Watch out for the growing list of ‘exceptional’ items in company results

Otmane El Rhazi from Mindful Money » Shares.

Every results season offers The Value Perspective the opportunity – the obligation even – to work through a wide range of announcements to see how companies are getting on financially and what they are saying about life writes Andrew Lyddon…

Along the way we also see how they present what they are saying and, in recent years, have noticed the lengths some businesses are going to present their earnings in a more favourable light.

Rather than concentrating on the past by naming and shaming individual offenders, we will instead focus on some of the methods companies have started using to try and flatter their reported numbers. That way, visitors to The Value Perspective will be better equipped to spot instances themselves in future reports and accounts.

By their nature, these issues will rarely be black or white and with restructuring – a particular favourite with the adjusters – the greyness relates to how much something is truly an exceptional item rather than a continual cost of doing business. Some costs associated with closing a business, say, could well be a true one-off but, if a business needs to ‘restructure’ every year to keep up with the latest trends, it probably is not.

Speaking of trends, something we are seeing more and more in the retail sector is businesses looking to make an adjustment for the cost of refitting stores and then flagging that as ‘exceptional’. Again, it can be a matter of degree but surely one must at least ask the question as to how much keeping your stores looking nice so customers actually want to visit actually counts as an exceptional, and how much it is just a basic cost of retailing.

Another adjustment classic relates to acquisition costs. If a company is regularly buying other businesses, should the legal, investment banking and other costs being incurred every year in relation to that really count as exceptional? That is before we start to consider whether the reason a company is having to make regular acquisitions is to compensate for underinvestment in R&D or marketing.

In a similar vein, the same question may be asked about costs incurred by companies that regularly have to defend themselves against legal actions. For a number of multi-nationals – banks, pharmaceuticals and tobacco companies would be obvious examples – fighting lawsuits, dealing with regulators and so forth is not so much exceptional as a cost of staying in business. You might take a different view on the explicit large fines such companies can face but even negotiating their size is arguably part of the decisions those businesses make every day.

Then, since we mention the pharmaceutical sector, there are research and development costs – and indeed explorations costs for, say, oil and mining businesses. It is a well-established accounting practice that, if these costs are expected to have a high probability of leading to revenues or similar in the future, they can be capitalised as an asset on a company’s balance sheet rather than charged against profits on day one.

This is open to a fair amount of management discretion as it is, but the real distortion comes if it later transpires these costs will not yield any benefit, which results in the asset having to be written off. These write-offs tend to be treated by companies as exceptional items yet, if you are an oil producer or a pharmaceutical company, say, respectively digging for oil and investing in research and ending up with nothing to show for it is not so much exceptional as a fact of business life. In this way the inevitable costs of failed endeavours all businesses have can be hidden both as they are being incurred and when they are written off.

There are other examples of these rather unexceptional exceptionals – stripping out the costs of running a company pension scheme, stripping out the costs of giving employees shares as part of their remuneration package and so on – but you get the idea. The bottom line, if you will excuse the pun, is there is a growing list of reasons for investors to be wary of how companies are stating their profits.

In order to build up a real sense of what a company’s profits and cash generation actually are – and that, after all, is how you appraise the value of a potential investment – investors need to roll up their sleeves, dig into the numbers and come to their own view on whether certain costs really are as exceptional as some companies would appear to believe. Blindly accepting a company’s view of what its real profits are is an increasingly perilous thing to do.