It’s early days yet, but 2002 already seems strangely redolent of an earlier era. We have already seen strikes on the railways, the re-emergence of inflation and interest rate worries, fears about the future of manufacturing and the return of creative accounting.
Admittedly the last throwback is a US phenomenon, and it remains to be seen whether it will be imported into this country in the next few months. But it isn’t surprising that, as the US economy runs out of steam, companies are resorting to some pretty strong stuff to keep their earnings looking good.
The seriousness of this problem can be assessed by the response of the Securities & Exchange Commission. It addressed its “cautionary advice” to company management, auditors, audit committees and their advisers, reminding them that investors “deserve transparency of accounting policies”.
It also warned companies they are liable to fall foul of anti-fraud statutes in US securities law if they aren’t transparent.
The SEC is really complaining about the widespread use of so-called “pro forma” financial information. This is little more than home-made (and therefore made-up) financial reporting. Or, as the SEC more delicately puts it, “the presentation of company earnings and operating results on the basis of methodologies other than Generally Accepted Accounting Principles (GAAP)”.
The original idea behind pro forma was that it allowed companies to present alternative figures where they genuinely believed the numbers produced by the accounting standards were misleading investors. It is also a result of quarterly reporting. Releasing figures every 90 days means investors want to see trends unsullied by supposed one-offs such as acquisitions.
Pro forma accounts began to be manipulated as stock market investments became an obsession in the US in a way we have never seen in the UK. Investors wanted to know the bottom line, so some companies would strip out costs they didn’t like – such as stock-based compensation. Another favourite pro forma adjustment was inventory (stock) write downs claiming unsold stock is a one-time charge that can be ignored.
This kind of pro forma is little more than PR by numbers. In the US, companies would release pro forma numbers to the press – including wire and web services – which would report those numbers to an interested share investing community. The statutory earnings fed to the SEC a fortnight later would come out unheralded.
The US Financial Accounting Standards Board has declared that pro forma is nothing to do with it. It says it has no control over what companies include in pro forma earnings because it is part of a press release, not a financial report. But the SEC has stepped in.
The extent of the issue is revealed by a survey conducted by KPMG and CFO.com at a New York Financial Executives Conference. Of 196 finance managers polled, 82% said their company reports some kind of non-GAAP earnings in press releases. When asked why they issue pro forma results, 45% said these figures help convey their company’s true performance, while 27% said analysts asked from them.
It is interesting to ponder how such a situation would be handled in the UK. The Accounting Standards Board would probably find itself in as much a bind as its US counterpart and responsibility would fall on the Financial Services Authority, a body which has considerably less experience than the SEC.
The SEC is committed to studying the use of pro forma earnings. The next likely step is for it to consider new rules designed to “elicit more precise disclosure” about the accounting policies a company believes are most critical to the portrayal of its results. In other words, the SEC will issue guidance on pro formas.
While the SEC ponders, it will be interesting to see how much notice companies take of its warnings. Experts in the US think that, while the SEC may have done enough to stop the worst excesses, it seems unlikely to halt vaguely misleading figures. There is certainly little pressure in the US to ban pro forma. However, it does seem likely the SEC will require companies to reconcile non-GAAP figures to GAAP.
In many ways this episode is heartening. It underlines the importance of financial reporting and shows a regulator ready and willing to protect investors.