Core Earnings Strip Away "Creative" Accounting

By Ben McClure AAA

Let's face it, numbers in earnings reports mean pretty much what company accountants want them to mean, neither more nor less. That's why investors looking at fundamentals must determine on a company-by-company basis what earnings are really saying. Wouldn't it be great if there were a standard measure that could make earnings evaluation easier, clearer and more meaningful?

Standard & Poor's, the ratings agency, tries to solve the problem with a new earnings metric: core earnings. While the core earnings approach gives investors a first glimpse of what truly "clean" earnings might look like, it also creates its own set of challenges. (Learn more in Peer Comparison Uncovers Undervalued Stocks and 5 Must-Have Metrics For Value Investors.)

Problems with the Traditional Metrics
Investors have lost faith in the three major categories of earnings: reported earnings, operating earnings and pro forma earnings. We've seen in the past that the traditional measure, the GAAP-based reported earnings, leaves companies with plenty of room for creative accounting and manipulation.

Operating earnings, which leaves out one-time gains and expenses from the bottom line, is meant to make the numbers comparable across companies. Unfortunately, many Wall Street analysts now have their own criteria for what should be excluded, so analyzing and comparing companies using operating earnings can be awfully difficult. Meanwhile, the definition of pro-forma earnings - which treats significant corporate transactions "as if" they never occurred - has become so broad that it can hide almost anything from investors.

Core Earnings: an Attempt at Solutions
To restore consistency and credibility to earnings reports and analysis, S&P sets out in a white paper, its stringent new measure. Core earnings includes all the revenues and costs associated with a company's ongoing operations. But it strips out all items that can mask a company's real condition, including goodwill charges, gains or losses from asset sales, hedging operations, litigation settlements, merger expenses and financing costs. These costs might be big, but they are not part of a company's core operations.

Here is a chart detailing the items included/excluded from the core earnings calculation:

What\'s In What\'s Out
Employee stock options expenses
Restructuring charges from ongoing operations
Pension fund costs
Purchased R&D expenses
Write-downs or depreciable operating assets
Goodwill impairment charges
Gains/losses from the sale of assets
Pension gains
M&A related expenses
Litigation/insurance settlement costs and proceeds
Unrealized gains from hedging activities

Main Differences Between Core and Reported Earnings
Two items account for most of the difference between reported earnings and core earnings. A big one is employee stock options. When calculating reported earrings, companies may record the value of stock options granted each year as an expense on the income statement, but most don't. Core earnings automatically includes stock options as an expense. For technology companies and others that rely on stock options to compensate employees, including options as an expense can have a drastic impact on the bottom line.

The other major difference between core and reported earnings stems from accounting for pension plans. This isn't a big issue for technology companies, but it is for large unionized companies with sizable employee pension funds. Under GAAP, a company can, without regard to the fund's actual performance, include each year's net pension gains as profits based on the long-term average return the company expects to realize on the pension assets. GAAP lets companies do this so their earnings do not fluctuate wildly with market swings, but this way of accounting for the pension fund's performance gives a less-than-accurate picture of earnings. Core earnings, by contrast, bases pension gains or losses on the fund's actual performance.

How Do the Differences Measure Up?
All in all, core earnings sounds like a reasonable approach for calculating a reliable and consistent measure of earnings. But it still leaves investors with a few thorny issues.

To start, we must ask whether stock option expenses can be fairly priced. It has been widely acknowledged that the Black-Scholes formula, the most frequently used option-pricing model, produces highly subjective results that can overstate the value of employee stock options. The formula is particularly problematic for companies with volatile stock prices, like emerging growth companies. Subtle changes in variables used in the Black-Scholes equation can produce exaggerated swings in options value - in practice, expensing options creates as many problems for investors as it solves. (For a focused look at how volatility fits into the options-pricing model, see the article The ABCs of Option Volatility.)

The other issue investors need to think about is that while pension fund gains are excluded from core earnings, losses are included in the calculation. This can be misleading. It makes as much sense to penalize a company for pension plan losses as it does to reward it for pension plan gains: neither a gain nor a loss has anything to do with how a company runs its business. Moreover, the policy of excluding gains nearly guarantees that whenever the market has a down year and pension-fund returns are weak, earnings will be penalized even if the pension plan is flush.

Conclusion
Accounting and reporting standards are essential to assessing company fundamentals and value. Investors rely on credible, transparent and comparable financial information. While it is probably impossible to develop a standard that can handle every contingency, S&P's core earnings approach is an important attempt to correct the problems investors have witnessed in the GAAP-based earnings calculations. Although the calculation of core earnings raises some questions about how to calculate employee stock options and how to account for pension plan losses, we can use core earnings as an important supplement and crosscheck to GAAP earnings.

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