Streetwise for Friday, April 14, 2017

There has been a lot of publicity lately over the need to check out people to whom you entrust your money. One often suggested Internet site is www.BrokerCheck.com. While not infallible, this is certainly a recommended procedure to help you avoid the mistakes made by those who failed to take such precautions.

Yet, vetting your broker or investment advisor is the easy part. Vetting corporations about the financial results disseminated each earnings season is a bit more difficult. For example, Warren Buffett, Berkshire Hathaway CEO, had some strong words on what he characterized as, “The most egregious example of how corporate executives fudge numbers to inflate profits.”

“I suggest that you ignore a portion of GAAP amortization costs,” Buffett said of some line items that were depressing Berkshire’s own reported profits. “But it is with some trepidation that I do that, knowing that it has become common for managers to tell their shareholders to ignore certain expense items that are all too real.”

GAAP, short for generally accepted accounting principles, was designed to promote uniformity in how companies report their financial results. However, financial statements based on GAAP often do not accurately reflect the ongoing performance of a company’s underlying operations.

For example, a company may write-down an asset, restructure its operations, or contribute to an underperforming pension fund. These actions usually come with large one-time costs that distort earnings and misrepresent long-term profitability. Therefore, a company will also provide an adjusted, or non-GAAP earnings number that excludes what are arguably non-recurring items.

To be clear, Buffett also sometimes strays from GAAP in his effort to more accurately portray his company’s financial performance. However, Buffett also cautions that straying from GAAP is a slippery slope towards outright financial deception.

Although the consensus is that GAAP earnings represent a stringent yet fair measure of profitability, it’s worrisome when the breach between GAAP earnings and the larger non-GAAP number continues to widen. Unfortunately, this is exactly what is happening in corporate America today as more and more companies engage in touting non-GAAP performance.

Billionaire investor Carl Icahn warned of the perils of non-GAAP accounting in a chilling video he released some time back. “The earnings they are putting out today, I think, they are very suspect,” Icahn said.

“You have not really increased earnings for three years. GAAP earnings for the S&P 500 have stayed at around $100 a share for three years,” Icahn said.

“We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power,” Bank of America Merrill Lynch analysts wrote last January.

Unfortunately, there is no a right answer for the GAAP versus non-GAAP debate. “Even GAAP earnings are suspect,” Icahn said. And he’s right, especially if everyone agrees that always abiding by GAAP does not offer a fair and accurate representation of profitability.

“We have always argued that the best earnings-per-share measure lies somewhere between GAAP and non-GAAP EPS,” Deutsche Bank’s David Bianco once wrote.

For investors who are concerned about any of this, one solution is to simply become more familiar with accounting and the accounting process.

“Accounting is the language of business,” Buffett said in response to a question from actress Glenn Close. “You have to be as comfortable with it as you are with your own native language to really evaluate businesses.”

“Accounting tells you a lot but unfortunately it can also be used in many ways to deceive. You saw it at Enron,” Buffett said. “But you really have to appreciate what a two-edged sword accounting is when such a methodology can give you both correct and incorrect answers [with little discrimination].”

Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.

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