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GAAP, “Items”, And Adjusted Earnings - Sometimes a Strange Tale
We often refer to the “bottom line’ of some issue or subject, usually meaning the net effect of everything that bears on the issue or its most important feature. A company’s income statement, by contrast, has many lines and can have several “bottom’’ lines. Due to the requirements of the Financial Standards Accounting Board (FASB), companies must include a good number of unusual items, often involving no cash, in their income according to generally accepted accounting principles (GAAP). This note presents our views on how to regard the most important of them in determining a company’s real, economic earnings.
Nonrecurring items can be divided into those which have an economic basis - - whether it is in the current reporting period or the past - - and those which a company must run through the P&L solely to obtain an unqualified audit report from their accountants. The latter must follow the dictates of the FASB, which require that many unusual items be accounted for as profits or losses, whether an item arises from events in the given quarter or year or has a penny of effect on cash flow. The most common nonrecurring or unusual items with some economic basis are impairments of assets, restructuring costs, and gains on sales of assets. Others include startup costs, losses on refinancing debt, merger/acquisition expenses, unusual legal expenses or benefits, research and development progress payments in the drug industry, and contract profit recalculations for engineering and construction companies.
The largest of these costs are impairments of assets acquired in better times. At least annually, companies are required to evaluate their operations and write down (“impair”) to current value any that are now worth considerably less than when they were bought. Independent oil and gas exploration and production (E&P) firms are particularly subject to impairments, as they have usually grown more through acquisition than have their big oil brethren, and the impairments of oil and gas properties are often larger than profits before all items. For example, in 2012, Devon Energy (DVN) reported $2.0 billion of impairments, and in 2011 Anadarko Petroleum (APC) wrote down $1.8 billion of assets. In contrast, Exxon-Mobil (XOM - Free Exxon Stock Report), Chevron (CVX - Free Chevron Stock Report), and Royal Dutch Shell (RDSA) have reported no impairments in the last three years. Impairments of acquired companies are also relatively common. The New York Times (NYT) bought the Boston Globe in 1994 for around $1.1 billion, later writing it down by about $800 million. And McClatchy Newspapers acquired Knight Ridder in 2006 and wrote off about $2.8 billion two years later. We exclude these impairments from our earnings figures, as they do not pertain to operations in the periods when the costs must be recognized and they entail no outlay of cash. True, the company has paid cash or other consideration, but including such an impairment distorts the company’s recent performance dramatically. Theoretically, the large reduction in value of an acquisition means that the company really earned less each year following the purchase, but GAAP does not permit companies to amortize goodwill any more, and amortization of some intangibles, such as patents and trademarks would not have been nearly enough to account for the large reductions in value imposed by Schumpeter’s “creative destruction’’ in a capitalist economy.
The other common unusual items usually involve some cash costs in the period when they are recognized or in the quarters immediately following. Restructuring costs and the others mentioned are usually well under half of profits before items, so we usually include these items, though we will exclude acquisition costs if they are large enough and pertain to a transformational transaction. Gain on sale of assets, though, is like the positive side of impairments and is always excluded. Some theoreticians argue that all profits and losses should be included in a company’s earnings, as they actually happened. But retaining these items moves profits and losses between years, at best, and obscures economic reality, at worst. One approach is to calculate moving five-year averages of companies’ results, with all nonrecurrings left in, and compare the most recent number with the corresponding one from five years ago. But that would be time-consuming and would lead the analyst to miss emerging earnings patterns.
A second category of nonrecurrings has less claim to be included in the income statement. The most prevalent of this type are mark to market values of derivatives, such as commodity futures contracts, that a company needs to run its business, and unusual income taxes. The FASB does permit companies to ignore some changes in derivative values if they qualify as “cash flow hedges”. But others, which appear to offer no more risk, must be marked to market at the end of each quarter. This creates noncash GAAP operating profits or costs in periods before the relevant contract closes, and we recommend ignoring such items when a company is good enough to report them. Unusual income taxes must also be run through the P&L, according to GAAP, when a company closes the tax books on a prior year. Even in the unusual case where the change to the income tax line was a cash item, these adjustments have nothing to do with a company’s activities in the period when they must be reported to please the FASB and should be ignored in the effort to arrive at economic profits.
Despite some of our comments on the FASB, it is now permitting some unusual items to be mentioned on their own lines on the face of the income statement. Where the company has given no guidance on the after-tax effects of these and other items, we usually estimate that their after-tax amounts reflect the company’s normal income tax rate. A particularly good example of full disclosure in this area is the big international pharmaceutical company Sanofi (SNY), which gives both pre- and after-
tax figures for all unusual items.
At present, the FASB allows only three kinds of items to be excluded from GAAP earnings from continuing operations: results of discontinued operations; truly “extraordinary” items, like hundred-year
storms; and changes of accounting principles; the latter two are quite rare.
At the time of this article's writing, the author had a position in XOM.