The SEC is cracking down on misleading “adjusted” earnings measures.

The 5/18 WSJ reported that Mark Kronforst, chief accountant of the SEC’s corporation finance division, warned that the SEC is “sending a message” to companies that excessively engage in this practice. Apparently, that message will come in the form of an “uptick” in SEC comment letters, i.e., official public correspondence between the SEC and US public companies. It will give companies the opportunity to “self-correct,” he said.

Consider the following:
 
(1) Earnings divergence. Melissa, Joe, and I have been covering this issue closely for a while now--especially since the Q4-2015 earnings season, when energy earnings were a major drag on S&P 500 companies’ aggregate earnings. Lots of energy companies were excluding write-offs from their reported GAAP earnings to calculate their operating earnings, or earnings excluding bad stuff (EEBS).
 
The spread between EEBS (i.e., operating earnings per share as compiled by Thomson Reuters) and GAAP EPS for the S&P 500 (i.e., reported earnings as compiled by S&P) was $5.24 in Q1-2016. It had risen from $2.57 per share in Q3-2014 to $10.82 per share in Q4-2015, which was the biggest divergence in quarterly EPS since Q4-2008. For the S&P 500 Energy sector, the gap between EEBS and reported earnings soared from $0.49 in Q3-2014 to $16.49 in Q4-2015, before dropping to $1.02 in Q1-2016.

(2) Nothing new. US public companies often adjust their GAAP earnings to exclude items. The SEC currently allows for this as long as “adjusted” earnings are shown alongside and reconciled back to GAAP. Sometimes that’s with good reason, to show a company’s results of operations excluding non-recurring items. In some cases, good stuff might be excluded too, but that doesn’t happen as often.

The problem is that the practice of excluding bad stuff might be getting egregious, at least according to the SEC. Interestingly, as we’ve discussed before, the divergence between GAAP and adjusted earnings tends to widen during recessions. That’s because companies tend to be more liberal in their exclusions to make earnings look better. Currently, the energy sector is in a recession and making appropriate and possibly inappropriate adjustments.
 
(3) Annoyance. Ostensibly, it really shouldn’t matter how companies adjust their earnings, as long as all the GAAP data are readily available. The problem is that the average retail investor might be fooled by the rosier “adjusted” picture. That’s especially true in light of the fact that the major data providers of public company earnings tend to compile consensus earnings forecasts based on adjusted earnings. Those forecasts often are given greater emphasis than GAAP earnings in financial press reports. Another problem is that corporate executive bonuses are often tied to adjusted results. But that’s more of a compensation issue than a reporting problem.
 
In any event, SEC officials are obviously sending a message that they’re looking out for the less savvy retail investor. But well-versed analysts and investors are already attuned to adjusted earnings. And they make valuation determinations based on their own interpretation of results. Ironically, if adjusted measures become less available due to the SEC’s push, that might just mean more number crunching for analysts.
 
(4) Comment letters. When Melissa tried to search the SEC’s EDGAR database for recent non-GAAP-related comment letters per the SEC’s instruction, she received the following response: “Server is extremely busy. Please try again later.” Tracking the SEC’s correspondences related to non-GAAP matters could be challenging. PwC has already done some of the work in its comment letter trend reports.

Among the sectors covered by PwC’s 2015 reports are Energy (p. 25) and Technology (p. 21), two sectors that are particularly prone to the overuse of non-GAAP measures. Energy is doing so as a result of the plunge in oil prices since mid-2014. Many Tech companies have gotten into the habit of inflating their adjusted operating profits by excluding stock-based compensation.

The SEC complaints focus mostly on subjective matters, such as when companies emphasize non-GAAP measures more than GAAP ones, or when non-GAAP measures aren’t reconciled back to what is considered to be the “most directly comparable” GAAP measure, or when non-GAAP measures are presented without a substantial reason why they help the financial statement user to better understand results.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.