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Companies, if granted the leeway, will surely present their financial results in the best possible light. And of course they will try to persuade investors that the calculations they prefer, in which certain costs are excluded, best represent the reality in their operations. Call it accentuating the positive, accounting-style.
What’s surprising, though, is how willing regulators have been to allow the proliferation of phony-baloney financial reports and how keenly investors have embraced them. As a result, major public companies reporting results that are not based on generally accepted accounting principles, or GAAP, has grown from a modest problem into a mammoth one. According to a recent study in The Analyst’s Accounting Observer, 90 percent of companies in the Standard & Poor’s 500-stock index reported non-GAAP results last year, up from 72 percent in 2009. Regulations still require corporations to report their financial results under accounting rules. But companies often steer investors instead to massaged calculations that produce a better outcome. I know, I know — eyes glaze over when the subject is accounting. But the gulf between reality and make-believe in these companies’ operations is so wide that it raises critical questions about whether investors truly understand the businesses they own.
Among 380 companies that were in existence both last year and in 2009, the study showed, non-GAAP net income was up 6.6 percent in 2015 compared with the previous year. Under generally accepted accounting principles, net income at the same 380 companies in 2015 actually declined almost 11 percent from 2014. Another striking fact: Thirty companies in the study generated losses under accounting rules in 2015 but magically produced profits when they did the math their own way. Most were in the energy sector, which has been devastated by plummeting oil prices, but health care companies and information technology businesses were also in this group.
How can a company turn losses into profits? By excluding some of its costs of doing business. Among the more common expenses that companies remove from their calculations are restructuring and acquisition costs, stock-based compensation and write-downs of impaired assets. Creativity abounds in today’s freewheeling accounting world. And the study found that almost 10 percent of the companies in the S.&P. 500 that used made-up figures took out expenses that fell into a category known as “other.” These include expenses for a data breach (Home Depot), dividends on preferred stock (Frontier Communications) and severance (H&R Block).
But these are actual costs, notes Jack T. Ciesielski, publisher of The Analyst’s Accounting Observer. “Selectively ignoring facts can lead to investor carelessness in evaluating a company’s performance and lead to sloppy investment decisions,” he wrote. More important, he added, when investors ignore costs related to acquisitions or stock-based compensation, they are “giving managers a free pass on their effectiveness in managing all shareholder resources.” It puzzles some accounting experts that the Securities and Exchange Commission has not been more aggressive about reining in this practice. Lynn E. Turner was the chief accountant of the S.E.C. during the late 1990s, a period when pro forma figures really started to bloom. New rules were put in place to combat the practice, he said in an interview, but the agency isn’t enforcing them. For example, Mr. Turner said, some companies appear to be violating the requirement that they present their non-GAAP numbers no more prominently in their filings than figures that follow accounting rules. “They just need to go do an enforcement case,” Mr. Turner said of the S.E.C. “They are almost creating a culture where it’s better to beg forgiveness than to ask for permission, and that’s always really bad.” As it happens, the commission is in the midst of reviewing its corporate disclosure requirements and considering ways to improve its rules “for the benefit of both companies and investors.” This would seem to be a great opportunity to tackle the problem of fake figures. But such work does not appear to rank high on the S.E.C.’s agenda. Kara M. Stein, an S.E.C. commissioner, expressed concern about this in a public statement on April 13. Among the questions the S.E.C. was not asking, she said: “Should there be changes to our rules to address abuses in the presentation of supplemental non-GAAP disclosure, which may be misleading to investors?”
With the presidential election looming, Mr. Ciesielski said it was unlikely that any meaningful rule changes on these types of disclosures would emerge anytime soon. That means investors will remain in the dark when companies don’t disclose the specifics on what they are deducting from their earnings or cash flow calculations. Consider restructuring costs, the most common expense excluded by companies from their results nowadays. “Why shouldn’t companies say, ‘This is a restructuring program that is going to take us four years to complete, and here are the numbers,’” Mr. Ciesielski said in an interview. “Restructuring programs cost cash. Why not face up to it and be real about what you’re forecasting? If everybody did that consistently, that would be a dose of reality.” Mr. Turner, the former S.E.C. chief accountant, agreed. What investors need, he said, is a clearer picture of all items — both costs and revenues — that companies consider unusual or nonrecurring in their operations. These details should appear in a footnote to the financial statements, he said. “We need to require the disclosure of both the good and the bad,” Mr. Turner said. “If you have a large nonrecurring revenue item, you need to disclose that as well as a nonrecurring expense. Then you should require auditors to have some audit liability for these items.” Of course, some of the fantasy figures highlighted by companies are worse than others. Excluding the impairment of an asset, Mr. Ciesielski said, is “not the worst crime being committed. But when you’re backing out litigation expenses that go on every quarter, that’s a low-quality kind of adjustment, and those are pretty abhorrent.”
The bottom line for fraud examiners, auditors, investors and everyone else, according to Mr. Ciesielski and Mr. Turner, is to ignore the allure of the make-believe. Real-world numbers may be less heartening, but they are also less likely to generate those ugly surprises that can come from accentuating the positive.