In June 2000, Intel pre-announced that its second quarter earnings would include $1.5 bn from investments. That was positive news to anyone hoping to see a prodigious earnings increase, but the disclosure sparked heated debate as analysts following the semiconductor giant argued over whether the tremendous windfall should be included or excluded from their earnings estimates.
In past quarters, analysts had been including such gains for Intel, though the amounts were minuscule compared to the second quarter’s gain. Now, given the magnitude of the number, a vocal minority of analysts wanted to exclude the figure since it represented a non-recurring and non-operating gain. After all, it wasn’t as if the company picked up the income from chip sales.
What ensued was a battle of wills, as Intel pressed its case for inclusion. ‘Some analysts immediately took the number into account in their earnings projections. Others looked at it and felt they weren’t going to include it because they viewed it as something that was more of an unusual gain rather than an operating gain. In the end, it turned out more analysts were increasing their estimates. The others were unusually low, and ultimately they decided to change their estimates,’ recounts Mike Sullivan, a company spokesperson.
But one person intimately familiar with the events says that some analysts had wanted to back out, or remove, the income long before the second quarter and had only been going along in order to have their estimates conform closely – and thus be included – with the consensus, despite their preference to exclude gains from investment as non-operating. When Intel announced the huge windfall in June, these reluctant analysts were especially outraged. ‘The majority who wanted to include was very slim, and several analysts were very upset, but they went along in the end,’ the source admits.
Pro-forma flourishes
While notable as a story of analysts’ malleability – by convincing analysts to include investment gains in their estimates, Intel upped its earnings nearly 50 percent – the episode highlights a very contentious issue: pro-forma earnings.
Pro-forma earnings include income statement items that fall outside of generally accepted accounting principles (Gaap). They almost always look better than the actual Gaap results because they are adjusted to exclude certain non-cash items as well as some cash items (which means they’re similar to ‘cash earnings’, which exclude all non-cash items). The most common items excluded: amortization of goodwill, many related charges from M&A and restructurings, payroll taxes, losses in investment portfolio, and – until the uproar became too great – losses from internet subsidiaries.
According to critics, companies are using pro-forma earnings to exclude what they don’t like while including beneficial items to make their performance appear stronger. In October the topic drew these pointed comments from the SEC’s chief accountant, Lynn Turner: ‘Today, we are seeing earnings releases published that convey an incomplete or inaccurate picture to investors.’
Turner’s chief complaint is that some pro-forma earnings exclude questionable items, while the releases fail to disclose sufficient information to reconcile the pro-forma numbers with Gaap. She calls these releases ‘EBS’ releases, as in Everything but bad stuff, and some of her more colorful examples (earnings before marketing costs, and earnings before losses from new product lines) would make most IROs blush.
Stretching intent
In fairness, most tech firms – it’s almost invariably tech companies that use pro-forma earnings – tend to restrict themselves to excluding one-time or non-recurring charges, the most common being costs associated with acquisitions such as amortization of goodwill. By backing out these costs, so the thinking goes, investors can see how the current results stack up against corresponding historical results.
‘CNet has used pro-forma results when we’ve done acquisitions that have impacted the income statement, which was the case with our recent acquisition of ZDNet. If you’ve done a big transaction, you want to see what the company would have looked like historically if it was then the way it is today,’ says Robert Borchert, CNet’s VP of IR.
The Financial Accounting Standards Board (Fasb) has inadvertently increased the profile of pro-forma earnings with its controversial proposal to eliminate ‘pooling of interests’ accounting. Pooling of interests enables merging companies to simply combine their balance sheets, avoiding charges from amortization of goodwill (goodwill being the premium paid above the book value of an acquired company). Conversely, companies using ‘purchase accounting’ methods have to take large, periodic write-downs for amortization of goodwill.
Pro-forma earnings statements exclude the write-downs. But with a smaller, related provision, Fasb may have opened the door for acquisitively active tech companies to take liberties with pro-forma earnings. That provision, effective January 1, 2001, calls for companies to report earnings before amortization of goodwill – also known as cash EPS – and earnings after amortization of goodwill.
While the provision is irrelevant as of December (when Fasb announced firms would no longer have to account for amortization of goodwill at all), critics argue technology companies took sanctioned cash EPS as a signal to begin throwing in – or out, to be more precise – a host of other items along with amortization of goodwill.
Apples to apples
For their part, technology companies argue they work at a much faster pace than other companies, and therefore they tend be more active with M&A which can cloud earnings statements. They’re also forced to rapidly reinvent themselves, so even if they needn’t worry about goodwill amortization, it makes sense to exclude other charges like restructuring costs, which would cripple earnings.
‘Qualcomm today is different than it was two years ago, when we had the infrastructure business and phone business in addition to the chip business, versus today when we’re primarily a semiconductor and intellectual property company. So you need the pro-forma results to show our performance quarter-to-quarter and year-over-year, without these charges,’ argues Julie Cunningham, VP of IR at Qualcomm.
Indeed it’s hard to argue against excluding restructuring charges – as long as so-called one-time charges don’t keep popping up every quarter. But what about payroll taxes incurred when employees exercise stock options, another cost companies are often excluding from their pro-forma results? Clearly, critics argue, such costs represent a recurring expense associated with running a business.
Andrew Kramer, IR director at Chelmsford, Massachusetts-based Sycamore Networks, offers the following explanation: ‘The problem with payroll tax is it’s unpredictable – you don’t know how many employees are exercising options or how many they’ll exercise. You can’t give guidance, because you can’t calculate that number with any accuracy.’
Of course, most companies present information as they believe analysts and investors want to see it. And that seems to be exactly what they’re doing with some 300 companies – roughly 5 percent of the total – reporting pro-forma results, according to First Call. ‘We’re going to back most of these items out as well, so it makes sense. Most of us don’t care about the Gaap numbers,’ says one analyst covering internet vendors.
Ashwin Navin, an associate at Epoch Partners who covers Sycamore Networks, sees the positive side of pro-forma numbers: ‘They offer the most comparable way of looking at companies. There are limitations, and investors have their way of looking at things, but that’s how we do it. I think you’ll see more pro-forma, especially if pooling of interests goes, and you’ll see more cash EPS.’
The flip side
While not wholeheartedly embracing pro-forma numbers, skeptics are willing to go along with the basic premise that they allow investors to better compare results from company to company. But they fault how some companies treat pro-forma results.
‘My view as an investor is that I don’t mind seeing pro-forma numbers, and I think in a lot of cases you get better comparisons by having them. The problems arise when companies aren’t clear about exactly what they’re doing, or they slant things in favor of the positive and don’t adjust for the negatives,’ says Eric Von der Porten, manager of Leeward Investments, a hedge fund in San Carlos, California.
On his latter point, Von der Porten points to press releases where the pro-forma earnings number receives prominent placement, while the actual Gaap earnings figure is buried at the bottom of the release. Priceline, for example, announced in the headline of its third quarter release a pro-forma net loss of $0.01 per share for its third quarter. To find the actual figure – a far more considerable loss – one has to comb through the income statement. (The company didn’t respond to requests for comment, though the calls were placed in December when it shed 11 percent of its work force – which perhaps affected the IR department).
Qualcomm’s third quarter release also highlighted the pro-forma results in the headline as well as the opening paragraphs of text, though the company provides an explicit table showing both the pro-forma and Gaap results. Cunningham says the company is sensitive to the need for transparency. ‘We try to focus our investors on the pro-forma results because that’s how we’re gauging our performance. But we also provide three pages of tables that show the pro-forma and the reported numbers. We try to make it as clear as possible because it’s an area that causes a lot of confusion, particularly for individual investors.’
Providing both sets of numbers is exactly what investors say they want. But they also want detail. ‘We’re striving for as much transparency as possible, because our job is to get to the bottom of things. The way that pro-forma is often used by companies doesn’t enhance the transparency. What I’d like is to have the availability both ways. If they’re using pro-forma, I’d like more detail about what’s bundled into it,’ says Faye Landes, an analyst at Sanford C Bernstein & Co.
Lack of standards
Many firms give prominence to both pro-forma and Gaap numbers, as well as detail on how they arrive at the pro-forma results (what they backed out of their calculations). But press releases don’t fall under the purview of Fasb, unlike financial statements, which must conform to Gaap, so there are no real standards despite recent developments.
In September 2000, the American Institute of Certified Public Accountants (AICPA) auditing standards board revised its guidelines to address the range of numbers that fall outside the Gaap financial statement. The result: the new standards allow accountants to review pro-forma results.
Arleen Thomas, a vice president at the AICPA, says she doesn’t know of any companies that have asked auditors to sign off on the pro-forma results issued in their releases, but the organization’s announcement does provide some clarity on best practice. For example, in instances where the pro-forma number differs from the Gaap number, companies would have to disclose how those non-Gaap numbers were computed.
‘We don’t have a position on stock options or payroll taxes, for example,’ admits Thomas, ‘but if you are going to back them out, and you want an auditor to sign off, you have to clearly say exactly what you’re backing out, rather than leave it unclear.’
As for Fasb, it has not addressed the issue of pro-forma earnings directly, though it is looking at other issues concerning best practice for reporting information that lies outside of financial statements, including strategy and data on intangible assets. ‘I personally think people can report whatever they want, so long as they accurately describe what it is, and accurately compute what they say it is,’ comments an Fasb insider.
As for the accuracy of the press releases, and whether or not companies follow this unspoken best practice for reporting pro-forma earnings, neither Fasb nor the AICPA have much sway. The SEC is the real authority, and it has remained on the sidelines. But in her speech in October, Turner may have given some insight into the SEC’s thinking: ‘I believe if the members of the financial and business community, including financial executives, analysts and the accounting profession, are not able to stem the tide of unbalanced and incomplete earnings releases, a regulatory response might be necessary.’
Striking a balance
The demand for transparency and credibility only rises in falling markets. This is especially true for technology companies, given that they’ve endured the brunt of the market’s sell-off. This means companies can no longer expect investors and analysts to blindly embrace pro-forma results without demanding clarity.
‘It’s very important in the current environment to be very explicit in your communications,’ says CNet’s Robert Borchert. He says the internet company gives extensive guidance through 2001, so investors know what to expect from the pro-forma results. ‘You don’t want to change your reporting quarter to quarter. If you decide the pro-forma EPS report is not going to be the one you do this quarter, that would have serious consequences. You have to be consistent so the numbers don’t move around.’
Andrew Kramer of Sycamore Networks says that while pro-forma results are the ones investors care about when it comes to his company’s performance, its earnings releases do not hide the Gaap results. ‘We still keep the Gaap number up there at the top as well, so investors have both figures. Obviously we want to present the numbers in conformity with Gaap, but equally important, if not more so, is the presentation of our numbers on an apples-to-apples basis that gives investors the opportunity to see how the operations themselves performed excluding all non-recurring charges.’
Kramer stresses that companies communicating pro-forma results should clearly indicate what items they’re excluding ‘There are so many companies that went public in the last couple of years, and many of those simply communicate pro-forma results, but they don’t provide any insight. I think that muddies the waters a bit. You shouldn’t assume that people understand what the pro-forma number means just by looking at the number.’
