In an alarming development on Wall Street, a growing number of firms looking to make an initial public offering are turning to creative accounting in an attempt to appeal to investors. According to a January 7th article by Michael Rapoport of the Wall Street Journal, it’s now almost becoming the norm for firms looking at an IPO to create custom earnings metrics or other “tailored accounting” methods to reflect their company’s financial performance in the best possible light.
Under generally accepted accounting principles, the standard U.S. accounting rules, firms are still required to prominently disclose their standard accounting earnings even if they also include bespoke earnings figures under “non-GAAP” measures.
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Forty IPOs in 2014 used creative accounting
Of note, forty companies went public in 2014 that reported losses under traditional accounting rules, but claimed profits under their own tailored accounting. That represents just over 18% of all U.S. initial public offerings in 2014, Audit Analytics, the highest percentage since 2009. Moreover, the bigger they are, the more likely they are to use creative accounting. Among the 10 biggest IPOs of the year, nine offered nonstandard earnings metrics as well as the standard accounting treatment.
Zoe’s Kitchen Inc is a typical example of the creative accounting trend.
Zoe’s Kitchen is a chain of more than 125 Mediterranean-theme restaurants that went public last April. The firm reported an adjusted profit of $13.2 million for the first nine months of 2014 using its own tailored accounting treatments that don’t include a number of expenses.
When you include all the expenses required under standard GAAP accounting rules, Zoe’s actually had a loss of $8.4 million.
Accounting industry and SEC “concerned”
This creative accounting problem is finally getting some real attention. The Securities and Exchange Commission wrote letters to Zoe’s and several other firms telling them the tailored figures they use are too prominent and requesting revisions to regulatory filings.
“I think it’s a sign of frothiness” in the IPO market, commented Brandon Rees, deputy director of the AFL-CIO’s Office of Investment, when asked his opinion on the growing trend toward creative accounting. “Why investors tolerate it, I don’t know.”
Critics note that many of the costs being stripped out are things that clearly should be a part of earnings calculations, including executive bonuses, stock offerings fees and expenses related to mergers or acquisitions.
“I was just astounded at the wide variety of elements that people thought were appropriate to exclude,” said Curtis Verschoor, a DePaul University emeritus professor of accountancy. “Investors should be aware that a company’s nonstandard numbers “are more likely to be slanted rather than balanced,” he continued.