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Should Directors Ignore Those One-Time Items?

|Includes:AIG, BAC, CLX, International Paper Co. (IP)

Of course not.

The issue is not what direc­tors ignore. You can­not ignore some­thing about which you are unaware.

The real issue is that most direc­tors and investors are sim­ply unaware of the many one-time items because they are buried deep in the annals of foot­notes in annual reports or 10-K filings.

Pro­fil­ing the degree to which com­pa­nies bury impor­tant finan­cial data in the foot­notes, Agenda mag­a­zine's Tony Chapelle alerts direc­tors, espe­cially those on audit com­mit­tees, to the dan­gers of earn­ings manipulation based on hid­den items.

Tony Chapelle writes: “Investors can be fooled by one-time items, since they can arti­fi­cially dis­tort earn­ings reports. So direc­tors should be on the look­out. Even when they’re used with good inten­tions, one-time items can make the profit pic­ture cloudy for investors. What’s more, the con­fu­sion can cause decreased val­u­a­tions or tar­get prices for a company’s stock.”

The fact of the mat­ter is that earn­ings manip­u­la­tion is ram­pant, and almost no one is doing any­thing about it.

For exam­ple, Inter­na­tional Paper (IP — dan­ger­ous rat­ing) hid more than $2.1 bil­lion of one-time tax credit income in an oper­at­ing line item in 2009. Investors who didn’t read the item in the foot­notes may have cal­cu­lated that the com­pany increased its 2009 return on invested cap­i­tal to 7.6% instead of the real 2.2%.

Although IP com­plied with all GAAP and SEC report­ing guide­lines, a study by New Con­structs says that, of 16 paper com­pa­nies stud­ied, only four (includ­ing IP) bun­dled the credit into reg­u­lar oper­at­ing cost of sales.

An Inter­na­tional Paper spokesper­son called the alle­ga­tion “with­out merit.” “Not only did we meet all of the report­ing require­ments,” writes Tom Ryan, “but we also [went] beyond them to help our share­hold­ers under­stand the… credits.”

IP’s direc­tor of cor­po­rate account­ing, Kevin Fer­gu­son, says investors know that 10-K foot­notes con­tain impor­tant infor­ma­tion. He says not read­ing them is like “hid­ing” the data from themselves.

Ferguson’s state­ment reeks of hypocrisy.

The truth of the mat­ter is that com­pa­nies and Wall Street con­stantly guide investors to focus on earn­ings and earn­ings per share with no men­tion what­so­ever of the footnotes.

How many times have you heard or read about a com­pany refer­ring investors to the footnotes?

Ever heard of “foot­note sea­son”? No, it is earn­ings sea­son where an inor­di­nate amount of atten­tion is paid to top-line rev­enue and account­ing earn­ings per share with lit­tle to no men­tion of any­thing in the footnotes.

Fer­gu­son and Inter­na­tional paper are not alone in their hypocrisy. Reg­u­la­tors, cor­po­rate Amer­i­can and Wall Street are singing the same tune all the way to the bank.

In June 2009, I gave the Secu­ri­ties and Exchange Com­mis­sion (SEC), the Finan­cial Account­ing Stan­dards Board (FASB), the Pub­lic Com­pany Account­ing Over­sight Board (PCAOB) and other reg­u­la­tors a report that showed over 100 spe­cific exam­ples of cor­po­rate dis­clo­sure trans­gres­sions, such as:

  1. Entire required dis­clo­sures miss­ing from filings
  2. 10 fil­ings where income state­ments did not add up cor­rectly and
  3. 20 fil­ings where bal­ance sheets did not balance.

In another report New Con­structs pre­pared for a con­gres­sional sub-committee in June 2009, I revealed that reg­u­la­tors had also com­pletely dropped the ball with respect to track­ing the deriv­a­tive activ­ity of Bank of Amer­ica (BAC – dan­ger­ous rat­ing) and Amer­i­can Inter­na­tional Group (AIG – dan­ger­ous rat­ing). The report clearly showed the credit default swap lia­bil­i­ties of both firms sky­rock­et­ing to dan­ger­ous lev­els as early as 2005. Just think how much tax­payer money could have been saved if reg­u­la­tors had addressed the credit default swap lia­bil­i­ties before they made banks too big to fail…

I urged the SEC to pro­vide investors eas­ier and more trans­par­ent access to mate­r­ial data buried in the foot­notes. Their response was “…as long as the info is dis­closed then there is noth­ing we need to do …”

I found the SEC’s response dis­ap­point­ing, to say the least. The fact of the mat­ter is that dis­clo­sure is not enough when con­sid­er­ing how hard it is to find the buried information.

Find­ing key foot­note data is like search­ing for nee­dles in a haystack. The length of annual reports (i.e. 10-K fil­ings) makes read­ing more than a few of them imprac­ti­cal. Nearly every pro­fes­sional money man­ager I have met over the past 15 years read­ily admits they do not have time to read the 10-Ks of the com­pa­nies in their portfolio.

This fact is not sur­pris­ing con­sid­er­ing the volu­mi­nous length of 10-Ks. Did you know that BAC’s 2009 10-K was over 300 pages long? 296 of those pages are for the foot­notes. We are not talk­ing about a 296-page comic book. Foot­notes are writ­ten by lawyers and audi­tors using com­pli­cates jar­gon and eso­teric account­ing concepts.

Exper­tise and expe­ri­ence are required to deci­pher footnotes.

Com­pa­nies have no inten­tion of mak­ing the foot­notes any eas­ier to nav­i­gate. The haystack is get­ting larger and there are more nee­dles. First, regard­ing the haystack: 10-Ks are get­ting longer. When I started ana­lyz­ing the foot­notes in 1995, most 10-Ks were about 20–30 pages. Now, they are over 100 pages long. Many are much longer. A study by Deloitte reports that the aver­age length of annual reports has grown by more than 250% over the past 14 years[1]. Sec­ond, there are more nee­dles in the haystack as com­pa­nies find new ways to manip­u­late account­ing rules to their favor and lever­age their influ­ence on con­gress[2] to cre­ate new account­ing loopholes.

Why would the SEC not sug­gest a new report­ing stan­dard based on eco­nomic earn­ings that account for all the rel­e­vant finan­cial data, includ­ing foot­notes? No good reason.

The SEC would not even have to require adop­tion of the stan­dard. Cer­tain com­pa­nies, like Clorox (CLX – attrac­tive rat­ing), already vol­un­tar­ily dis­close eco­nomic earn­ings. Many com­pa­nies with noth­ing to hide would fol­low Clorox’s lead and exploit the oppor­tu­nity to show their will­ing­ness to pro­vide investors with a truer mea­sure of their prof­itabil­ity. Nat­u­rally, I rec­om­mend buy­ing CLX and sell­ing BAC, AIG and IP.

Even­tu­ally, the equity mar­kets would have nat­u­rally achieved a higher level of trans­parency and integrity as investors could decide for them­selves whether or not they wish to invest in com­pa­nies not will­ing to report eco­nomic earnings.

Instead, the real­ity is that manip­u­lat­ing account­ing to max­i­mize earn­ings has become a com­pet­i­tive require­ment. Com­pa­nies can­not afford not to employ the same tricks as their peers or they risk lower earn­ings growth.

Bet­ter do your homework.

If you think you can get away with no dili­gence, take a look at what I find when we look behind the reported earn­ings curtain of the 3000 most actively-traded companies:

  • More than 13,000 one-time items were buried in the MD&A or foot­notes between 1998 and 2011.
  • More one-time items are leav­ing the income state­ment and mov­ing to the MD&A or footnotes.
  • Last year, the value of those hid­den items rose by 17% from 2009 to more than $57.9 bil­lion. That was 0.4% of the com­pa­nies’ net rev­enues. The num­ber of hid­den one-time items also climbed; up by 13% last year.
  • By con­trast, the value of non-hidden items fell by almost a third to $159.6 bil­lion. The num­ber of those items also fell, by more than 10%.

A myr­iad of account­ing loop­holes enable com­pa­nies (and Wall Street) to dupe investors about their prof­itabil­ity and valuation.

Investors need to focus on eco­nomic earn­ings that are adjusted for and free of account­ing dis­tor­tion. It takes a lot of work, but it is worth it.

Bot­tom line: “investors and boards of direc­tors need to study finan­cial foot­notes if they really want to under­stand a company.”


[2] Larry Sum­mers states that the finan­cial sec­tor spent in lob­by­ing expenses in 2009 $1mm per con­gress­man. Here is link to the inter­view:

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Stocks: IP, BAC, AIG, CLX