The return of earnings shenanigans

While Federal Reserve monetary policy has been the latest obsession for regular investors, last decade was all about the accounting malfeasance from the likes of Enron, the housing bubble and resulting financial crisis, and the regulatory responses -- like the Dodd-Frank Act -- that tightened standards with the intent of protecting working Americans.

And for a while, at least some of that crackdown -- on shifty accounting -- worked.

But driven by recent pressure on corporate profitability from a stronger dollar, weaker overseas growth and a collapse in energy prices, new evidence shows corporate executives are once again playing fast and loose with their earnings results. Warren Buffett even highlighted the problem in his recent shareholder letter.

They have a few reasons to play with the numbers. For one, the overall stock market has been unable to set new highs since last May, and management compensation is often tied to a rising share price. So, the pressure is on to do something, anything, to get stock prices higher.

Moreover, S&P 500 earnings have dropped for three consecutive quarters for the first time since the recession ended. According to FactSet, the first-quarter 2016 reporting season -- which will unofficially kick off on April 11 when Alcoa (AA) releases results after the bell -- is also expected to feature a drop in earnings. The chance to pad bad news, as any kid caught in the cookie jar will attest, is a powerful motivator.

You can see this in the growing divergence between regular reported earnings per share on what's known as a "GAAP" basis (that is, generally accepted accounting principles) and a pro-forma, or non-GAAP, basis that removes the impact of things management dubs "nonrecurring" or "one-time" events. There's some discretion in what qualifies as a nonrecurring charge, which raises suspicion CEOs are trying to fool around.

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Alcoa has been a poster child of this behavior: In January it reported "adjusted" earnings of 4 cents per share on $65 million in "adjusted" net income, easily beating the consensus estimate of 2 cents per share. The problem: Driven by an 18 percent year-over-year decline in revenue, the company should have reported a $500 million loss on a GAAP basis.

But thanks to $534 million in "one-time" charges, like magic, Alcoa was profitable. As the chart above shows, it has been a frequent user of this trick.

FactSet has noted a growing difference between non-GAAP and GAAP earnings per share for the companies in the Dow Jones industrials index as more and more one-time charges are used to pad the bottom line. The largest offenders? Merck (MRK), General Electric (GE), and Microsoft (MSFT).

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They note that supporters of this practice argue that non-GAAP measures provide investors with a more accurate picture of profitability from day-to-day operations. Critics highlight the fact no industry standard prescribes what non-GAAP earnings should be. And that undermines the entire purpose of corporate accounting in the first place: To provide an honest and comparable testament of financial health to help investors make decisions.

Ed Yardeni of Yardeni Research has also noticed the trend, and as shown in the chart above, he highlights that reported earnings (GAAP) and operating earnings (non-GAAP) tend to diverge during times of market weakness and stress. It happened in 2000-2001. It happened in 2007-2009. And it's happening again now.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.