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Many of the UK companies I analyse “adjust” their earnings numbers by excluding certain items that they are forced to include in the proper – accounting body rules – income statement. Thus they draw up two sets of numbers and try to direct your attention away from the statutory version, and towards the one they have adjusted to make themselves look better.
Admittedly, from time to time, unusual events occur, e.g. a one-off loss on the sale of a factory, or one-off redundancies, or one-off gains from the sale of subsidiary.
And so, it is legitimate to draw up adjusted accounts to show what the profit would have been in the absence of the distorting one-off event – the “underlying” profit number needs to be brought to the attention of shareholders.
But, I would expect that the quantum on one-off “good” events would over a span of years roughly equal the number of one-off “bad” events. Thus over say ten years the accounting standard reported profit for the decade equals the adjusted profit.
But not a bit of it. Many company managers seem to get hooked on the gaming of the profit numbers: we sacked 10 people because we made a duff decision to open branch in Cardiff? oh, we’ll write that down as “exceptional item” and ignore the loss in the adjusted accounts; we closed down a subsidiary that we had badly managed for five years? Well that too, is “exceptional”, so we’ll direct shareholders attention to the profit from “continuing operations” and ignore the “discontinued operating” numbers other than a small note to the accounts.
You’ll notice, in those value investing approaches where I make use of earnings numbers I look at both the accounting standards profit number, called “basic” earnings, as well as the adjusted number, e.g. in the case of using the cyclically adjusted earnings per share method with EPS averaged over ten years.
Examining both gives the necessary wider perspective to judge a company’s performance and potential; and it sheds light on the integrity of the managers running the show.
I find that many down-to-earth business folk, such as engineering entrepreneurs, couldn’t give a damn about accounting appearances, or the London brokers and analysts for that matter (especially Yorkshire ones, it seems), and just get on with managing the business for the long term with very few “adjustments” to accounts. Quite often they’ll take one-off costs such as redundancy costs or restructuring costs on the chin, and just report the statutory profit after taking a write-off hit that year.
Buffett’s view (2016 letter to BH shareholders):
“Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses.
Charlie and I want managements, in their commentary, to describe unusual items – good or bad – that affect the GAAP numbers. After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting “adjusted per-share earnings” makes us nervous. That’s because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well.……..
Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers.
Let’s get back to the two favorites of “don’t-count-this” managers, starting with…………………………To read the rest of this article, and more like it, subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
