
Fantasy Math Is Helping Companies Spin Losses into Profits - hvo
http://www.nytimes.com/2016/04/24/business/fantasy-math-is-helping-companies-spin-losses-into-profits.html
======
bko
As usual, Matt Levine offers some insight into the issue, which I tend to
agree with. He offers the following three scenarios:

1\. GAAP, which is a man-made set of social conventions for how to present
financial results, does not accurately reflect Company X's economic reality
and continuing future earnings power, while the pro forma results do. (Or,
less strongly, GAAP is informative, but the pro forma numbers are also
informative, about a different aspect of the company's situation.) Investors
know that it is a useful discipline to hold all companies to the GAAP social
convention, but appreciate Company X's efforts to provide them with more
insight into its real economic position, and use the non-GAAP numbers to
inform their own models.

2\. The GAAP numbers are more or less right, the non-GAAP numbers are just
fake and flattering, but investors, whose job it is to make intelligent
decisions about the future earnings power of the company, ignore the non-GAAP
numbers and focus on the GAAP numbers, which are after all reported
prominently in the same press release.

3\. The non-GAAP numbers are fake and flattering and all the investors are
chumps who believe whatever management puts in the big font at the top of the
press release.

Pretty much every discussion of non-GAAP accounting focuses exclusively on
Possibility No. 3, which, as both an efficient-markets fundamentalist and an
accounting post-modernist, I find by far the least plausible of the three
possibilities. Anyway, here's a column by Gretchen Morgenson with the
pleasingly archetypal title "Fantasy Math Is Helping Companies Spin Losses
Into Profits."

[http://www.bloombergview.com/articles/2016-04-25/investing-r...](http://www.bloombergview.com/articles/2016-04-25/investing-
robots-and-goldman-deposits)

~~~
nostrademons
There's a fourth possibility:

4\. Companies increasingly occupy Extremistan, where a large portion of their
financial performance comes from one-off, Black Swan events. Both the GAAP and
non-GAAP numbers are true but useless; the future cash flows of the company
depend upon unforeseeable events in the future.

The description that the article gives of the non-GAAP results supports this.
Take, for example, a lawsuit against the company that results in a $5B
judgment, payable out over many years to survivors of an environmental
disaster. GAAP results include this lawsuit, non-GAAP results exclude it.
Which more closely represents the future financial performance of the company,
from the POV of a long-term value investor? Well, that depends whether there
will be future lawsuits like this one. It depends whether the verdict will be
reversed on appeal. It depends how many survivors survive.

The same goes for things like severance pay and patent lawsuits. Increasingly,
it also applies to "normal" business, things like product introductions and
the price of oil.

In Zero to One, Peter Thiel mentions (and decries) that an increasingly large
portion of America is adopting an "indefinite" worldview, where the future
cannot be known and it's futile to try to predict it. I'm not sure folks
really understand the potential implications of this shift. Does "investing"
have any meaning when the assumption is that returns will be dictated by
large, random events? Does "meaning" have any meaning? What does it even mean
to be rational, when reason is a tool we use to _predict_ and our assumption
is that events are unpredictable?

~~~
dv_dt
Treating environmental disasters as 'random' events is too kind. I think in
just about every major recent environmental disaster you can without too much
difficulty, trace back the disaster to cost cutting measures where decisions
were made to put off long term risks in favor of short term profits.

The BP oil spill, shortcuts were made in the safety of the drilling equipment
emergency cutoffs, in the Los Angeles methane leak, the company had put off
maintenance to try to make rate payers pay for improvements instead of out of
profits to the company. The Northern California San Bruno pipe explosion -
safety funds had been diverted to executive bonuses.

Smart investors (and insurers of these companies) should be digging into long
term risks. It is not that we cannot predict it - we are too cheap and profit
oriented to pay to mitigate it.

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catnaroek
If losses can be socialized (which they indeed can, if you're big enough),
it's smart (albeit sociopathic) not to bother mitigating risks. It's much
cheaper to PR your way out of disasters than to actually prevent them from
happening.

~~~
dv_dt
Though sometimes it seems like it's executives reaping short term gain while
the company itself pays the long term cost at a later point after the execs
have moved on.

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chollida1
Proforma results aren't necessarily bad, they are the company trying to show
themselves in the best possible light. Historically they were used to show how
the company was doing ex of one time events( almost exclusively negative
events) such as layoffs, lawsuit settlements, divesting/closing money loosing
units, etc.

The biggest issue I see is that often the company will clearly spend more time
with their proforma results than their GAAP results.

The outcome from this is that often when analyst or data companies try to put
together metrics on a company they'll use GAAP results but if a ratio they
want isn't present they'll substitute the ratio from the proforma results.

This means many of the data you get on google finance or even Bloomberg is an
amalgamation of the two, which leads to garbage in-garbage out.

Side note: if you can clean data, you'll have a job for life!!!

Tech companies tend to be big users of pro forma results. Facebook famously
turned a $700 million loss (GAAP) in 2012 into a $400 profit (Pro forma) by
not using Black Scholes to calculate the cost of employee stock options.

Groupon was another poster child for pushing pro forma results vs GAAP results
and that turned out about as well as you'd expect. Just google "Groupon pro
forma vs GAAP".

~~~
themartorana
Wrapping lies in a name like "pro forma" and calling it legit is still a lie.

It boggles _my_ mind that this is written off as acceptable, just another way
of looking at the results. I own a business. I understand its accounting.
Turning a $700m loss into a $400m profit is a $1.1b lie.

Edit: if you'd like to put recurring profits and expenses on a sheet and show
it to me, fine. But if you omit one-off expenses when representing your
financial position (and let's be honest, there are always one-offs) you've
fraudulently represented yourself.

~~~
lmm
Accounting is not a world of absolute truth like that, because no-one really
knows what next year's cash flow will be. There is plenty of scope for
opinion. Valuing your employee stock options according to Black Scholes is one
possible model, not the absolute truth, and valuing them according to their
face value is not a lie.

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jpeg_hero
There are two main "users" of financial statements: the companies that produce
them and the investors/analysts that consume them.

The problem is 15-17 years ago, the income statement got "political" and
congress / nasd/finra/ accounting standards boards started inserting
accounting lines in the income statement that _neither_ the companies or the
analysts wanted. Cost of stock compensation being the primary one.

Look, when an investor looks at the numbers they want to dig down to the core
operations economics and the health there of to create his valuation.

The investor/analyst isn't going to blindly say "oh they have negative GAAP
Net Income ergo company value = 0"

~~~
curiouscats
I have been an investor for decades. Of course I want stock compensation
treated as a cost when companies report earnings. It is especially crazy when
companies trumpet their billions spent buying stock at the same time they want
to treat stock giveaways as not a cost.

You might think just avoid in investing in companies that are so crazy as to
do that (in their promoted non-GAAP numbers) because that must be a sign they
are not so bright and why rely on them to make wise investing decisions for
your company. But you would find yourself ruling out many technology
companies. It isn't that they don't know this is wrong, they just realize it
is in their executives (CFO, CEO etc.) interests to promote the false earnings
because many people will accept it.

My blog post from last week

    
    
      http://investing.curiouscatblog.net/2016/04/21/buybacks-giveaways-to-executives-and-non-gaap-earnings/

~~~
jpeg_hero
fully diluted eps?

~~~
kgwgk
How do you think they help? Imagine a company with 1mn shares trading at $100,
with $5mn earnings (ignoring taxes for simpliciy), i.e. $5 per share. Let's
say they can reduce cash compensation to employees by $5mn giving instead
$10mn in stock (0.1mn new shares). GAAP earnings are now $0 per share. Fully-
diluted earnings (excluding stock based compensation) are $9.1 per share.

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malandrew
All those one offs sound like technical debt that businesses are borrowing on.
For example:

\-- environmental disasters are the result of under investment in preventing
environmental disasters.

\-- security breaches are the result of under investment in security.

\-- restructuring is the result of under investment in continually adapting
the organization to a changing reality

\-- layoffs are often the result of under investment in hiring to make sure
you don't hire bad performers and under investment in cleaning out poor
performers continuously. The only layoffs that aren't like technical debt are
those caused by external forces like a recession.

There is nothing wrong with under investing over time and then paying the
piper when the time comes, but any one off expense that could have been
prevented if things had been managed differently should not be excludable.

The litmus test should be along the lines of asking, "Is this cost our
fault?"...

~~~
TheOtherHobbes
I can agree with the first two. But layoffs are more often the result of
incompetent management failing to find a profitable use for the existing
workers.

Or sometimes they're caused by management playing the "Let's cut costs to
increase returns so we earn more from our shares" game.

Big layoffs are a management failure, not a hiring failure. Realistically, how
likely is it that a company that's been running profitably for years suddenly
discovers that thousands or tens of thousands of staff were a poor hire?

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cortesoft
My confusion is why would investors fall for this? I understand why a company
would put out these massaged numbers, but why would an investor use that to
make their investment decisions? It sounds like the companies are putting out
both GAAP numbers and their own numbers... why would an investor not just look
at the GAAP numbers? It would seem in their financial best interest to not
fall for the ploy.

~~~
dharmon
Like most dangerous situations, they begin with a nugget of truth. In this
case, GAAP has many limitations / shortcomings, and has been patched up
piecemeal over the decades, leading to some oddities.

Tech companies in particular are annoyed by accounting methods developed for
completely different types of businesses and are often frustrated that net
earnings, for example, doesn't accurately reflect their situation.

However, combine that nugget with investor's willingness to be swooned by the
latest growth company, and said company's desire to hit wall street growth
targets and you get a dangerous combination.

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carsongross
The (pro-forma) beatings will continue until investors demand dividends.

Owners, sharing the profits of the businesses they own, rather than making a
levered bet on central bank money printing.

Crazy, I know.

~~~
aetherson
Dividends are taxed as ordinary income, which for a high income person means
that they lose 25 cents on the dollar or more compared to the company
retaining the value and selling their investment.

~~~
carsongross
Yep. We should fix that.

I vote we make dividends deductible for the corporation, and treat capital
gains as income, since it is.

~~~
aetherson
Cap gains is genuinely different from earned income in that you have to risk
your capital to get it, and you have to risk your capital in a way that at
least on some margin has social benefits.

Like, if I invest $10k for a year in the hopes of getting 6% return, that's a
thing! I could've gone on a really swank vacation for that $10k, or I could've
bought a really nice TV or whatever. Instead, I took that $10k and I said,
okay, maybe this will give me $600. Or maybe I'll lose $1k instead.

But let's say it pays off, and I get $600. But it's taxed. If it's taxed at
20% (current cap gains), I get $480. If it's taxed at ordinary income (and my
income is high), I get $360.

That's not _irrelevant_. I might pretty reasonably say "Man, in order to get a
chance at $360, I'm tying up $10k for a year? And maybe I lose some of the
$10k instead?"

And it's particularly relevant if this belief that cap gains should be taxed
as ordinary income is paired with a belief that the top marginal tax rate for
ordinary income should be higher than it is.

We've seen, all over the place, recently, that the financial sector responds
to incentives. When it becomes hard to generate a return through traditional
means, the financial industry chases returns no matter what. Sometimes the
consequences of that are kind of scary. Now, if someone understands all that
and has a considered opinion that none the less capital gains should be taxed
as ordinary income, well, okay. But I've never actually seen anyone tackle all
that. Instead, it's always one pithy sentence like "it should be treated as
income, since it is."

~~~
carsongross
I don't agree that there is a difference, at least from a taxation standpoint.
I see no reason why someone who made a million dollars trading stocks (or
selling homes) should be taxed differently than someone who made it performing
open heart surgery.

There isn't some magical ethical category open to capital. I risk my life
commuting to work to perform labor. What of it?

In any event, even if I can't convince you that there shouldn't be a
distinction between income and capital gains, I hope I can convince you that
there shouldn't be a taxation difference between dividends and capital gains.
We need to make the way company ownership works much more like an LLC, where
profits flow through to owners by percentage of ownership. Capital gains are
easily manipulated with creative accounting, the madness of crowds, central
bank money printing and, most significantly, leverage fluctuations. If
anything, I would want tax capital gains _more_ heavily than dividends, which
do not lie.

A steady return of profits to owners would enforce the discipline our
corporations so desperately need. Wall Street, of course, doesn't want that,
and neither do most boards, because it would force them to give up cash that
they would rather use for bonuses and stock grants. And that would be great.

~~~
aetherson
We entirely agree that the difference in taxation between dividends and cap
gains is ridiculous -- especially since you can "time" cap gains and get a tax
advantage from that. Why privilege cap gains _more_ than that, compared to
dividends?

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abannin
Another interpretation of the same data is that GAAP is so bad at representing
a company's operations that both investors and firms choose to not make
decisions off the statements. I don't know of any company who, internally,
lives and dies by GAAP reporting. Sophisticated investors know this.

~~~
mey
Is there another standard model that is better at representing the company
(either from a company or investors perspective)?

~~~
asmithmd1
EBITDA - earnings before interest, taxes, depreciation, and amortization - is
often used for companies that don't have large pieces of equipment that wear
out.

[http://www.investopedia.com/terms/e/ebitda.asp](http://www.investopedia.com/terms/e/ebitda.asp)

~~~
frivoal
You still need to go through GAAP (or some other ruleset) to figure out what
goes into the E I T D and A of the EBITDA.

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asmithmd1
This seems like a non-story.

Lets say a company buys another company for its SAAS product, customers and
revenue. GAAP rules state that anything paid above "book value" for the
company must be called "good will" and be depreciated. This might have made
sense in a world where the value of a company was the equipment it owned and
the value in a brand name but doesn't make as much sense for a SAAS company.
That is why companies are often valued on "EBITDA" \- earnings before
interest, taxes, depreciation, and amortization

~~~
kgwgk
> GAAP rules state that anything paid above "book value" for the company must
> be called "good will" and be depreciated.

Goodwill is not subject to amortization since 2001 (depreciation is the term
for tangible assets, amortization for intangible assets). It has to be tested
for impairment, though. For example, HP bought Autonomy for $11.1bn in 2011
and took an impairment charge of $8.8bn in 2012 (the goodwill and a good chunk
of the book value as well).

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calbear81
For some reason, I first read this as "Fantasy Math" being the name of a new
startup that helps companies spin losses into profits as a service. Maybe it's
"creative resourceful accounting as a service" otherwise known as CRAAS.

------
Sam--------
Two thoughts on why this is not such a big deal...

1\. SEC rules require GAAP results to be presented with equal prominence to
non-GAAP metrics. This is why reports usually have "Core" and "As Reported"
metrics.

2\. Starting mid 2014 to early 2105 we saw a large increase in the value of
the dollar relative to other currencies. GAAP accounting requires that
currency hedges be marked to market with fluctuations in non-realized
gains/losses. This creates a lot of noise, hence the increase in non-GAAP
reports.

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Animats
Yes. And journalists cooperate by publicizing non-GAAP figures. My general
position, having run Downside.com, is that you're only a "growth" company for
a short period, three years at most after you have a product. After that, you
better have good GAAP numbers.

When was the last time you saw an "extraordinary item" in a footnote that was
excluded from making the earnings look better? Have you ever seen one?

EBDITA is called "earnings before all the bad stuff" by value-oriented
analysts.

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randyrand
This seems like a good thing to me.

We should be using these fantasy math innovations to help the poor. There is a
lot of fantasy profit that could really help people.

Some of the presidential candidates have actually good proposals about this
idea.

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c3534l
I'm an accounting student in my fourth year, so I thought I could lend some of
my insight as to why I think this is a bad article. The __tl;dr __of it is
that this article contains almost no content other than a lament that
financial statements are "fantasy" without ever explaining what she means by
that.

First, all publicly traded companies are legally required to disclose
financial statements that have been prepared according to GAAP and audited by
an outside firm who ensures the financial statements are a "faithful
representation" of the firm's financial position. Companies are also legally
prohibited from suggesting that GAAP numbers are somehow insufficient or don't
count in their official financial statements. This system is not perfect -
Arthur Anderson had certified Enron's financials and it is known that the need
to get continued business as well as form relationships with the companies'
can mean that they don't always get the level of pushback that they should
from audit firms. Additionally, traditional audit methods aren't really meant
to detect outright fraud.

The claim that 90% of financial statements were prepared under some method
other than GAAP is absurd and the link the author provides does not actually
lead to an analysis for that number.

Accountants prepare financial statements for the benefit of investors and the
rules and principles that form GAAP take into account people's willingness to
abuse them, selectively apply them, and otherwise subvert them. There's also a
great deal of genuine ambiguity where two reasonable people can look at the
same situation and disagree as to the proper accounting treatment. None the
less, any investor who would ignore those numbers in favor of some fictitious,
back-of-the-envelope calculation in the Management Discussion & Analysis is a
fool.

However, GAAP also _requires_ that you discuss your company's financial
situation, your strategy, your risks and special considerations _beyond_ what
is just in the book-keeping calculations. A typical financial statement has
more notes and text to it than it does actual tables of accounts and balances.
This is necessary because whereas accountants prepare their financial
statements for the benefit of outside investors, we try to be as objective as
we can and let the debt and equity holders be the ones to actually assess and
estimate the meaning behind those numbers according to their own economic
theories and financial needs.

So what exactly is the problem then? The author briefly gives three reasons
that financial statements may not be as faithful as we'd like, but describes
none of them in detail: restructuring and acquisition costs, stock-based
compensation and write-downs of impaired assets.

First is the most obvious one, a write down of an asset due to impairment _is_
an expense. As for executive compensation, that used to be a bigger problem
than it was, but the accounting rules were changed to address that and we've
seen a massive decrease in fishy compensation deals. There could well be
issues about compensation that are emerging, but I don't happen to know about
them and the author doesn't bother to mention them. Finally, there's
restructuring and acquisition costs. Thankfully, this portion does get a one
or two line explanation, but I don't see what this has to do with "hidden
expense." The author says that future costs of restructuring are not recorded
in the balance sheet. If you did, then you'd record the future cost as a
liability and you'd match the expense with the actual work of restructuring.
The expense would be the same in either case, but you'd have a liability on
your books earlier. Except that you're not actually obligated to continue to
spend money on restructuring, so there's no reason to accrue that cost anyway.
This is a perfect use-case for a note, with an estimate about how much the
company is planning on spending (given the article, the author would probably
lament it as a non-GAAP fantasy number anyway).

The way accounting is done is not without it's problems, but the author
doesn't seem to have anything intelligent to say about those problems.

------
coldcode
Given the nature of Cruz, Trump and especially Clinton, we can only expect
even more allowance of fake accounting data in the future. Wouldn't surprise
me if the SEC was simply closed.

~~~
MichaelGG
Really? It seems politicians want to increase "oversight" and stop scary-
sounding, misunderstood, tech like HFT. Seems like the SEC is the place to do
that.

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api
Are you sure this isn't just hiding profits for tax purposes?

~~~
dharmon
Statements required by the SEC are not the same as those sent to the IRS.

For example, a company can use straight-line depreciation in their GAAP
statements, but use accelerated depreciation for tax purposes. The difference
becomes a tax credit on the balance sheet.

The IRS is much less likely to fall for shenanigans than investors.

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daveguy
It's all about the users man. It doesn't matter if you're profitable, as long
as the number of users is growing! It's all about revenue growth! You can
always hack the expenses later. Profit is so 90's.

