"The reason every developed economy uses standardized accounting rules is to give investors a modicum of insight into what is going on in a company, compare these numbers to those of other companies, and make at least not totally ignorant investment decisions.
In the US, these are the generally accepted accounting principles, or GAAP, the most despised acronym of Wall Street and Corporate America. Yet even these principles offer plenty of flexibility for financial statement beautification. We get that.
Yet they’re way too harsh for Wall Street. So companies file the required financial statements under GAAP for everyone to look at, but then they hype their “adjusted” earnings in their communications with investors. And the gap between the two in 2015 was a doozie
While companies can play with revenues to some extent, it’s more complicated and not nearly as rewarding as “adjusting” their profits. That’s the easiest thing to do in the world. A few keystrokes will do. There are no rules or laws against it, so long as it’s called something like “adjusted earnings.” The rewards are huge, in terms of share prices, stock options, bonuses, and for Wall Street, fees. The ultimate target of the magic is earnings per share. EPS is the most crucial term in the canon of the markets.
Turns out, the 2015 “growth” in earnings, and particularly the “growth” in EPS – so a decline – as reported by FactSet and others is a figment of the vivid imagination of Wall Street and Corporate America, called “adjusted earnings,” where everything bad has been “adjusted” out of it.
For example, of the 30 components of the Dow Jones Industrial Average, 20 reported “adjusted” earnings, with 18 of them reporting adjusted earnings that were higher than their earnings under GAAP, according to FactSet. That 18-to-2 relationship alone shows the clear bias of these adjustments: They’re used to inflate earnings, not to lower them to some more realistic level.
These adjusted EPS were on average 31% higher in 2015 than EPS under GAAP. That’s way up from 2014 when 19 of the Dow components reported adjusted earnings that were on average 12% higher than under GAAP.
And yet, despite the soaring portion of fiction, these adjusted EPS of the companies in the DOW still declined 4.8%. That’s bad enough. But under GAAP, beautified as it might have been, EPS plunged 12.3%.
The biggest sinners?
Merck & Co. won hands-down: it reported adjusted fictional EPS of $3.59 for 2015; but under GAAP, its earnings dwindled to $1.56 per share. Its elegant adjustments inflated EPS by 130%! You’d think it would take some balls to somehow get this by keen-eyed Wall Street analysts. But no. Wall Street ate it up. Consensual hallucination.
GE reported EPS of a measly $0.17 for the entire year 2015 under GAAP, but once it got through with excising all the bad stuff, EPS jumped 106% to $0.35. OK, that’s still crummy….
Our tech-darling Microsoft reported EPS of $1.48 under GAAP, and so its financial-statement beauticians set out to do their magic and adjusted them up by 78% to $2.63. Pfizer inflated its EPS under GAAP of $1.24 by 77% to $2.20. And United Technologies, in this elegant manner, raised its EPS by 40% to an adjusted $6.30.
These are among the most established members of Corporate America. Other companies, which were not part of FactSet’s report, were much more extreme.
