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The article “Yahoo, Google and Accounting — Web-Search Powerhouses Count Revenue Differently, Making Valuation a Chore” deals with the different methods Yahoo and Google use to report their revenues. In particular, Yahoo and Google treat revenue from small-text advertisements that they place on other companies’ Web sites differently.

Both companies act as technological intermediaries and quasi-advertising agencies, bringing together Web publishers and advertisers. They get paid each time an Internet user clicks on an ad, then give some of that money to the Web publisher on whose site the ad appeared.

Yahoo reports its revenues using the gross method (counting its payment to the publisher as an expense, labeled as a “traffic acquisition cost”), whereas Google only reports the net amount  (after it pays the Web publisher).

Using the gross method enables Yahoo to inflate its revenues and to appear faster growing (revenues grew 168%). If Yahoo had used the net method revenues grew only 94%. In Google’s case it is exactly the other way round. However, when it comes to gross profits, Yahoo’s profits appear smaller whereas Google’s profits appear larger.

I know we touched on this a little on class when discussing how to create an income statement, but it still seems a little crazy that 9/11 is not deemed an extraordinary by accounting standards.  While we deem those extraordinary items as infrequent and unusual (which 9/11 seems to be), the FASB’s final decision makes more sense when thinking from an accounting perspective.  The real world and the accounting world are two separate things and that is important to remember.

The thing that made this article confusing is that the FASB’s Emerging Issues Task Force decided 9/11 was extraordinary and then a week later decided just the opposite.  It really shows this is one of those easily debatable issues, which means no matter what FASB decided there were going to people on the other end that were going to be upset.

The quote from task-force member Dick Stock helped me to better understand the reasoning behind FASB’s change of heart.  Mr. Stock said that 9/11 affected almost every company and created such a broad new economic landscape that, “it almost made it ordinary.”  If most or all companies are going to have financial issues, everyone is going to be on a similar playing field so creating an extraordinary item line is not necessary.  It’s hard to envision many, if any other scenarios where ALL companies are affected.  This makes it harder as well because there is really no precedent to work off of.

The last paragraph is similar to what I thinking when I read the quote from Mr. Stock.  Although 9/11 did affect our entire economy, it definitely had a much larger impact on some companies as opposed to others.  We have no way of figuring out what that exact effect is (or more importantly what the company believes it is) and that means investors have to try and figure out individually what they believe the impact was.

The growing number of companies with Internet activities has prompted the SEC to address accounting for these activities already in October 1999. The SEC Chief Accountant back then, Lynn Turner, sent a letter to the FASB director of research and technical activities requesting that FASB consider a number of issues related to accounting for Internet activities. But have new specific guidelines been provided?

One issue related to accounting for Internet activities is the choice between using gross versus net revenue and cost display. This issue is still open to the company interpretation. Should companies report the amount received from the end-user as revenue and the amount paid to the supplier as cost of sales (expense), or report just the net amount as revenue (as if that amount were a commission paid by the supplier for generating a sale)? Those two methods are different in their essence: Gross reporting treats the transaction as the company purchasing a product or service from the supplier and then selling that product or service to the end-user while net reporting relates to the transaction as the end-user making a purchase from the supplier with the company acting as a sales agent. In order to make this determination there is a need to evaluate the relationships between the supplier, the company and the end customer.

The same logic is used for the case of Yahoo and Google: the proper accounting method depends on the company’s perception of its business. Is the company acting as an “agent” for a deal, or as a “principal” taking the risk to lose money?

It seems to me a bit absurd that FASB leaves this issue open to the personal interpretation of companies. For FASB, as long as a company keeps consistency in its reporting method, the company is following the principles. However, this situation of diversity in practice confuses investors and other financial statements users. I think that FASB should provide additional, specific guidance on the issue, guidance that will result in consistency and unity and won’t leave room for personal interpretations. A situation like that would improve the financial information presented and make the life of investors easier.

Given investors’ focus on earnings as a key indicator of a company’s efficiency and financial potential, earnings numbers clearly have a significant impact on public market valuations. While earnings per share calculations seem straight forward, companies often report “pro forma” EPS numbers as well. Basing valuations on these pro forma numbers versus GAAP EPS numbers can translate into significant changes in valuations.

Pro forma earnings are non-GAAP numbers and may exclude items such as restructuring charges, asset impairment charges, losses on the sale of businesses and assets, goodwill amortization, and losses on equity method investments. While companies claim that pro forma numbers are net of “items they deem non-reoccurring, non-cash or otherwise unimportant,” and that pro forma numbers portray a more accurate picture of their value and potential.

The Predictive Value of Expenses Excluded from Pro Forma Earnings study analyses the informational value of pro forma earnings numbers. The study concluded that charges excluded from pro forma earnings were in fact meaningful and important.

In the 4^th quarter of 1997, pro forma earnings were 17-21% greater than GAAP numbers. This signals a cause for concern that companies may be providing financials that are misleading by removing charges which negatively impact the company’s performance, even if though GAAP require those charges to be included in earnings. Even more disturbing, is that companies will often highlight these better pro forma earnings numbers and bury GAAP numbers further back in press releases.

However, there is some value in these pro forma numbers. The SEC wrote in a 2001 release that “companies may quite appropriately wish to focus investors’ attention on critical issues.”

While pro forma numbers maybe misleading, investors are not free from a responsibility to analyze how pro forma numbers are being calculated and determining their validity. GAAP earnings numbers are also provided and investors must make an educated determination on how to evaluate a company.

This article enlightened me—a novice in the investment world—to a few things:

1)    In regards to earnings, companies release either/both of two figures to the public: 1. “as reported earnings” which conform to GAAP, and 2. “operating earnings” which exclude one-time items (and allow management a bit more flexibility in what is reported).
2)    Historically, the gap between “reported” and “operating” earnings has been wide, illustrating a fundamental and philosophical divide between how FASB and businesses define earnings. Why can’t the two camps figure out one standard for reporting earnings? Subjective judgments from company to company make them non-comparable over time.
3)    Regardless of which camp you’re in, two earnings figures translates to investor confusion. So, don’t make an investment based on “earnings,” unless you’ve first read the financial statements and determined exactly what those “earnings” report.

On the businesses side of things, “operating earnings” are calculated to the exclusion of one-time events, presumably reflecting a more accurate account of “business-as-usual” earnings.  The article points out that since 1995, “operating earnings” have topped GAAP earnings by an average of $2.47 per share—showing that the “business-as-usual” outlook has historically been brighter than what has actually occurred in any given year (how optimistic!). But recently (June 2009), the gap between those earnings figures narrowed to $0.31.

The author interprets this narrowing as a sign of market stability. I speculate that a major cause for this narrowing is investor skepticism (a mark of instability). On the heels of the Madoff scandal, and in response to public outrage, I think Wall St. reported earnings more conservatively, and closer to their GAAP earnings, in the name of transparency and in attempts to restore investor confidence. Honestly, I think that we’ll need to deem one consistent, less prone-to-manipulation method for reporting earnings (among doing many other things), to restore my confidence. But in the meantime investors, it pays to mind the GAAP gaps.

“Investors, It Pays to Mind the GAAP Gaps”, is a great article that shines a light on the increasing gap between non gaap operating earnings and gaap conforming operating earnings among companies within the Standard & Poor’s 500.  Before expanding on the significance of this gap, first, let me briefly explain the reasoning behind announcing non gaap operating earnings along with gaap earnings.  Management teams inside of corporations as well as some analysts believe that non gaap operating earnings can be a better indicator of the performance of a corporation.  This alternative method of reporting operating earnings removes any one-time charges or any one-time gains as opposed to gaap conforming operating earnings which account for the impact of one-time items.  Executives and analyst will argue that the impact of these special items skews or blurs a company’s true financial picture. 

The Microsoft case is a great example of this occurrence.  Microsoft in the quarter ended June 30^th 2007, reported gaap operating earnings of $4 billion while also providing investors with non gaap operating earnings of $5 billion.  The difference in the two figures is related to a $1.06 billion Xbox warranty enhancement charge.  According to management and probably most of the analyst community, this charge is a one-time occurrence and is not expected to reappear.  Looking at this example it is understandable why some investors would prefer non gaap earnings as they believe it is a better depiction of Microsoft’s operating performance for the quarter. 

The article’s author, Mark Gongloff, raises a number of legitimate concerns.  When looking at the past 14 years, the gap between gaap and non gaap operating earnings numbers has risen by $2.41.  When the averaging the gaps between these earnings over the past 10 years to eliminate any spikes or dips, non gaap operating earnings were almost 24% higher than gaap earnings.  After reading the article, I thought to myself, “What does this signify?”  Why has the gap between gaap and non gaap earnings grown so much over the last decade or so?  Is it simply that executives are managing today’s corporations more differently than before or could there be an underlining cynical reason that’s causing one-time charges to increase when compared to one-time gains.

A critical look inside the Microsoft case might provide some answers to these questions.  As mentioned, Microsoft took an Xbox related charge of $1.06 billion.  Part of the charge was related to warranty claim payments to customers who bought the Xbox, experienced problems with the device, then turned to Microsoft for a fix.  Microsoft, in an attempt to ensure customers who were interested in the Xbox that it stood behind its product, enhanced the existing warranty policy.  Thirty five percent of the charge was also “attributable to inventory valuation adjustment” or, in other words, Microsoft looked at its Xbox and realized that some of its chips did not work properly and had to replace them. 

It is very possible that when Microsoft’s management team was setting the budget for its latest innovative product that the team was more interested in supporting Xbox’s profit margin, therefore, cutting cost and corners.  This cost cutting strategy might be the reason that Xbox did not perform as expected by customers thus forcing Microsoft to pay high warranty claims.  It would not be the craziest idea to think that executives would push today’s cost to tomorrow in the form of one time charges to help please Wall Street and most importantly to help pay for the new home in Hawaii.  This strategy and others that compromise product quality across America’s industries might be just one reason for the increasing gap between gaap earnings numbers and non gaap earnings numbers.

I believe the article “Investors, It Pays to Mind the GAAP Gaps” does an ok job in explaining why there is a difference between GAAP numbers and Non-GAAP numbers in terms of operating expenses for income statements for different companies. According to the article, many companies will have higher Non-GAAP numbers than GAAP numbers because many companies will not include one time costs/revenues in their income statements in the Non-GAAP numbers. Of course the reason for doing this is because they want their investors to see what their “normal” operating earnings usually are under normal circumstances. I say the article does an ok job because it doesn’t really say why the Non-GAAP numbers have been higher on average for the past 10 years, even when we weren’t in the recession. It is highly unlikely that more one time costs have occured than one time revenues every single year. I believe it is always higher because companies will try to be as optimistic as possible, especially when things are looking bad. This is evidenced in the article when it states that companies with a larger difference tend to do worse in the long run.

Additionally, the article goes on to discuss how over the past few years, the recession has caused the gap between GAAP and Non-GAAP numbers to increase because due to the recession, more bad events have occurred than good ones. Therefore one time losses have increased and one time gains have decreased. However, according to the second quarter numbers, the difference between GAAP and Non-GAAP decreased significantly. I believe this could be for three reasons: Either the economy is recovering so there is less incentive to inflate numbers, the one time bad events are no longer one time events, but have been continuously recurring, or people are starting to realize that heavily inflated Non-GAAP numbers is actually a sign of weakness. Personally, I think our economy could get a lot worse, but for the time being it has been somewhat stable, which has decreased the number of one time costs and decreased the need for companies to feel like they have to inflate their numbers in order to have a better image. Regardless of why, it is still important to follow both numbers because in general, an analyst may want to leave out extraordinary events when projecting a companies future growth. However, I also believe it’s important to take one time factors into account when making investments because although they are very rare and extremely difficult to predict, they DO occur, and if one is prepared, he/she can make a healthy profit or in some cases, save a lot of money.