A fascinating article by AP came out yesterday. In most papers the headline read “Experts worry that ‘phony numbers’ are misleading investors;” but in the UK the same article was titled, “Revealed: S&P 500 companies are saying they make BILLIONS more than they actually do so they can rake in investments despite net losses.”
I think the second title is more accurate, but I have a quibble about the stated cause. Raking in investments is certainly key, but I believe the motivation may actually be about executive pay. In these days of so-called “pay for performance” executives have a lot riding on making the numbers work and on pushing the envelope to make the numbers work.
The analysis looked at S&P 500 companies, and found that “the gap between the ‘adjusted’ profits that analysts cite and bottom-line earnings figures that companies are legally obliged to report, or net income, has widened dramatically over the past five years.” There are occasions when adjustments need to be made – when a truly extraordinary event takes place, for example — but those are or should be rare. And this report shows that far from being rare they’ve become increasingly common, and larger. At 20% of the companies the adjusted profits were at least 50% higher than net income under required disclosure. One problem here is that systemic problems can be hidden by a mass of individual “non-recurring” costs or other adjustments. They muddy already confusing financial statements.
These misleading figures are also what are too often used to calculate pay. I spent a bit of time looking at the proxy statements of the companies highlighted for either having an especially big difference between reported and actual pay, or for being serial-adjusters. In the proxy statements I looked at, the word “adjustments” inevitably showed up most often in the section of the proxy devoted to discussion of pay.
Boston Scientific’s proxy has what they call an “annex” devoted to describing reconciliation of measures to most directly relatable GAAP measures. The CEO’s bonus was paid at 127% of target. It was the only part of pay that came in above target.
Alcoa’s CEO Klaus Kleinfeld received over $9 million in cash bonuses over the last three years, though both TSR and return on assets have lagged the S&P 500. Alcoa uses the term “normalize,” to describe its adjustments and it appears 39 times in the most recent proxy statement, as opposed to four mentions in the 2011 proxy. If there need to be that many adjustments perhaps there is a new normal. The description of performance metrics includes a subtle asterisk, and if you follow it to the fine print you read, “For the reconciliation of free cash flow to the most directly comparable GAAP measure, cash from operations, see “Attachment C—Calculation of Financial Measures.”
These financial shenanigans are costly in more way than one. Stryker, another company mentioned in the article, needed to file an amendment to their proxy this year to clarify that Tax Fees paid to Ernst & Young LLP in 2014 “consisted of $635,000 for tax compliance services and $7,030,000 for tax advice and tax planning services.”
It would take someone with more accounting expertise and more time than I have to really take apart these figures. Another interesting avenue for research would be to look at insider stock sales at these companies. Even if adjustments don’t affect compensation directly, the premise of the AP study is that these numbers are inflating stock price beyond its merits. One hopes that sophisticated analysts are conducting just this sort of research, but I’m skeptical.