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David Trainer
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David is CEO of New Constructs (www.newconstructs.com), an independent research that specializes in unearthing key insights from the Financial Footnotes of Annual Reports. Having analyzed over 50,000 annual reports and their Financial Footnotes, New Constructs research regularly produces Hidden... More
My company:
New Constructs
My blog:
Hidden Gems and Red Flags
My book:
The Valuation Handbook
  • Should Directors Ignore Those One-Time Items? 0 comments
    Sep 7, 2011 6:20 PM | about stocks: IP, BAC, AIG, CLX

    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.”

    [1] web.archive.org/web/20101022055201/http:...;1833

    [2] Larry Sum­mers states that the finan­cial sec­tor spent in lob­by­ing expenses in 2009 $1mm per con­gress­man. Here is link to the inter­view: www.politifact.com/truth-o-meter/stateme.../

    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
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