case for a note, with an estimate about how much the company is planning on spending (given the article, the author would probably lament it as a non-GAAP fantasy number anyway).
The way accounting is done is not without it's problems, but the author doesn't seem to have anything intelligent to say about those problems.
For example, a company can use straight-line depreciation in their GAAP statements, but use accelerated depreciation for tax purposes. The difference becomes a tax credit on the balance sheet.
The IRS is much less likely to fall for shenanigans than investors.