Should Directors Ignore Those One-Time Items?

david trainer Of course not.

The issue is not what directors ignore. You cannot ignore something about which you are unaware.

The real issue is that most directors and investors are simply unaware of the many one-time items because they are buried deep in the annals of footnotes in annual reports or 10-K filings.

In an excellent article profiling the degree to which companies bury important financial data in the footnotes, Agenda magazine features New Construct's research on hidden items to alert directors, especially those on audit committees, of the dangers of earnings manipulation.

Tony Chapelle writes: "Investors can be fooled by one-time items, since they can artificially distort earnings reports. So directors should be on the lookout. Even when they're used with good intentions, one-time items can make the profit picture cloudy for investors. What's more, the confusion can cause decreased valuations or target prices for a company's stock."

The fact of the matter is that earnings manipulation is rampant, and almost no one is doing anything about it.

For example, International Paper (IP � dangerous rating) hid more than $2.1 billion of one-time tax credit income in an operating line item in 2009. Investors who didn't read the item in the footnotes may have calculated that the company increased its 2009 return on invested capital to 7.6% instead of the real 2.2%.

Although IP complied with all GAAP and SEC reporting guidelines, a study by New Constructs says that, of 16 paper companies studied, only four (including IP) bundled the credit into regular operating cost of sales.

An International Paper spokesperson called the allegation "without merit." "Not only did we meet all of the reporting requirements," writes Tom Ryan, "but we also [went] beyond them to help our shareholders understand the... credits."

IP's director of corporate accounting, Kevin Ferguson, says investors know that 10-K footnotes contain important information. He says not reading them is like "hiding" the data from themselves.

Ferguson's statement reeks of hypocrisy.

The truth of the matter is that companies and Wall Street constantly guide investors to focus on earnings and earnings per share with no mention whatsoever of the footnotes.

How many times have you heard or read about a company referring investors to the footnotes?

Ever heard of "footnote season?” No, it is earnings season where an inordinate amount of attention is paid to top-line revenue and accounting earnings per share with little to no mention of anything in the footnotes.

Ferguson and International paper are not alone in their hypocrisy. Regulators, corporate American and Wall Street are singing the same tune all the way to the bank.

In June 2009, I gave the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), the Public Company Accounting Oversight Board (PCAOB) and other regulators a report that showed over 100 specific examples of corporate disclosure transgressions, such as:

Entire required disclosures missing from filings
10 filings where income statements did not add up correctly and
20 filings where balance sheets did not balance.

In another report New Constructs prepared for a congressional sub-committee in June 2009, I revealed that regulators had also completely dropped the ball with respect to tracking the derivative activity of Bank of America (BAC � dangerous rating) and American International Group (AIG � dangerous rating). The report clearly showed the credit default swap liabilities of both firms skyrocketing to dangerous levels as early as 2005. Just think how much taxpayer money could have been saved if regulators had addressed the credit default swap liabilities before they made banks too big to fail...

I urged the SEC to provide investors easier and more transparent access to material data buried in the footnotes. Their response was "... as long as the info is disclosed then there is nothing we need to do ... "

I found the SEC's response disappointing, to say the least. The fact of the matter is that disclosure is not enough when considering how hard it is to find the buried information.

Finding key footnote data is like searching for needles in a haystack. The length of annual reports (i.e. 10-K filings) makes reading more than a few of them impractical. Nearly every professional money manager I have met over the past 15 years readily admits they do not have time to read the 10-Ks of the companies in their portfolio.

This fact is not surprising considering the voluminous length of 10-Ks. Did you know that BAC's 2009 10-K was over 300 pages long? 296 of those pages are for the footnotes. We are not talking about a 296-page comic book. Footnotes are written by lawyers and auditors using complicates jargon and esoteric accounting concepts.

Expertise and experience are required to decipher footnotes.

Companies have no intention of making the footnotes any easier to navigate. The haystack is getting larger and there are more needles. First, regarding the haystack: 10-Ks are getting longer. When I started analyzing the footnotes in 1995, most 10-Ks were about 20�30 pages. Now, they are over 100 pages long. Many are much longer. A study by Deloitte reports that the average length of annual reports has grown by more than 250% over the past 14 years[1]. Second, there are more needles in the haystack as companies find new ways to manipulate accounting rules to their favor and leverage their influence on congress [2] to create new accounting loopholes.

Why would the SEC not suggest a new reporting standard based on economic earnings that accounts for all the relevant financial data, including footnotes? No good reason.

The SEC would not even have to require adoption of the standard. Certain companies, like Clorox (CLX � attractive rating), already voluntarily disclose economic earnings. Many companies with nothing to hide would follow Clorox's lead and exploit the opportunity to show their willingness to provide investors with a truer measure of their profitability. Naturally, I recommend buying CLX and selling BAC, AIG and IP.

Eventually, the equity markets would have naturally achieved a higher level of transparency and integrity as investors could decide for themselves whether or not they wish to invest in companies not willing to report economic earnings.

Instead, the reality is that manipulating accounting to maximize earnings has become a competitive requirement. Companies cannot afford not to employ the same tricks as their peers or they risk lower earnings growth.

Better do your homework.

If you think you can get away with no diligence, take a look at what I find when we look behind the reported earnings curtain:

More than 13,000 one-time items were buried in the MD&A or footnotes between 1998 and 2011.
More one-time items are leaving the income statement and moving to the MD&A or footnotes.
Last year, the value of those hidden items rose by 17% from 2009 to more than $57.9 billion. That was 0.4% of the companies' net revenues. The number of hidden one-time items also climbed; up by 13% last year.
By contrast, the value of non-hidden items fell by almost a third to $159.6 billion. The number of those items also fell, by more than 10%.

A myriad of accounting loopholes enable companies (and Wall Street) to dupe investors about their profitability and valuation.

Investors need to focus on economic earnings that are adjusted for and free of accounting distortion. It takes a lot of work, but it is worth it.

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