We're currently deluged by earnings releases but can you trust them? The answer should be 'yes' but in a conversation with Francine McKenna, we discussed the risks that go alongside a delay between earnings announcements and the filing of the audited quarterly 10-K. It makes for an interesting conversation during which Ms. McKenna explained some of the pressures that are upon those who report earnings.
I thought I knew it all about the earnings cycle until I joined MarketWatch. Financial analysts are mostly concerned about the earnings report and the net is that there is rarely any follow up to the 10-K. Reporters are therefore under pressure to make the most of the earnings release.
What's the issue?
Put simply, earnings releases are not strictly SEC compliant documents and as such often contain non-GAAP measures. This is a potential minefield because again and often, adjustments are made that are designed to show the company releasing its report in the best possible light. Ms. McKenna has written extensively about this topic and is now of the opinion that reporting companies are treating the earnings release almost like a license to do whatever they want.
The practice is validated by financial analysts who have determined that GAAP earnings reports are of lesser value than the 'wild west' reports often put out. While it is not entirely clear why analysts have taken this position, the trend I see is for an overly enthusiastic obsession with growth. That is reflected in the widely differing ways in which companies are valued. We frequently hear CEOs lauding their growth as a way of persuading financial analysts that their companies are worthy of a higher valuation than those considered as 'value plays.'
What are the risks?
The short answer is legion, the reality is unknown. However, in a recent story, MarketWatch noted:
Nell Minow, vice chair at ValueEdge Advisors, said lag time is bad news for investors who rely on earnings to provide a clear view of a company’s financials.
“Earnings reports have become less and less reliable, and investors are understandably increasingly skeptical,” she said. “The next step should be increasing skepticism about boards who permit sloppy, unaudited numbers to be released, and I predict we will begin to see withholding of votes for audit committee members who allow this to happen.”
What's more and as we discussed, there has to be increased pressure on auditors to avoid reporting on errors and omissions when there is any significant delay between earnings releases and the 10-K filing. The extent to which that's the case again is unknown but given the regularity with which companies find themselves in SEC hell, and the accompanying lawsuits falling on audit firms, you have to ask the question: who is guarding the gates?
In the same story, MarketWatch found that:
Data provided by research firm Audit Analytics shows that of 174 companies with a market cap of at least $10 billion that reported earnings in that period, just six filed their 10-K and auditors report with the Securities and Exchange Commission on the same day or earlier.
Ergo, we're not talking about a few but the vast majority of filers in the current season are delaying their 10-K filings.
It's not all bad news though and among those that are filing contemporaneously with the earnings release, MarketWatch discovered that
There is a tremendous amount of focus, coordination, and effort that goes into our quarterly and year-end closing processes,” Andrew Limoges, United Rentals’ vice president and controller, told MarketWatch.
Ms. McKenna wondered whether there is a link between timeliness and ERPs. I don't think that's the case at all. ERPs are, by their nature transactional systems. There is a strong focus on auditability and transaction tracing inside the best ERPs but reporting happens outside of those systems. And while there has been a trend towards ensuring a fast close, I'm not convinced there has been the same emphasis on getting unreliable spreadsheets out of the hands of those tasked with report preparation.
For my part, I almost always ignore non-GAAP measures because past experience has amply demonstrated that those numbers represent a movable feast at best and outright fantasy at worst. And it's not new. In August 2012 I wrote this about a Facebook analyst presentation:
When I saw the Facebook analyst presentation I was horrified. The meat of the presentation barely bore any relationship to a financial statement that I recognise and senior Facebook leadership steered clear of any meaningful discussion about the numbers. It was almost as though they were an incidental discussion topic. They are of course free to do that and it has become common practice to steer analysts towards non-GAAP measures - i.e. those the company wants you to believe but which are a larded version of what the SEC demands for filing purposes.
Some argue that GAAP measures are no longer a good indicator of value but that doesn't make the logic of applying 'make it up as you go' non-GAAP measures any more reliable. On the contrary, I find it odd that financial analysts seem content with attempting to compare apples and oranges among those companies that are bucketed in the same industry segments. Explain that logic and I'll buy you a gourmet dinner. I will concede that providing additional information that weers towards operational performance is useful but that should not represent a license to produce information that holds the potential for inaccuracy.
In the meantime, it will be interesting to see where this discussion goes. It's a long-running story with no end in sight.