Overall, the economy in 2013 was sluggish net-net the world over. India was no exception. Companies, including sub-continent stalwarts such as Bharti Airtel, struggled to maintain margins. Pricing power being close to nonexistent, corporations had to focus on controlling costs. As the calendar year and fiscal year for many companies enters the fourth quarter, 2014 has turned out better than 2013. But there are still headwinds. Many publicly traded corporations have to continue squeezing productivity improvements out of their operations, while at the same time holding the line on expenses. Some enterprises have already reached the end of the game as far as these maneuvers are concerned and have opted for more drastic measures. In these cases, until the economic tide raises all boats with sustainable organic growth, companies may resort to chicanery with their financials to make results appear better than reality.
Investors will see many metrics touted in the name of transparency in order to make quarterly filings more “understandable” or so the officers of these companies will say. These metrics are loosely grouped under the heading of “non-GAAP” earnings. To comprehend non-GAAP earnings, first we must define GAAP earnings. GAAP stands for Generally Accepted Accounting Principles. GAAP accounting principles were established in the United States in the aftermath of the “Black Tuesday” stock market crash of October 29, 1929. On that fateful day, the Dow Jones Industrial Average closed down more than 11 percent with a total volume of shares traded that would not be surpassed for 40 years or more. Technically, the abysmal statistics of the Black Tuesday crash of 1929 may have been overtaken by subsequent stock market crashes, but the devastating fallout of the Great Depression that started on Black Tuesday and which did not end for more than 10 years still marks it as the most consequential economic calamity of modern times.
In any event, GAAP principles were part of the solution to deal with publicly traded companies who did not report their results regularly and/or provided a very opaque view of their financial operations, which were some of the reasons investors lost confidence in the market and caused it to crash in the first place. GAAP seeks to provide a yardstick by which to measure the performance of different companies against one another. In other words, it makes an “apples to apples” comparison possible.
Some basic precepts of GAAP accounting are that expenses and revenues must be recorded in the fiscal quarter within which the actual goods or services associated with them are delivered. For example, if a corporation pays the lease on its headquarters all at once at the beginning of the year it will not take an expense for the entire value of the lease in its first quarter. It will make what are called accrual entries in its general accounting ledger in each of the four fiscal quarters to better reflect the timing of when the occupancy of the lease is “consumed” by the corporation over the course of the year. In the same vein, a corporation under GAAP may receive payment for a contract to deliver services or software licenses to a customer all in one lump sum in a particular fiscal quarter. Because all the services or useful life of the software are not utilized at once by the customers, the corporation will recognize the revenue from the contract in roughly equal amounts in each quarter that the contract covers (there are exceptions to this concept that are too intricate to cover here).
Cliché but accurate: If something seems too good to be true, it probably is
Many corporations will cite non-GAAP results in their quarterly results and conference calls to make their performance seem better than it is according to GAAP. The GAAP results and any reconciliation of non-GAAP results are always filed with the Securities and Exchange Commission for U.S.-based public companies, but this is often done with the bare minimum of legal notification.
A particularly egregious example of a company trying to mask its operating results with non-GAAP accounting is the partial closing of office facilities. The company’s CEO, CFO and other responsible parties will insist that since a quarter, half or three-quarters of the office is closed off or otherwise not in use they can claim a “savings” in the debit column of the ledger. Perhaps, they have moved this expense into discontinued operations, which has an entirely different impact on the balance sheet. Whatever the on-paper treatment of this expense, the landlord continues to get her entire lease payment every month, and the company must spend real money to make the payment, not some illusory accounting entry on an Excel spreadsheet in the corporate data center.
Accounting gimmicks, not ‘The Hunger Games’
Charles Darwin may have been misquoted or misconstrued over the years, but the underlying premise of evolution remains valid: survival of the fittest. The financially fittest corporations will not need to resort to accounting gimmicks. They will be able to win “The Hunger Games” of the marketplace through honest but vigorous competition. Now that the Federal Reserve has finished “saving” the world economy, unfettered free enterprise should be back en vogue very soon. In that kind of economic climate some will necessarily fall by the wayside. Winners and losers will be chosen. And the prudent capitalist will definitely need to do her due diligence to be able to see through the PR smokescreens some companies emit to pick the true value creators.
There is a basic rule of thumb every individual-stock-picking investor should follow: to know the true financial results for any company, all you have to do is read the headline on the quarterly press release. If it fails to mention the word “profit” think twice about investing in that corporation.
Derek Handova is a freelance journalist, part-time blogger and full-time marketer in the telecommunications industry with an emphasis on social media and related channels.