Posts Tagged ‘Accounting’

Mind the GAAP – and the perceptions

August 1, 2016

London, United Kingdom - October 30, 2013: Detail in the Metro with train in station. The door are open in on person is written "Mind the Gap". Inside the train is strong light and door on other side is closed. On right is woman, passenger sleeping in train.

One of many fond impressions London offers to visitors is the warning “Mind the gap” – a uniquely British way of cautioning subway riders not to trip over, or get their foot stuck in, that space between platform and railcar. Very polite and considerate. A stumble could be nasty.

The gap investor relations people must mind – pardon the pun – is the difference between earnings under Generally Accepted Accounting Principles and the measures that CEOs, as well as some investors, prefer for assessing the performance of businesses. The EBITDAs and Adjusted-Whatevers are so many and varied that investors and IR professionals must watch our footing.

A good primer on the issues is provided in “Where Financial Reporting Still Falls Short” in the July-August issue of Harvard Business Review. A couple of accounting profs look at GAAP and the gaps in terms of what investors should look out for, and to some extent what policy wonks might try to regulate next. For accounting is also all about regulation.

Issues they cover are disclosure matters that IR people need to “get”:

  • Universal standards, with GAAP and IFRS converging (or not)
  • Revenue recognition, especially for complicated products or services
  • Unofficial earnings measures, Adjusted-How-We-Look-At-Our-EPS
  • Fair value accounting vs. what you paid for an asset
  • Cooking the decisions, not the books

The writers call this last item “the more insidious – and perhaps more destructive – practice of manipulating not the numbers in financial reports but the operating decisions that affect those numbers in an effort to achieve short-term results.” So a CEO (or other execs) seeing indications of a revenue shortfall will cut prices to move more product before quarter-end, or to save earnings will delay a discretionary cost like an R&D project or ad buy. Voila! Suddenly EPS meets expectations.

I’m not sure that’s new, or always insidious. When you judge people by numbers, they strive to hit the numbers – teachers teach to the test, sales people sell what they have incentives to sell, and CEOs try to hit their numbers. If the market wants to encourage long-term thinking, boards and perhaps investors can start judging CEOs by the change in performance over years, not quarters. Short-termism is an issue. But I am skeptical of policy makers (or accounting profs) tinkering with regulations to alter how executives make decisions.

The perceptions behind this article are more concerning: Investors don’t trust, with good reason or not depending on the company, disclosures they receive. GAAP or non-GAAP, trust is absolutely critical. Perceptions matter.

What can investor relations people do about this gap?

  1. Understand our own companies’ GAAP and non-GAAP metrics, not just to provide the mandated reconciliations but to be able to work through the numbers and clearly explain the rationale.
  2. Ask investors what they like (or don’t) about our financial reporting.
  3. Benchmark peer companies for insightful metrics and best practices.
  4. Challenge our managements if metrics are confusing or misleading.
  5. Be an advocate for simplicity and clarity.

Being transparent means giving information that enables investors to see what’s going on in the business. That doesn’t just mean more pages of accounting boilerplate and reconciliation tables. Perspective is one of the greatest values IR people can give investors.

© 2016 Johnson Strategic Communications Inc.

The “all lawsuit” channel

April 29, 2010

Browsing a litigation magazine borrowed from my favorite legal beagle – as a non-lawyer, I’m a little put off even by the idea of a litigation magazine – I ran across a neat online resource from Stanford Law School on shareholder lawsuits.

Stanford’s Securities Class Action Clearinghouse, in collaboration with litigation consultant Cornerstone Research, tracks shareholder lawsuits, reports recent filings and settlements, and slices and dices data on different kinds of cases. The website is like a special cable TV channel: all securities lawsuits, and nothing but.

Professor Joseph Grundfest of Stanford Law and John Gould of Cornerstone offer analysis that will interest many investor relations people and corporate lawyers.

For example:

  • Not so many securities class actions were filed in 2009, after 2008 gave plaintiffs’ attorneys a robust year via the financial crisis. In 2009, the lawyers just about ran out of financial institutions to sue, and some even went back to file suits based on older issues, Stanford says. The high point was 2001, when the dot com bubble turned into a litigation bubble related to IPO allocations. We’re off to a so-so start in 2010.
  • More securities class actions were settled in 2009, on the other hand. This reflects lawsuits filed 3 to 5 years earlier, since it usually takes awhile for both sides to get down to settling. Median settlement was $8 million, but the total was $3.8 billion.
  • The biggest settlements tend to involve alleged accounting violations, especially if there is a parallel SEC action. Also, when the plaintiffs are public pension funds rather than individual investors, settlements are typically higher.
  • Stanford also provides articles and papers on topics like D&O insurance and litigation outcomes and a page of links to news stories and releases.

So, for those of you who are intrigued – or scared stiff – by securities litigation, happy browsing!

© 2010 Johnson Strategic Communications Inc.

Two bottom lines (at least)

September 21, 2009

DollarSignGreenAs everyone knows, corporate earnings today commonly include two bottom lines: Companies report net income and EPS under Generally Accepted Accounting Principles, and then there’s a second number on the street that takes out one-time items. These metrics are commonly called GAAP earnings and “operating earnings,” without one-offs.

Over the years the gap between these two numbers has been growing, so that operating earnings for the S&P 500 have averaged nearly 24% higher than GAAP earnings in recent years, says a column (“Investors, It Pays to Mind the GAAP Gaps”) Friday in the Money & Investing section of The Wall Street Journal.

Says the Journal:

It isn’t clear why the difference has grown so wide. One inescapable conclusion is that, since 1995, either by happy accident or accounting shenanigans, one-time losses have grown more quickly than one-time gains, elevating the operating earnings that Wall Street watches.

Investors have mixed feelings about excluding one-offs from earnings. When you throw in EBITDA or adjusted EBITDA, which proponents in some industries prefer as a tool for valuation, some investors are confused or skeptical. You may have heard unconvinced accounting profs push back on “Earnings Before All the Bad Stuff.”

The Journal observes that companies tend to label negative events (write-downs or special charges) as one-offs more often than happy events (windfalls or gains on assets), and excessive write-offs may signal deeper problems:

Investors are well advised to watch both figures for another reason: Some companies have bigger differences between GAAP and operating earnings than others. According to research by Société Générale quantitative strategist Andrew Lapthorne, those with bigger gaps tend to underperform in the long run.

An interesting cautionary note, that bit about underperforming long-term.

Companies need to be careful that one-time accounting items and adjustments do help investors understand the business realities. Inflation in the gap between as-reported and “operating” earnings raises questions. For IR professionals, clarity in reporting (including consistent accounting approaches) should be the goal.

Talk about real economic value …

March 12, 2009

Most investor relations people have run into fund managers who aren’t satisfied with the tables in the 10-Q. Donning green eyeshades, these investors want to slice and dice operating cash flows, cost of capital, and returns on capital in pursuit of … well, their own metric.

They’re after some version of a shareholder-oriented performance measure known as “economic value added” (EVA) or economic profit. To build value, the approach says, a company must earn a rate of return greater than its cost of capital.

Bennett Stewart, one of the originators of EVA, continues to promote its benefits for companies that are truly committed to building shareholder value. Speaking today to a Financial Executives International gathering in Kansas City, Stewart argued other metrics like free cash flow and even return on capital can create perverse incentives for managers – while improving EVA invariably creates real shareholder value, the kind a shareholder sees in the share price.

Essentially, EVA is a non-GAAP calculation of net operating profit after taxes (a cash flow measure) minus a capital charge (the firm’s cost of capital times capital deployed). You can look at EVA as a spread between return and cost of capital, compile a detailed EVA P&L, look at EVA margins at each level, and consider changes in the trend. You can get lost in an endless stream of alphabet-soup abbreviations.

Stewart says “EVA momentum,” a ratio of change in EVA to trailing-year sales, is highly predictive of market value for public companies.

To confess my bias, I’ve have always liked the EVA approach. Stewart’s book The Quest for Value (HarperBusiness, 1991) is one of my favorites in the finance genre. Its shareholder-oriented insights are relevant in developing messages on, say, a proposed merger or new initiative – even for companies that don’t formally use EVA.

Stewart, who left EVA consulting firm Stern Stewart & Co. to start EVA Dimensions in 2006, now is working to “commoditize” the management approach with a software package, a stock rating tool and a hedge fund using EVA methodology. The EVA Dimensions website offers a variety of articles – and, yes, promotion – on using the approach to manage for results.

Stewart offers innumerable proof cases for EVA, but two of our best-known corporate giants offer a good contrast:

  • Wal-Mart. Managers minding only the P&L might focus on raising margins, but Wal-Mart chose a low-margin pricing strategy to pull consumers in, driving faster turns of inventory and higher returns on capital. And it invested in profitable growth. Stewart wrote WMT up as an EVA champion in 1991; since then it has continued to build value.
  • General Motors. When Fortune wrote the carmaker’s early obituary this fall (“GM: Death of an American Dream”), a bar graph showed eight straight years of negative EVA – and a TTM figure of minus $11.5 billion. Oddly enough, GM also was getting horrible marks for negative EVA two decades earlier when Quest for Value was written.

As if to emphasize the relevance of EVA in the Internet era, Stewart also cites Google’s high EVA momentum and stock-price appreciation. So investment in profitable growth and careful management of capital work in the new economy, too.

For companies burdened by the recession, Stewart says, “The first message of EVA in these tough times is don’t go cutting and slashing and burning … We should cut where we should cut, and we should invest where we should invest [in projects and businesses where the numbers show positive economic returns].”

The decision on whether to use EVA as a management tool is typically an issue for CEOs and CFOs. Accountants also have something to say about it. (One FEI member today asked a controller sitting at our table, “So are you ready to start keeping two sets of books?” referring to GAAP accounting plus EVA.) Investor Relations communicates whatever management adopts.

If a company uses EVA, the IRO needs to work diligently on how to communicate the shareholder benefits clearly. Focus on intuitive concepts like earning returns greater than the cost of capital, generating cash and increasing the productivity of assets. Benchmark EVA communications. And don’t bury investors in jargon.

The EVA body of knowledge suggests important principles for investor communication. Most companies, for example, don’t do a good job of talking about the relationship between the income statement and balance sheet. We need to discuss cash and what happens to it. We need to explain (and quantify) management’s effectiveness in using assets to create value.

An IR approach driven only by disclosure requirements is likely to obsess over GAAP accounting – to “worship at the altar of EPS,” Stewart would say. Instead, we should explain performance in terms of real economic value for shareholders. Assuming we really are in the shareholder-wealth business.

Thanks – NIRI & University of Michigan

August 23, 2008

This week I’ve been attending the Theory and Practice of Investor Relations executive education program at the University of Michigan Ross School of Business. The seminar is an opportunity to delve into financial, regulatory and communication aspects of IR with an expert faculty – plus a diverse group of colleagues who bring their own experiences and insights.

The annual program is co-sponsored by the National Investor Relations Institute (NIRI) and the University of Michigan. I was thrilled to attend with a scholarship awarded at the NIRI 2008 annual conference in San Diego. One purpose of this post is to say thanks to NIRI and the University – and, at end of the week, I strongly recommend it to any IR, finance or corporate communications executive.

Besides advancing my own skills, the seminar has been a time to step away from day-to-day work and think about what we do as IR and communications professionals. I’ve assembled quite a few of my comments and take-home learnings on a Lessons @ NIRI-U of Michigan notes page in this blog. Let me know if anything sparks a question or reaction for you.

Markets & information

June 12, 2008

“The lifeblood of capital markets is good information.”

– Robert H. Herz, Chairman, FASB
at NIRI annual conference, June 9, 2008