June 2003

Required Reading

I rarely read an article from beginning to end, but the interview with [Acting PCAOB Chair] Charles D. Niemeier in your April issue was an exception. This should be required reading for all CPAs. Thank you for sharing his wisdom.

Debbie A. Cutler, CPA
Kramer Love & Cutler, LLP
Chair of NYSSCPA Accounting & Review Services Committee, and member of NYSSCPA Accounting & Auditing Oversight Committee
getting to the core

Pro forma after-tax earnings—GAAP after-tax earnings adjusted for nonrecurring items of revenues, costs, and expenses—has been used by shareholders and analysts as a starting point for projecting future after-tax earnings when making investment decisions.

Absent any generally accepted standards for defining nonrecurring items, and with an increase in the number of companies reporting pro forma earnings, abuse in reporting has become common practice. In “Pro Forma Earnings: Adding Value or Distorting Perception?” (March 2003), authors Dan L. Heitger and Brian Ballou do a very effective job of cataloging the abuses and stressing the need for generally accepted standards for defining nonrecurring items. FASB has this topic on its agenda, but a pronouncement is unlikely to be issued in the near term.

Standard & Poor’s (S&P), a division of McGraw-Hill that provides independent financial information, analytical services, and credit ratings to the world’s financial markets, has taken the initiative in providing standards for the calculation of pro forma after-tax earnings, which it identifies as “core earnings.” It plans to use core earnings for equity analysis to evaluate corporate operating earnings of publicly held companies in the U.S. S&P’s recommendations are contained in its publication “Measures of Corporate Earnings,” revised, May 14, 2002.

Core earnings are defined as “earnings from a company’s ongoing operations.” The derivation of a company’s core earnings involves three steps:

• Reported after-tax earnings from continuing operations as defined by GAAP (APB 30) is the starting point.
• The following items are then included in the balance calculated in step one:
  • Employee stock option grant expenses;
  • Restructuring charges from ongoing operations;
  • Write-downs of depreciable or amortizable operating assets
  • Pension costs
  • Purchased research and development
    
• The following items are then excluded from the balance calculated in step one:
  • Goodwill impairment charges
  • Gains or losses from assets sales
  • Pension gains
  • Unrealized gains or losses from hedging activities
  • Merger and acquisitions related fees and litigation settlements
  • Litigation and insurance settlements.

Measures of core earnings provide S&P details of their rationales for each of the items included and excluded in their calculation. S&P does use the terms “recurring” or “nonrecurring.” It is evident that included items suggest “recurring” and excluded items suggest “nonrecurring.”

S&P has published core earnings for 10,000 companies in its Compustat database for the year 2001; data for 2002 are also available.

S&P should be congratulated for its preemptive strike on abuses of pro forma earnings reported by an increasing number of American corporations and its attempt to enhance the validity and comparability of pro forma earnings for the long term. S&P provides a well-reasoned starting point for FASB when it addresses the promulgation of generally accepted standards for pro forma earnings. If a company’s financial reports are made available with a reconciliation of GAAP earnings to pro forma earnings (as currently required by the SEC) and the company’s S&P core earnings as reported by Compustat, a financial analyst can derive a more representative pro forma earnings number.

Allen I. Schiff, PhD
Professor of Accounting, Fordham University, New York, N.Y.
Jonathan B. Schiff, PhD
Professor of Accounting, Fairleigh Dickinson University, Teaneck, N.J.

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