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CGRP09 - Pro Forma Earnings: What's Wrong with GAAP?

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In recent years, there has been a proliferation of non-GAAP metrics to supplement audited financial statements. Are these adjustments being made for the benefit of shareholders, or to distort …

In recent years, there has been a proliferation of non-GAAP metrics to supplement audited financial statements. Are these adjustments being made for the benefit of shareholders, or to distort financial results?


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  • 1. stanford closer look series 1 Pro Forma Earnings: What’s Wrong with GAAP? Non-GAAP Financial Information Reliable financial reporting is essential to the prop- er functioning of capital markets. Investors rely on reported financials in order to make investment decisions and to evaluate the performance of man- agement and the company over time. When re- porting quality suffers—either through inaccurate reporting or lack of transparency—assets become more difficult to value and capital market efficiency declines.1 For this reason, the Financial Account- ing Standards Board (FASB) has established a set of accounting principles in the U.S. known as GAAP (or, generally accepted accounting principles) that dic- tate how companies record business transactions. Despite the rigor of the U.S. accounting sys- tem, companies still retain considerable discretion over financial reporting. They may elect to apply accounting standards conservatively or aggressively, or they may adopt higher or lower levels of trans- parency in their disclosure. Of particular concern to accounting experts, however, is the proliferation in recent years of non-GAAP metrics to supple- ment official financial statements.2 Non-GAAP metrics—also referred to as core, pro forma, operating, or adjusted results—exclude certain income statement or balance sheet items that are required under GAAP. These tend to be non-cash items such as restructuring charges, asset impairments, and amortization of intangibles. They may also include realized gains or losses on asset sales, or mark-to-market changes on investments or derivatives that the company intends to hold to maturity. Management may prefer non-GAAP metrics because it believes the exclusion of these items provides a more relevant basis for measuring company performance during a specific reporting By David F. Larcker and Brian Tayan August 20, 2010 period. Not surprisingly, non-GAAP earnings also tend to be higher than GAAP earnings. Accountants and regulators have long been con- cerned that the use of non-GAAP financial metrics is abused by management to mislead investors and overstate earnings.3 To discourage this practice, the Sarbanes Oxley Act of 2002 added restrictions to their use. Whenever a company reports a non- GAAP metric, it must also disclose the most direct- ly comparable GAAP figure and provide a table that reconciles the two. Still, over half of the companies in the Dow Jones Industrial Average continue to report non-GAAP earnings (see Exhibit 1). The discrepancy between these metrics is not insignificant. Take, for example, Pfizer. Over the ten year period 2000-2009, the company reported cumulative earnings per share of $18.51 on an ad- justed basis. On a GAAP basis, cumulative earnings per share were only $12.68, a difference of 46 per- cent (see Exhibit 2). The practice has become so engrained that se- curities analysts expect companies to exclude one- time charges. For example, in July 2010, auto- supplier Johnson Controls announced earnings that missed consensus expectations by a penny a share, sending its stock down 5 percent. If it had adjusted for one-time costs, however, the company would have exceeded expectations. When asked by an analyst why the company had not done so, CFO Bruce McDonald replied, “I think we’re going to be transparent in terms of when we have these types of costs, but we want to get away from pulling out all these things and saying just look at this or look at that. […] We are going to be transparent when we have them, both good and bad, but we want to steer away from a lot of non-GAAP adjustments.”4 Topics, Issues, and Controversies in Corporate Governance and Leadership S T A N F O R D C L O S E R L O O K S E R I E S
  • 2. stanford closer look series 2 Pro Forma earnings: what’s wrong with gaap? Despite the potential for abuse, there is consid- erable academic evidence that certain non-GAAP earnings have higher information content than GAAP earnings. Non-GAAP earnings are seen as more permanent than GAAP earnings in that they strip out one-time charges that are unlikely to re- cur. As such, they may provide better indication of the future earnings power of a company. For this reason, Wall Street analysts tend to forecast earn- ings estimates using non-GAAP metrics. Similarly, investors tend to value companies on this basis.5 For example, in 2008, Berkshire Hathaway en- tered into a series of long-duration derivative con- tracts whereby it promised to make payments to third parties if certain stock market indices traded below agreed upon values on specified dates rang- ing from 2018 to 2028. The aggregate notional value of these contracts was $38 billion. Such de- rivatives are required under GAAP to be valued on a mark-to-market basis, even though the contracts specify that they cannot be exercised until expira- tion. As such, CEO Warren Buffett warned that the company’s quarterly earnings would be subject to “wild swings.” To improve transparency, the com- pany would “continue to separate out these figures (as we do realized investment gains and losses) so that you can more clearly view the earnings of our operating businesses.” In the first quarter 2009, the derivative portfolio had a mark-to-market loss of $1.5 billion. The next quarter, it had a gain of $2.4 billion. By comparison, the operating businesses re- ported relatively stable net income of $1.7 billion and $1.8 billion in those quarters, respectively.6 Other accounting principles have the potential to distort corporate earning power. For example, GAAP requires companies under certain circum- stances to take mark-to-market gains or losses on the value of their own corporate debt, based on changes to its fair value. Ironically, the rules state that when a company’s credit quality deteriorates such that its bonds decrease in value, the company should record a gain because it has the potential to repurchase those bonds in the open market at a discount.7 Likewise, the company would record a loss on its bonds when its credit quality improves and its bonds trade at higher values. During 2008, Morgan Stanley recorded a $5.3 billion gain when the market value of its bonds plummeted during the financial crisis. The next year, the company re- corded a $5.5 billion loss when the value of those bonds recovered.8 Why This Matters 1. The quality of financial accounting is critical to the proper functioning of capital markets. It also aids the governance process by allowing inves- tors to closely monitor management and cor- porate performance. What does it say about the quality of the system that so many companies report non-GAAP earnings? 2. The passage of Sarbanes Oxley was expected to decrease the prevalence of non-GAAP adjust- ments. Although it has succeeded in improving disclosure about their calculation, these metrics continue to be widely used. Who is driving this decision: the board, management, or the invest- ment community? How can investors be sure that these adjustments are being made for their benefit and not to distort results? 3. Companies commonly make adjustments to income figures when determining management performance bonuses. Should the same non- GAAP measures be used for bonuses as those reported to the market? If not, why not?  1 Capital market efficiency depends on the accurate pricing of labor, natural resources, and capital. When reporting quality suffers, capi- tal market participants do not have the information they need to appropriately weigh risk and reward. As a result, decision making will be impaired and capital will not be allocated to its most efficient use. Market participants will invest too much money in assets where the risks are excessive given the rewards and not enough money in situations where the rewards are appropriate given the risks. 2 The use of non-GAAP metrics increased sharply between 1986 and 1997. See: M. Bradshaw and R. Sloan (2002), “GAAP versus the Street: An Empirical Assessment of Two Alternative Definitions of Earnings.” Journal of Accounting Research, 40, 41-65. 3 David M. Blitzer, Robert E. Friedman, and Howard J. Silverblatt, “Measures of Corporate Earnings,” Standard & Poor’s, May 14, 2002 (revised). Available at: http://www2.standardandpoors. com/spf/pdf/index/ Core_MeasuringofCorpEarnings_2nd_ Ed-v6.pdf; John B. Carlson and Erkin Y. Sahinoz, “Measures of Corporate Earnings: What Number is Best?” Federal Reserve Bank of Cleveland, Feb. 1, 2003 Available at: http://www.cleveland- fed.org/research/commentary/2003/0201.pdf. 4 Michael Santoli, “Totally in Control,” Barron’s, Aug. 16, 2010; and “Q3 2010 Johnson Controls Earnings Conference Call,” CQ FD Disclosure, Jul. 23, 2010 (edited lightly for clarity). 5 M.T. Bradshaw (2003), “Discussion of ‘Assessing the relative infor- mativeness and persistence of pro forma earnings and GAAP oper- ating earnings”, Journal of Accounting and Economics, Vol. 36, pp.
  • 3. stanford closer look series 3 Pro Forma earnings: what’s wrong with gaap? 321–335. 6 Berkshire Hathaway, 2009 Annual Report. Available at: http:// www.berkshirehathaway.com/reports.html. 7 This is ironic because companies that suffer a decrease in credit quality tend not to have the free capital required to make these repurchases. 8 Morgan Stanley, 2009 fourth quarter and full year results. Available at: http://www.morganstanley.com/about/ir/ shareholder/4q2009.pdf. David Larcker is the Morgan Stanley Director of the Center for Leadership Development and Research at the Stanford Graduate School of Business and senior faculty member at the Rock Center for Corporate Governance at Stanford University. Brian Tayan is a researcher with Stanford’s Cen- ter for Leadership Development and Research. They are coauthors of the books A Real Look at Real World Cor- porate Governance and Corporate Governance Matters. The authors would like to thank Michelle E. Gutman for research assistance in the preparation of these materials. The Stanford Closer Look Series is a collection of short case studies that explore topics, issues, and controversies in cor- porate governance and leadership. The Closer Look Series is published by the Center for Leadership Development and Research at the Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stan- ford University. For more information, visit: http://www.gsb.stanford.edu/cldr. Copyright © 2012 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
  • 4. stanford closer look series 4 Pro Forma earnings: what’s wrong with gaap? Exhibit 1 — Dow Jones companies: GAAp and non-gaap earnings per share (2009) Source: Company press releases, fiscal year 2009. Company Reports Non- GAAP EPS? GAAP EPS Non-GAAP EPS Difference Exclusions 3M Yes $4.52 $4.69 4% Restructuring, gain on sale Alcoa No $-1.06 $-1.06 0% None American Express No $0.72 $0.72 0% None AT&T No $2.12 $2.12 0% None Bank of America No $-0.29 $-0.29 0% None Boeing No $1.84 $1.84 0% None Caterpillar Yes $1.43 $2.18 52% Redundancy costs Chevron No $5.24 $5.24 0% None Cisco Systems Yes $1.05 $1.35 29% Stock options, in process R&D, amortizations, acquisition costs Coca-Cola Yes $2.93 $3.06 4% Asset impairments, restructuring DuPont Yes $1.92 $2.03 6% Restructuring, hurricane proceeds Exxon Mobil Yes $4.01 $3.98 -1% Litigation General Electric No $1.03 $1.03 0% None Hewlett-Packard Yes $0.99 $1.14 15% Asset impairments, restructuring Home Depot Yes $1.55 $1.66 7% Strategic charges, asset impairment Intel Yes $0.77 $1.17 52% Fines, settlements IBM No $10.01 $10.01 0% None Johnson & Johnson Yes $4.4 $4.63 5% Restructuring, gain on litigation JPMorgan Chase No $2.26 $2.26 0% None Kraft Foods No $2.03 $2.03 0% None McDonald's No $4.11 $4.11 0% None Merck Yes $5.65 $3.25 -42% Gain on sale, in process R&D, restructuring, merger costs Microsoft No $1.62 $1.62 0% None Pfizer Yes $1.23 $2.02 64% Amortization of intangibles, in process R&D, restructuring Procter & Gamble Yes $3.58 $3.67 3% Restructuring Travelers No $6.33 $6.33 0% None United Technologies No $4.12 $4.12 0% None Verizon Yes $1.29 $2.4 86% Restructuring, merger costs Wal-Mart Stores Yes $3.72 $3.66 -2% Restructuring, tax benefits Walt Disney Yes $1.76 $1.82 3% Restructuring, asset impairments
  • 5. stanford closer look series 5 Pro Forma earnings: what’s wrong with gaap? Exhibit 2 — Pfizer: GAAP and Non-GAAP Earnings per Share (2000 – 2009) Source: Pfizer, forms 8-K filed with the SEC. Year GAAP EPS Non-GAAP EPS Difference 2009 $1.23 $2.02 64% 2008 $1.20 $2.42 102% 2007 $1.20 $2.20 83% 2006 $2.66 $2.06 -23% 2005 $1.09 $2.02 85% 2004 $1.49 $2.12 42% 2003 $0.54 $1.75 224% 2002 $1.46 $1.59 9% 2001 $1.22 $1.31 7% 2000 $0.59 $1.02 73% Cumulative $12.68 $18.51 46%