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This chapter is from the book

The Emergence of the Core Earnings Idea

The suggestion that nonoperational items should be excluded from results of operations is no small idea. In many cases, these adjustments will run into the billions of dollars in earnings. For example, among publicly listed companies reporting earnings in fiscal 2002, one dozen of the largest companies reported earnings that, when adjusted to actual core earnings, would have made downward adjustments exceeding $1 billion. Table 1.1 summarizes these.

Table 1.1 Core Earnings Negative Adjustments above $500 Million

These substantial adjustments are graphically illustrated in Figure 1.1. This figure shows in billions of dollars the amount of adjustment required to reported results to arrive at core earnings.

Figure 3.1Figure 1.1 Core earnings negative adjustments above $500 million. (Source: original graph derived from information on BusinessWeek online, 2002 index.)

The S&P calculation has been used for these adjustments. As summarized in Table 1.1, the earnings numbers using traditional methods are drastically cut when adjusted to core earnings. Several companies' earnings are reduced by over 100% using the calculation.

The adjustment is not always downward. Some companies' earnings would rise under the S&P core earnings method. Big, positive changes applied for fiscal 2002 to AT&T (adjustment of $6.7 billion); JDS Uniphase ($3.2 billion); and Verizon Communications ($3.4 billion).1

Core earnings adjustments serve not only as a means for reflecting operating results on a purely operational basis: the degree of adjustment tells us far more for the purpose of analyzing a corporation as a potential investment. The more liberal the accounting interpretations of a corporation, the larger the likely core earnings adjustments. So, in comparing one corporation to another, you can often draw a conclusion about the quality of accounting by the degree of core earnings adjustments required. This means that the adjustment itself can be used as a comparative fundamental indicator. When used in conjunction with other indicators, it is one of the many pieces of the puzzle. (We present much more on the topics of discovering, interpreting, and confirming trends in Chapters 2, 3, and 4.) The point to be made here is an important one: corporations whose operating results are inflated with nonoperational items are serving investors poorly; in comparison, those corporations requiring little or no adjustment are acting in a far more conservative manner. Investors may view the degree of change required as a sign of the corporation's reporting policies. If they want to provide investors with an honest look at their results, they will have fewer core earnings adjustments. If they wish to inflate their earnings, then their core earnings adjustments are likely be higher as a consequence. S&P referred to its decision to apply core earnings adjustments as an "effort to return the transparency and consistency to corporate reporting."2

Corporate executives and auditors have traditionally been able to make adjustments such as deferral of costs and expenses, early booking of revenues, inclusion of favorable extraordinary items, earnings captured as part of mergers and acquisitions, optimistic estimates calculated under pro forma investment income within profit-sharing plans, and more. The purpose of such adjustments—all done within the rules—often has been to meet earnings predictions, continue favorable sales and earnings trends, and in general to keep the market price of stock at or above current levels. Augmenting these liberal accounting practices, the rules have also allowed corporations to include capital gains from sale of assets, profits from discontinued operations, and more in their operating profits. Even though these items distort the profit picture, the accounting culture, always slow to change, has not taken a serious look at the reforms needed to make financial statements accurate. GAAP is going to react to trends made within the industry rather than take the lead and require change.

Key Point: GAAP is slow to change. Accounting conventions allow great latitude in interpretation, so we need to be able to identify core earnings so that our comparisons and forecasts are realistic.

While corporations may continue to operate under liberal GAAP guidelines, we need to look to S&P and other services for the like-kind adjustments that enable analysis on a realistic basis. Many of the larger U.S.-based corporations, recognizing the change in the whole culture, have already taken steps to adjust their practices. The trend—whether followed voluntarily or not—is moving toward the use of core earnings as the basis for public reporting on the part of several listed companies.

For example, in July 2002, General Electric—whose core earnings adjustment under the S&P calculation was a reduction of $3.9 billion in fiscal 2002—announced that it would start expensing the fair value of employee stock options. The company also enacted a holding period on option exercises by senior management of at least one year and further required officers to accumulate and hold stock on a formula "equal to a specified multiple of their base salary."3

Another high-profile company, Microsoft, announced in July 2003 that it would end stock options altogether. Replacing the options program is the granting of shares of stock directly, which will be shown as an expense in the year granted. Some market experts predict that this change may be a trend among other companies in the future.4

Those corporations taking the lead in making change voluntarily—whether GAAP eventually catches up with such reform quickly or slowly—demonstrate one of two things: a commitment to strong corporate governance or the acceptance of an inevitable trend. The decision is not always an easy one. Corporations that voluntarily make core earnings adjustments could also see a decline in stock prices and perhaps an additional reduction in credit rating by S&P and other services. However, whether corporations actually book these adjustments or the adjustments are used simply to reevaluate the method of fundamental analysis, the outcome is the same: Planners and analysts will be able to review corporate reports in a new light, one based on a realistic valuation of earnings, rather than using the past method of merely accepting what was listed on the audited statements.

Key Point: Some companies will voluntarily change their reporting, while others will only do what is required and demanded of them. One criterion for identifying quality of management may be its policies regarding the new reporting environment.

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