Corporate Earnings Fiction

By Wolf Richter – Re-Blogged From Wolf Street

The Biggest Sinners in the Dow.

All 30 companies in the Dow Jones Industrial Average have now reported earnings for the third quarter. As required, they reported these earnings under Generally Accepted Accounting Principles (GAAP). These standardized accounting rules are supposed to allow investors to compare the results of different companies. But that’s too harsh a fate for many of our corporate heroes, and so they proffer their own and much more pleasing accounting strategies – as expressed in “adjusted” earnings and “adjusted” earnings per share (EPS).

Of the 30 companies in the DJIA, 14 reported “adjusted” or “non-GAAP” earnings in Q3 that were significantly higher than their GAAP earnings. Total “adjusted” EPS of these 14 Dow components exceeded their total EPS under GAAP by 26%! Nice work!

“Adjusted” earnings are the great American fiction conceived to serve the great American passion: inflating share prices by hook or crook.

The biggest sinner: Merck & Co. miraculously turned its loss of -$0.02 per share under GAAP into an “adjusted” profit of $1.11 a share. This is not a “one-time” event either. Merck keeps showing up in the ignominious top five Dow earnings adjusters time after time. Among the repeat offenders in the top five are also Pfizer, Coca-Cola, and GE.

So the theory that these are “one-time items” that should be excluded – even if that theory ever made sense – falls apart if it happens quarter after quarter.

The chart below shows the 14 Dow components with EPS that have been inflated by adjustments, and the percentage difference between their EPS under GAAP and their “adjusted” EPS. I cut Merck’s bar off because it goes to 5,650%, which would be about 12 feet beyond the edge of the chart. Wal-Mart Stores inflated its earnings by 72% and DowDuPont by 67%, and Warren Buffett’s favorite beverage company by more than half:

Under increasing pressure from the SEC, some of them disclosed GAAP earnings upfront in their earnings report, before pointing at non-GAAP earnings. Others were not so forthcoming. J&J’s GAAP EPS was particularly cumbersome to dig up, buried in the earnings release all the way down in the Non-GAAP reconciliation schedule.

These are among the large companies in the US that are deemed to be the most representative of their industries. They tend not to go entirely crazy, unlike smaller companies that haven’t yet figured out how to make money and that desperately need to show some kind of positive results.

Twitter is a good example. It’s not in the DJIA. It loses money every year, but after its adjustments, there’s always a fat “adjusted” profit. In the last quarter, it lost $21 million under GAAP, on declining revenues. But after it got through “adjusting” a lot of expenses out of the way, its non-GAAP income was $78 million. This took its loss per share of $-0.03 under GAAP to an adjusted profit of $0.10 per share.

These kinds of tricks work miracles. They’re promoted endlessly on Wall Street. And many companies use them. Even though GAAP gives companies a lot of leeway to beautify their results, it’s just not enough to hype stock prices sufficiently.

Some companies show alternative measures to GAAP earnings, after they show GAAP earnings, to show for example how the core portion of the business is doing. In many cases, these “core” earnings are lower than GAAP earnings because they cover only part of the operations. Such additional metrics, if presented as additional metrics, might make sense. Pointing out particularly ugly items that impacted earnings also makes sense.

But EPS is a final summary figure that underlies the all-import price-earnings ratio which is used to value shares. Wall Street analysts and the media put these “adjusted” numbers into the headlines, which are all many people and trading algorithms read. Data aggregators use these “adjusted” numbers in their reports and charts about the stock market overall, such as the aggregate earnings multiple of the S&P 500 companies. These “adjusted” numbers are everywhere, drowning out any sense of reality.

Even the SEC has lost patience with companies promoting their beautified non-GAAP measures. Since last year, it has been admonishing them about the prominence of these “adjusted” numbers in earnings presentations and in press releases. Some companies have since abandoned “adjusted” earnings. But many others – including about half of the Dow components – are still doing it.

Wall Street loves nothing more than to tout these “adjusted” earnings and how they “beat” expectations that have been lowered in prior weeks so that they could be beat. And given the grossly inflated stock prices, boosting earnings with “adjustments” is a game that is just too good to stop.


4 thoughts on “Corporate Earnings Fiction

    • There likely are ways to manipulate any number a company reports. As a company gets larger, and growth becomes more difficult to obtain, deception becomes a bigger threat. Over multiple periods, revenue and cash flow (not per share) are less easy.

      And, there are a few ratings companies (eg Value Line) which specifically look at how a company is doing compared to other companies. In the final analysis, you have to trust somebody.


  1. Generally Accepted Accounting Principles (GAAP) were issued to force Accountants to make reasonable reports. The spirit is there but accountants can still play with every details so that reports always make the management looks better! The latter can then receive outrageous payments at the expense of shareholders!

    Shareholders are almost on their own in the current investment environment.


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