Accentuating the positive or just plain old lying?
Companies continue to dress up their earnings using pro form statements
NEW YORK » If it weren't for some pesky accounting rules, telecom-equipment company Ciena Corp. would have lost a mere 2 cents a share in the fourth quarter. With those accounting rules, it lost 44 cents a share.
The disparity is "the GAAP Gap" -- the difference between "pro forma" earnings and earnings prepared according to Generally Accepted Accounting Principles, or GAAP.
GAAP is the nation's accounting standard. Pro forma earnings, by contrast, are governed by no fixed standard. Companies can toss out one-time charges, options expenses, goodwill write-downs -- anything that looks bad. One-time windfalls, however, usually manage to stay in.
Merrill Lynch's U.S. Strategist Richard Bernstein did the math on 1,600 stocks and found total earnings for their third calendar quarter grew 22 percent on a GAAP basis, but 31 percent on a pro forma basis.
The gap was greater when the companies were subdivided by Standard & Poor's quality rankings. S&P grades stocks on their annual sales and dividend growth and actual earnings over a 10-year period. A company with very stable growth would rank "A+," while a company in bankruptcy would be a "D."
"Lower quality companies are dramatically overstating their growth rates by using pro forma earnings," Bernstein wrote in a Dec. 19 research report.
Companies with a B- ranking have a GAAP growth rate of 1 percent, but a pro forma growth rate of 38 percent, according to Bernstein. B+ companies are more than doubling their growth rate: GAAP growth is 13 percent, but pro forma growth is 27 percent.
Part of the problem, according to Bernstein, is that most post-bubble regulations focus on the quality of formal financial reporting, but "there appears to be no regulation" covering earnings conference calls and press releases.
"Although the newer regulation is laudable, stocks trade on press releases and conference calls, and not on the formal financial statements that are released weeks after the announcement and call," he wrote. "We think regulation regarding company press releases and conference calls is sorely needed because of the significant deterioration in the quality of announced earnings."
He calls for an end to pro forma earnings, saying they have made U.S. corporate earnings perhaps the most opaque they've been in his 23 years in the business.
"Given the growing competitiveness of global financial markets, it is inconceivable to us why they (regulators) continue to allow U.S. financial reporting to become increasingly opaque," he wrote.
Which brings us back to Ciena, which has the widest gap between GAAP and pro forma earnings in the S&P 500, according to Bernstein.
Ciena reported a fourth-quarter loss of $252.9 million, or 44 cents a share. But the company said big one-time costs, including a $176.6 million write-down for goodwill, cut earnings by 31 cents per share.
Culling items that make their earnings look weak is nothing new at Ciena. In the second and third quarters, the company's pro forma numbers excluded restructuring charges, amortization and stock compensation costs. In the first quarter, the company's pro forma numbers excluded an amortization charge and a tax charge.
Ciena refused to comment for this report but Chief Executive Gary Smith said in a statement when the company's fourth-quarter earnings were released that they "demonstrate Ciena's steady progress toward profitability and positive cash flow, and more importantly, our continued progress toward future earnings growth."
The rest of Bernstein's Top Ten GAAP gappers in the S&P 500 are, in order of the percentage spread between their real earnings and their pro forma earnings: CMS Energy Corp., Tenet Healthcare Corp., Teradyne Inc., Textron Inc., Eastman Kodak Co., Symantec Corp., Boston Scientific Corp., Office Depot Inc. and Du Pont Co.
Ciena, CMS, Tenet and Teradyne are, incidentally, all ranked as C stocks by Standard & Poor's. The other six stocks are all ranked from B+ to B-.