Who wins from ‘adjusting’ earnings per share? Time for some rules.

Most companies in this results season are delivering reassuring updates, but can investors trust the numbers? Tesco’s issues have not only rattled its own shareholders; across the market, analysts wonder how widespread accounting concerns might be.

Growth is scarce, and CEOs are under pressure to deliver. This has put more emphasis on presentation; but recent results reveal a worrying pattern of favourable adjustments to reported profits. This practice can mislead, distorting share prices. Regulators need to step in with stronger guidance on adjustments and presentation.

Adjusted earnings per share is a widely used metric, yet can be an inconsistent guide to company performance. CEOs know that unexpected costs or restructuring expense can be simply wished away by talking instead about “core” earnings or underlying trends. Since few companies even in the same industry adjust in the same way, comparisons are impossible.

Generally accepted accounting practices are meant to level the field, but are now disregarded where it matters; in the price formation that relies on the quality of analysts’ research. In the rush to write up results, analysts simply do not have enough time to amend what companies put out.

Crucially, analysts may not have enough information to correct the “adjustments”. It is the preliminary figures that drive results coverage – much less is written when the actual annual reports are published with the additional information needed to unscramble adjustments.

Even worse, many executive incentive schemes are driven by adjusted earnings. Effectively, new adjustments can move the goal posts. It is this that has allowed companies to make major pay-outs to successive CEOs, even as the longer-term earnings trend has disappointed.

Re-setting the presentation of earnings usually involves changing leadership, with a new CEO starting off at a lower base. Investors do not have this luxury. Over time, it is the stream of statutory earnings that shareholders own. There is little sign that “core” or “underlying” earnings represent fundamental value. The practice of using tailored numbers has become embedded in research; flattering the mediocre, and effectively penalising the companies that do not play the adjustment game.

Nor, is the UK unique in this failing. In the US, there is a worrying trend amongst recent IPOs. Many are reporting profits on their own customised basis, whilst actually incurring losses in terms of statutory accounting. But helpfully, the US Regulator, the Securities and Exchange Commission, requires companies not to give undue prominence to the adjusted numbers – a rule that might be useful in the UK.

Investor confusion is understandable; it is adjusted earnings that appear in bright lights at the start of company reports, while the statutory number is usually downplayed. If companies were forced to give equal prominence to true earnings alongside the company’s own tailored figures, any pattern of favourable adjustments might be obvious.

Thomas Cook Group’s latest annual results, for example, showed that its “ turnaround” involved excluding restructuring costs, impairment charges and customer claims relating to flight delays. Results to 30 September 2014 showed a basic earnings per share loss of 8.2p was adjusted to underlying positive earnings per share of 11.3p. Even Thomas Cook’s board seemed finally to question this “transformation”. CEO, Harriet Green left as these results were published, but having earned substantial bonuses from a company still in loss.

While a group undertaking a major restructuring might have a particularly wide divergence between adjusted and statutory earnings, there are gaps in most industries. IT outsourcer, Innovation Group, presented a 30% gain in 2014 adjusted earnings per share, although statutory “basic” earnings actually fell. Engineering group, Meggitt, has reported adjusted “underlying” earnings per share 47% higher than the statutory figure. Property services group, Mitie, in its most recent interim results showed a statutory earnings per share loss of 1p, but gave much more prominence to what it called a ‘headline’ figure of a positive 12.4p.

However well-meaning adjustments are – typically intended to help investors understand sustainable earnings – the big picture of how well a company is doing is missed. Analysts have an impossible task in assessing what adjustments might really represent business-as-usual. Many items do not look particularly exceptional. In some industries, earnings adjustments typically exclude business acquisition costs, which effectively means some companies are shielded from presenting their true cost of capital. Conveying the costs and risks of goodwill and takeovers clearly to investors is essential.

Despite all the effort in setting generally agreed accounting standards, statutory earnings per share have been demoted by many companies in favour of idiosyncratic calculations. And, while the work needed to unscramble this puts a premium on high quality research, it risks impairing stockmarket efficiency in allocating capital.
Company reports have become dominated by a false narrative. Adjusted EPS is just one number, but its prominence at the start of an annual report is key to framing investor perceptions. It sets the tone for the statements that follow from the chair and chief executive.

The ambiguous nature of earnings adjustments seems to be why UK regulators have stood back. Early this year, the Department of Business Innovation and Skills will consult on UK implementation of the EU Directive on Non-Financial Reporting. This might be an opportunity to signal just where adjusted numbers stand. They are not statutory financial reporting, yet are not regulated as a high-impact narrative. What looks like a number, may just be a story.

It is not that an accounting standard should define adjusted earnings, but that clear regulatory guidance is needed on presentation. This should require equal prominence at the start of the report, with full explanation of the adjustments appearing on the same page. And, the audit and remuneration committees should question whether tailoring results in this way really helps shareholders’ understanding, or mainly benefits executives. The FRC should make it clear that both committees need to be involved in data governance.

Although the presentation of adjusted EPS itself does not constitute market abuse it can represent a distortion in price formation. If this regulatory gap persists, it risks undoing much of the effort that goes into improving the quality and relevance of company reporting. Regulators should step in now to set some boundaries on adjustments, and ensure all the numbers in company accounts are credible.

A version of this article was published as an Op-Ed in Financial News on March 2nd 2015.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice. At the time of writing neither I nor my employer’s clients had interests in any stock mentioned apart from client fund positions in Innovation Group and Mitie Group, and had no plans to initiate any new positions.

Image credit; Thomas Cook some rights reserved.

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