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How SEC rule legitimises bogus earnings reports

Regulation G allows companies to downplay the bad stuff in their financial results filings

PUBLISHED : Monday, 11 November, 2013, 5:17am
UPDATED : Monday, 11 November, 2013, 7:01am

Twitter's red-hot stock offering last week makes clear that, as in the first internet bubble, investors will pay up for a company even if it has not turned a profit.

And managers of companies that have generated only losses, like Twitter, and even those that are profitable, are happy to suggest metrics that they think are better suited for assessing their operations.

Managements' recommended measures, typically not found in generally accepted accounting principles (GAAP), have an uncanny way of burnishing a company's results. They do so by eliminating some pesky costs of doing business.

As such, these benchmarks are also known as earnings without the bad stuff. They were central to the valuations that propelled internet stocks skywards in the late 1990s. Then, the higher the market climbed, the kookier the metrics became.

My favourite measure was used by analysts to hype the prospects of Homestore.com, a web-based provider of real estate services. They lauded its potential because of the "share of mind" it enjoyed among its customers.

That "share" may have been meaningful in early 2000, as the company's stock hit US$489, but it vanished quickly when Homestore.com crashed in 2001. (Stuart Wolff, a former chief executive, was sentenced to prison in 2010 after pleading guilty to conspiracy to commit securities fraud.) The company now operates as Move; its stock closed at US$16.09 on Friday.

What costs do companies want investors to remove from the income statement? Among the most popular are those associated with stock-based compensation, like options and restricted stock. Because these forms of pay are not made in cash, the theory goes, they should be backed out of a company's expenses.

Twitter's recent prospectus serves as an example. Its management suggests that investors not focus solely on its US$134 million net loss for the first nine months of this year, a figure calculated under GAAP. If you want to see the firm's operating results "through the eyes of management", the prospectus suggests, look at its "non-GAAP net loss" of US$44 million for the period.

To get to that figure, Twitter removed two large costs. Stock compensation for the first three quarters of this year was the biggest, at US$79 million. It also removed US$11 million in costs associated with amortising or reducing the value of intangible assets it acquired previously.

The idea that these items do not cost the company is nonsense, says Jack Ciesielski, an accounting expert at RG Associates and publisher of The Analyst's Accounting Observer.

"When they back out stock-based compensation, they're basically saying that management is working for free," he said. "We know that's not the case."

Ditto for the intangibles, he said. "When they acquired a company, they spent money for things like in-process research and development, contracts and customer lists," he said. "To back out those intangibles is bogus."

Twitter is just one of many companies that point shareholders to rosier earnings measures. And when they do so, they are adhering to a 2002 rule prescribed by the United States Securities and Exchange Commission in response to the Enron and WorldCom accounting frauds. That rule, known as Regulation G, allows companies to use non-traditional metrics in financial reports but only if they present generally accepted accounting measures alongside so that investors can compare the two.

If the SEC wanted its rule to discourage accounting gimmickry, it failed, Ciesielski said.

"The SEC inadvertently legitimised the practice with Regulation G," he said. "It's defining behaviour down … If company Y is backing out stock-based compensation, why wouldn't company X do the same?"

To plumb the popularity and pervasiveness of such metrics, Ciesielski and his associates analysed filings from technology and health-care firms in the S&P 500 Index. They identified those that presented non-traditional figures to investors and compared those results with the companies' actual earnings for the past two years.

Of the 69 technology companies in the index, he found 56 used non-GAAP earnings presentations; of the 54 health-care companies, 45 used them.

Among technology firms, Ciesielski found non-traditional metrics resulted in so-called earnings that were 19.5 per cent higher than actual profits in 2011 and 36 per cent higher last year. In the health-care group, such earnings were 39 per cent and 45 per cent higher, respectively.

The New York Times

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