Seeing is believing

The way earnings are reported has become a hot IR issue.

The way earnings are reported has become a hot IR issue.

In April, Yahoo! earned minor plaudits from market pundits and members of the financial press when it released its first-quarter earnings report. This was quite an achievement for an internet company posting a loss of $53.6 million, especially since the announcement marked the sixth consecutive three-month period during which Yahoo! had lost money. Yet what pleased market watchers had nothing to do with Yahoo!'s financials, but instead had everything to do with how they were presented. In previous quarters, Yahoo! had presented investors with two sets of results. One reflected the company's performance under the strict set of accounting guidelines and conventions know as the "generally accepted accounting principles" (GAAPs). The GAAP guidelines are the accounting rules that auditors must follow when preparing official financial reports, which are filed with the Securities and Exchange Commission. The second set of results are known as "pro forma" earnings, and do not conform to any official accounting standard. Instead, pro-forma financials are designed to be an informal measure of earnings derived by excluding "non-reoccurring" expenses from the original GAAP numbers. Pro-forma results have historically excluded one-time costs or gains that must be included in GAAP numbers. Pro forma is usually translated to mean "as if," because the earnings results are calculated as if certain events never happened. Moving away from pro forma Pro-forma advocates would argue that such out-of-the-ordinary items obscure the true operating efficiency and health of the underlining businesses, and hinder comparisons to results released in previous quarters. For instance, if a company made a large cash acquisition or paid out a sizable severance due to layoffs, it might posit that excluding those costs would give investors a better perspective on the profitability of its ongoing business. Back in April, Yahoo! CFO Susan Decker said her company had used pro forma to primarily exclude acquisition costs "that didn't affect long-term value." The company says a new GAAP accounting rule that treats acquisition costs more favorably made the move more seamless. "It made it easy for us to stop using pro forma," confirms a Yahoo! spokesperson. "It seemed like the right move, because pro forma did not really serve our needs anymore." The company has not used pro-forma reporting since April. (It posted a $28.9 million profit in its most recent quarter, using GAAP accounting.) Yahoo! appeared to be on the front edge of a trend in IR that has seen many companies abandoning the use of pro forma on a quarter-to-quarter basis. A survey by the National Investor Relations Institute (NIRI) of 652 companies found that the percentage of companies that were using pro-forma earnings dropped from 48% to 40% in the six-month period between the fourth quarter of 2001 and the second quarter of 2002. It appears companies are reacting at least in part to investor skepticism about the credibility of financials and management in the wake of the accounting debacles at WorldCom and Enron. In fact, there is little debate that the manner in which companies present their earnings to investors has become an important corporate-reputation issue. Some have suggested that pro forma has been undermined by sheer excess. Pro forma was once a mere accounting convention used by companies and sophisticated investors, but during the booming 1990s it became commonplace in some industries for companies to consistently headline each quarterly release with pro-forma results while burying GAAP numbers deep in the text of the release. Companies have also felt the heat for purportedly using pro forma to exclude non-reoccurring charges and special events. In mid-October, Motorola became the latest company taken to task for this practice as a hard-hitting Wall Street Journal article questioned why it had reported pro-forma earnings that excluded "special" items in 15 consecutive quarters. An analyst openly wondered how special such items can be when they occur every quarter. "If a company's pro-forma earnings are supposed to reflect the exclusion on non-reoccurring expenses, but it publishes pro-forma results every quarter, you get into this world of reoccurring non-reoccurring expenses," says NIRI CEO Lou Thompson. "There is also a problem with a lack of standardization of pro-forma earnings, and this can cause investor confusion as well." The lack of an officially recognized pro-forma standard also seems to be causing some of the investor skepticism over these sets of earnings. It is a reality that has also recently become apparent to executives. After network company 3Com abandoned pro-forma reporting in July, CEO Bruce Claflin explained the dilemma bluntly. "There are precious few guidelines for how to do pro forma," Claflin said in an interview with Dow Jones Newswires. "The vagaries of it open us up to criticism." It should be noted that Claflin and 3Com abandoned pro forma after Wall Street analysts publicly criticized 3Com for not excluding a $7 million non-reoccurring gain that boosted its pro-forma earnings in a July report. The analysts' gripe with 3Com was a familiar one. Many pundits have complained that companies are quick to exclude one-time losses from their pro-forma earnings, while at the same time liberally including one-time gains in the same figures. This alleged inconsistency has led to a new favorite joke in the usually buttoned-up IR space: "Have you heard of the new pro-forma golf?" asks one IR veteran sarcastically. "It allows you to drop your five worst holes from each round." There is also criticism that companies bury the details of how they derived their pro-forma numbers deep in earnings releases. The last quarter that Yahoo! used pro-forma earnings, it explained how they were derived in a 51-word footnote at the end of the release. Accounting alternatives Many companies continue to headline earnings releases with subsets of pro-forma earnings, the most popular of which is EBITDA (earnings before interest, taxes, depreciation, and amortization). In short, EBITDA is the cash a company earns before it pays its taxes, pays the interest it owes on debts, and writes off assets that have fallen in value. Some say that although EBITDA and similar metrics are clearly defined, investors are starting to realize that they ignore GAAP numbers at their own peril as more companies are now being crushed under a mountain of debt. This new reality could make headlining an earnings release with EBITDA a tenuous proposition. "The big issue for a lot of people remains the use of EBITDA, which doesn't at all reflect a business' ability to earn enough money to pay its debts," says Eric Leeds, an executive director with IR firm GA Kraut & Company. "During the 1990s, investors gave companies the benefit of the doubt that interest expenses would just get paid somehow. Now people are starting to realize how close some companies are to bankruptcy, and that EBITDA can mask real problems of making debt payments." NIRI recently published a set of best-practices guidelines for IROs to follow when writing an earnings release (see sidebar). One of NIRI's more forceful suggestions was that all companies again put emphasis on GAAP numbers, while using pro-forma results as a complement where appropriate. IR pros say the reprioritizing that NIRI is urging is the right course, and that calling for the complete scrapping of pro forma would be overkill. "I don't think anybody is saying pro forma is wrong. Pro forma has a place and a use - especially for companies that are going through a lot of change," says Don Eagon, vice president of global communications at ATM manufacturer Diebold. "It's important everyone now realizes that since GAAP is the agreed-upon standard, it should be the figure you headline with." Indeed, as IR continues an exercise in maintaining and managing credibility with investors, the proper use of pro forma remains a balancing act. Experts say that means knowing your investors and knowing what they expect. "A company can and should provide whatever measures it and its investors have informally agreed upon makes sense," says GA Kraut's Leeds. "As long as what they offer can easily be reconciled back to GAAP." ------------------------------------ NIRI guidelines for earnings reports Writing a corporate-earnings release would seem, at first glance, to be among the most straightforward exercises in PR. The hard part would appear to be wading through the morass of financial jargon that tends to dominate the releases. Yet the process has become a hot IR issue as companies have come under increasing scrutiny about how they present results to shareholders. NIRI recently released a set of guidelines for earnings releases, essentially comprising three parts. 1. Headline an earnings release with GAAP earnings before pro-forma earnings. The arguments for and against each practice are addressed in the main text of this story. 2. Include a complete copy of the most recent income statement and balance sheet. An income statement lists revenues and expenses during a given period, as well as the resulting profit or loss. The balance sheet lists its assets and liabilities. IR veterans say that although many companies now provide their income statement quarterly, including the balance sheet would bolster corporate transparency. "They allow investors to make important decisions about how secure a company's financial position really is," says Eric Leeds, an executive director with IR firm GA Kraut & Company. 3. Include a narrative discussion of the company's business model and business conditions, similar to the discussion found in quarterly SEC filings. This section of the filing is called Management's Discussion and Analysis (MD&A). NIRI says it should include a brief description of the business model, the short- and long-term trends affecting the business, an explanation of the company's financial position, and the rationale for any changes in its accounting. "I was at a conference recently where Warren Buffett said he wants CEOs to tell shareholders what keeps them up at night," says NIRI CEO Lou Thompson. "I think that sums up what we want to be striving for."

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