Easy to overlook accounting subtleties

INVESTORS seldom consider the accounting policies and disclosures behind a set of financial statements very intently.

For most people, Generally Accepted Accounting Practice is not an enthralling topic.

However, this is the language of company reporting – and like any language, it is full of easily overlooked subtleties and innuendos.

Financial statements are finalised through negotiation

Most investors think that the process of producing a set of accounts is precise, with independent auditors supervising management closely.

However, auditors do not verify that accounts are accurate, only that they do not contain “material misstatements”.

Accounting choices can obscure true performance but still provide valuable insight

Management teams have far more discretion in their choice and application of accounting policies than generally imagined.

These choices allow them to present a company in a specific way – usually a very flattering one.

While potentially masking true business performance, the choices themselves provide valu- able information.

For example, a consistent pattern of aggression or conservatism in accounting policy and disclosure is vitally important evidence, providing a window into the true corporate culture of a business.

Management can be good at getting investors to ignore statutory earnings

Many management teams disclose their own adjusted earnings alongside statutory numbers, using disclaimers such as “adjusted”, “normalised”, “underlying” and “operating”.

The idea is to eliminate once-off or non-cash items that distort reported earnings.

While improved disclosure is laudable, there are several potential problems with adjusted earnings. Firstly, the adjustments are subjectively made by management.

Secondly, the temptation to classify more expenses as “non-operating” grows, especially in tough business environments.

This is further compounded if management incentivisation is based on adjusted rather than statutory earnings.

Case study: IBM – statutory versus operating earnings

IBM had a long track record of beating guided earnings, both quarterly and compared to long-term roadmaps that targeted growth over five-year periods.

In 2010, IBM announced its target for the next five years: achieving $20 of EPS in 2015.

However, unlike before, the $20 would be “operating” EPS rather than statutory reported EPS.

By mid-2014, IBM had beaten its guided earnings estimates for 31 consecutive quarters – an astonishing performance.

But in October 2014, it shocked the market by missing earnings.

It also announced that it would miss its 2015 roadmap target.

The share price dropped by 35% over the next 18 months.

One accounting clue that could have warned of this was that within three years of changing its roadmap target from statutory to operating EPS, the adjusting items had grown from a negligible amount to just under $1.5-billion.

Management’s accounting policy choices should not be overlooked

Investors should understand that management teams often have considerable leeway in their choice of accounting policies and disclosures.

These choices also give good insight into a company’s corporate culture.

It is important to evaluate non-statutory earnings numbers and incentives that drive management behaviour, as they are critical in determining accounting risk.