On May 17th 2016 the Securities and Exchange Commission (SEC) released a new set of rules (link) for the reporting of adjusted earnings by U.S. listed companies. The rules were released in the form of Compliance & Disclosure Interpretations ("C&DIs"). The new rules are meant to curtail some of the more serious abuses resulting from Regulation G (further information). Regulation G was implemented in 2003 and allows companies to report Non GAAP earnings. The theory was that companies could provide additional clarity to investors by excluding one-time items from their earnings.
Are the Earnings Real?
The method has come under additional scrutiny as more and more companies report adjusted earnings and the adjusted numbers have outpaced GAAP earnings. Adjusted earnings now exceed GAAP earnings by over 30%. Using the adjusted numbers often allows companies to meet or beat earnings expectations and can give the appearance that the company is doing better than it is (minding the GAAP gap). Meeting or beating the earnings estimates can be critical because if they are missed the company's management and investors can lose billions of dollars. Since the financial media, investors, analysts and information sources now use the adjusted numbers when determining the value of a company's shares there are billions and possibly trillions of dollars at stake. If the new rules are followed, investors may be in for a rude awakening. Starting with the reporting of second quarter 2016 in July there could be a permanent decline of up to 15%. If the values follow the earnings declines trillions of dollars could be lost.
Enter the Securities Regulators
Several of the most common abuses have been identified and corrected with the new guidance. In one tactic a company will identify a charge and then add it directly into the net income per share without adjusting for the tax effect. This immediately increases the earnings and creates higher earnings than if the charge had not occurred. The SEC has outlined that such charges will now need to be computed and taxed appropriately before being added to the adjusted net income. In a recent example of the effect, Pepsi Cola (NYSE:PEP) improved the earnings for the first quarter of 2016 by 39%. The company earned 64 cents per share, using GAAP, but was able to report adjusted earnings of 89 cents per share by adding a charge directly into net income. If PEP had correctly taxed the charge it would have reduced the adjusted earnings by seven cents or eight percent.
The SEC has also ruled against alternative methods which increase revenue. Microsoft could be one of the biggest losers from this change. The company increased adjusted earnings by 30% or 15 cents for the fiscal 1st quarter of 2016 by "accelerating deferred revenue". This may have been viewed as critical for (NASDAQ:MSFT) since the analysts had predicted earnings seventeen cents higher than what was produced on a GAAP basis for the quarter.
Another abuse curtailed is the inclusion of one-time gains in the adjusted earnings. Recently, Eli Lilly (NYSE:LLY) was able to increase its' adjusted net income above GAAP net income by an incredible 102% for the first quarter of 2016 by adding various charges directly into and retaining a 50 million dollar tax refund in the adjusted number. Using the new methodology for determining the adjusted earnings would have reduced Lilly's' adjusted earnings by 18%.
Other items addressed revolve around currency, the presentation of cash flow as earnings and insuring that the GAAP numbers precede the adjusted earnings.
Where are we going?
Currently 90% or more of the companies are using the adjusted earnings. We do not know what the full effect will be but, if the new rules have a large impact the net effect could be a reduction in adjusted earnings of up to 15%. As of May 20th, FactSet (report) expects second quarter 2016 earnings for the S&P 500 to decline an average of 4.7% due to the lower profitability of the companies in the index. The new interpretations from the Securities and Exchange Commission could, if followed, further reduce the adjusted earnings. If the values follow the earnings declines trillions of dollars could be lost.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.