Quality of Earnings Deteriorating?

In what might be a sign that corporate earnings quality may not be as good in the near future as in the recent past, a recent WSJ article mentioned that the difference between GAAP and “pro forma” earnings has widened over the last two quarters. This is the second-largest percentage move in two years, according to the article, which sources information from a strategist at Merrill Lynch.

Why could this be worrisome? Well, a difference between GAAP earnings and pro forma earnings indicates the use of below the line, one-time “nonrecurring” charges that are often ignored when comparing period-over-period changes in earnings. Some analysts will simply back out the one time charge, adding it back to earnings (pro forma) since the charge is supposed to be non-recurring, unusual or extraordinary. The problem is, sometimes these charges should not be ignored and actually should, at least in part, be considered part of a company’s ongoing operations, despite their apparent one-time or unusual nature.

To see how these one-time charges affect economic value, watch the cash flow statement and read the footnotes. These charges, though one-time from a GAAP perspective, will continue to show up in cash flow as companies pay for severance packages or restructuring costs, for instance. Or they may be non-cash in nature, such as asset writedowns, which won’t affect cash flows until the asset is sold, or goodwill impairment.

Note that these “nonrecurring” charges can also be used to manipulate earnings. Taking the hit in the current quarter may benefit GAAP earnings in the next. Sometimes this will occur in the form of a “big bath” where, when times are tough, a company might “move” all of the next few periods’ plant shutdown costs into the current period, so that future “earnings” are not crippled by these expenses. It’s the “Let’s get all the bad stuff out of the way now” idea. This can come in the form of asset writedowns, layoffs, restructurings, etc., whose actual economic effects are not really confined to a single period.

If this widening continues into the third quarter, it could lead to a troubling trend. Stick with companies that have high quality earnings and where cash flows and earnings tend to approximate one another. If there is a persistent sharp disconnect, the company may be trying to hide trouble.