- Companies ever more reliant on APMs
- Investors must look to the reported figures
Self-authored alternative performance measures (APMs) have come under the spotlight again after a new report by the Financial Reporting Council found that companies need to provide more disclosure over how they calculate these numbers, which can vary wildly from the 'reported' figures that comply with accounting standards.
The fact that APMs have started to proliferate in all major markets, and that companies sometimes use them to talk up their operational performance, has been a cause of growing regulatory concern since the European Securities and Markets Authority (ESMA) first highlighted the issue in 2015 and enacted new reporting rules a year later.
The FRC’s report, although only advisory, is helpful in defining clearly what constitutes an APM. According to the regulator, these include any ‘adjusted’ earnings measure, or based on ‘adjusted’ earnings, such as adjusted margin or adjusted earnings per share. Others include operating profit/earnings before interest and tax (EBIT) and everyone’s favourite – earnings before interest, tax, depreciation and amortisation (Ebitda). The FRC does not include non-financial APMs, such as customer numbers, or footfall, in its review as there no officially sponsored alternatives to these company-generated numbers.
The reason for the ongoing anxiety is that the divergence between reported numbers and company authored APMs can be quite startling, and the trend seems to be getting more pronounced. For example, Deloitte recently reported that the deviation between unofficial APMs and the officially reported earnings per share, as disclosed by S&P 500 companies, has grown from 12 per cent, to an eyebrow-raising 30 per cent difference in recent years. Under its previous management, co-working space company WeWork, took the cake for its 'community-adjusted' Ebitda, which removed tens of millions of dollars in recurring costs including much of its sales and marketing spend and took this figure from the red to the black.
Deloitte also found that over 80 per cent of FTSE 100 companies used or highlighted at least one non-statutory APM at the top of their financial statements. In other words, APMs are becoming ever more prevalent, difficult to understand and on their own terms, largely flattering to the operational performance of the reporting company.
The FRC finds broadly the same point in its report. It observes that large companies average about 20 APMs per financial report and that companies using APMs tended to adjust for the impact on costs, but not on income, when calculating profit-based performance measures. The net result, the FRC unsurprisingly noted, was that the non-GAAP adjusted results were always more favourable than the officially sanctioned numbers.
Investor red flags
The FRC’s list of common APMs practices reads like a list of investor warning signs:
1) Companies adjusted for the effects of significant multi-year restructuring programmes, but did not disclose cumulative costs, expected cash costs or their expected duration of the programmes.
2) Many companies use terms such as ‘underlying profit’, ‘non-underlying items’, and ‘core operations’ but do not explain them.
3) APM accounting policies rarely explain tax matters, including companies’ policies for classifying unusual tax items as adjusting items.
4) Certain adjusting items (eg, restructuring and litigation costs) had cash implications, but companies did not always detail the impact on cash flow.
So how did this happen?
An interesting footnote to ESMA’s report into APMs in 2019 is that many of these are used by pharmaceutical companies. Beginning in 2010, many pharmaceutical majors switched to a method of accounting that included separating out core and non-core earnings. Essentially, they started excluding the intangibles generated by acquiring lots of small biotech products from the calculated APMs, as well as discounting items such as legal and regulatory costs to give a 'true' picture of the pharmaceutical company’s operating performance.
The problem is equivalent to a shark's need to keep swimming, given pharmaceuticals must undertake the constant acquisition of companies (and their associated intangibles) in order to adequately replenish their drug pipelines. The same is true with legal costs – another cost that companies like to discount – as constant litigation to defend patents, or settle fines, is an inevitable and inescapable cost of doing business as a large pharmaceutical company. Stripping out these expenses is one reason why AstraZeneca (AZN), to use a representative example, could report 'core' earnings per share of $4.02 in 2020, when the reported figure was $2.44.
It certainly one of the banes of being a financial writer that when company-authored numbers deviate from the statutory figures, this can become a topic of dispute on its own terms. The Investors' Chronicle's own policy is always to use reported numbers for tables, as these ultimately represent the losses or gains individual investors will see at the end of the year, but to explain adjusted numbers further if they are relevant to the story.
APMs do have a useful function, particularly if there have been multiple disposals or acquisitions, so stripping out the effect of these gives some insight into the underlying state of a business. Unfortunately for investors, the tension between what companies say they do, and what they actually report is never likely to go away.