Companies can talk all they want about how the quality of their earnings are improving since the corporate business scandals. Truth be told, they...
NEW YORK — Companies can talk all they want about how the quality of their earnings are improving since the corporate business scandals. Truth be told, they might not be practicing what they preach.
At least that’s the conclusion of a new study showing plenty of companies are still releasing earnings reports that paint a picture of their businesses that is rosier than reality.
Not what they are doing is necessarily illegal in any way, but it gives a perception that things are better than they really are. And maybe worst of all is that investors and Wall Street continue to let them get away with this.
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This kind of behavior was supposed to change after executives at WorldCom, Enron and the like got caught inflating their corporate performance to boost their companies’ stocks. Many then went on to cash in on the share-price run-up.
Investors were stunned to learn that companies long touting big earnings gains had really been losing major money.
In recent years, securities regulators started enforcing stricter accounting rules that required companies to include profit figures based on the conservative Generally Accepted Accounting Principles, or GAAP, in their earnings news releases and were supposed to make it more difficult for companies to exclude all sorts of “special costs” from their earnings reports.
While those changes have forced companies to put more important data into financial reports, earnings still aren’t up to the quality that they should be. Companies continue to try to spin their earnings news in their favor, often by touting their “operating” or “adjusted” results.
“Management still has great discretion over what goes into their earnings, and how they report those earnings,” said Philip Wolitzer, an accounting professor at Long Island University.
New research by Merrill Lynch chief U.S. market strategist Richard Bernstein shows that the so-called improvement in corporate reporting hasn’t been an improvement at all. His methodology shows that the quality of earnings in the recent profit cycle was comparable to the worst levels seen during most profit cycles in the 1990s — when much of the accounting manipulation that led to the corporate scandals was going on.
He measures quality by looking at the difference between operating and GAAP earnings for companies in the Standard & Poor’s 500 stock index. The lower the gap between those metrics, the better the quality, largely because there are fewer write-downs and write-offs as well as a reduced level of accounting gimmickry.
His findings show that operating earnings were on average 9.6 percent higher than those reported under GAAP in the second quarter of last year, and that difference climbed to 13.7 percent in the fourth quarter of 2004, signaling a deterioration in quality.
The difference is still well below the 40.1 percent seen in the fourth quarter of 2002, but it’s important to put the size of the recent gap into a better context — it’s more than double the low seen in March 2000 and well above the long-term average gap of 6.7 percent.
“The general perception is that the quality of earnings improved demonstrably during the recent profit cycle,” Bernstein said. “Whereas that is clearly true relative to the extremely poor quality of earnings in 2000-2002, it is not true relative to history.”
Just consider how drastic the gap at some companies can be.
Ford earned 5 cents a share under GAAP in the fourth quarter while its adjusted earnings showed a gain of 28 cents per share. Wood-products company Georgia-Pacific also had a wide difference, with its GAAP figures showing a 6 cent gain in earnings per share versus the 51 cents a share it presented in operating earnings. Biotechnology firm Genzyme had a loss of 42 cents a share under GAAP, while its operating earnings were 52 cents a share, according to Merrill Lynch.
Companies throughout corporate America argue that their adjusted earnings present a better gauge of their operations by excluding special or one-time costs. Wall Street, too, has long favored these results over GAAP to value and analyze stocks, and investors still let companies play down the negative results by continuing to focus on adjusted earnings when buying and selling stocks.
That’s a strategy they may want to rethink now that overall corporate profit growth is decelerating. Bernstein found that 78 percent of the 50 stocks in the S&P 500 with the biggest difference between adjusted and GAAP earnings fall at the low end of S&P’s common stock rankings, which measure historical earnings and dividend growth. Included on that list: Delta Air Lines, Advanced Micro Devices and LSI Logic.
Bernstein points out that “lower quality” stocks tend to underperform when the profit cycle is slowing, which is happening right now.
So while companies might like to push adjusted earnings, investors might not want to pin their hopes on that measurement.