Streetwise for Friday, April 6, 2018

There has been a lot of publicity lately over the need to check out people to whom you entrust your money. The best Internet site for this purpose is www.BrokerCheck.com. While not infallible, using this site is certainly a recommended procedure. It will help you avoid the mistakes made by those who failed to take the precaution.

However, 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.

Therefore, I want to reiterate some of the words I have covered here in the past and that I warn my students about. Specifically, what corporations tell you when they release their quarterly earnings.

Specifically, be aware that even a brief review of a company’s earnings announcement readily shows more than one measure of earnings. Yes, public companies are required to report earnings according to general accepted accounting principles set forth by the Financial Accounting Standards Board (GAAP).

Unfortunately, the truth is often shaded a bit. In addition to GAAP numbers, companies can also report earnings based on whatever logic management finds suitable. The discrepancies between GAAP and non-GAAP can be significant.

GAAP was designed to promote uniformity among financial statements. Yet 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 often include 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, even Warren Buffett 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 and 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 as more and more companies engage in touting non-GAAP performance.

Billionaire investor Carl Icahn has 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 believe they are very suspect,” Icahn said.

The analysts at institutions such as Bank of America Merrill Lynch are becomingly increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that stress primarily GAAP numbers.

One possible reason for the emphasis on non-GAAP results is that it is simply a consequence of less earnings power. And unfortunately, there is no right answer for the GAAP versus non-GAAP debate.

“Even GAAP earnings are suspect,” Icahn said. And he’s right, especially if you agree to the premise that GAAP does not always 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.

One solution of course is to simply become more familiar with accounting procedure and methodology.

“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.” 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.