The COVID-19 pandemic has had a tremendous impact on the performance of companies around the world as lockdown measures, travel restrictions, and quarantine protocols have plunged the world economy into a recession in a matter of months.
The way this fallout is reflected in the financial statements of publicly-traded businesses is something investors should pay keep an eye on.
Companies may resort to potentially deceptive accounting practices to either cushion the impact of the situation in their top or bottom-line or to take advantage of an overly pessimistic outlook and write off more losses than planned and gain a bounce in the following quarter.
The Kitchen-Sinking Phenomenon
Kitchen-sinking is a corporate practice that consists of taking advantage of investors’ pessimism ahead of a quarterly or even annual earnings report to write-off any assets or report losses that the company has already experienced but have not fully reflected in their financial statements.
Business consultant Jasdeep Singh points to the financial and energy industry as examples of this practice, as both sectors have been heavily battered by the crisis in a way that has affected their ability to turn a profit.
In the case of banks, they have taken the first two quarters that followed the pandemic to report large loan-loss provisions ahead of a wave of defaults that have not really materialized yet.
Although this is a healthy practice for banks – to build reserves ahead of defaults – the size of these loan losses suggests that banks have preferred to report the majority of those losses upfront during quarters where investors were already expecting the worst. This will reduce the impact of the losses when they happen in the following quarters, allowing the businesses to show positive revenues.
As a result, these companies will increase the likelihood of turning a ‘surprising’ profit in the following reporting periods, which should have a positive effect on the price of their stock.
A similar case can be argued for energy companies – especially those in the oil and gas industries – which have faced greater volatility in the crude oil market and the threat of renewable energy for a long time. Until now, many have not reported the full-blown impact of those trends in their financial statements.
In this regard, the pandemic has provided an interesting landscape in which investors are already expecting severe losses due to plunging oil prices. A lot of companies in this industry have taken advantage of the situation to throw in sizable asset impairment charges and other write-offs as a way to flush everything down the sink in a time that seems convenient in terms of how the investment community will perceive it.
For investors, analyzing financial statements in a time like this is increasingly challenging as they have to filter out all the noise caused by these practices to truly reveal what the financial impact of the pandemic has been.
Be careful with giving too much credit to adjusted earnings
Companies have always resorted to adjusted earnings metrics to try to communicate the intrinsic value and profitability of their business in a way that generally accepted accounting practices (GAAP) are sometimes not fully able to.
This often involves including or excluding certain items from profitability estimates and calculations to truly reflect the business’ earning-generation capacity.
However, in the context of the current crisis, more companies than ever may emphasize adjusted earnings over statutory earnings – those resulting from following the GAAPs – to communicate to investors how the business has been doing.
Although most companies do this in good faith, some companies may also find a way to mislead investors by adjusting their earnings in a way that doesn’t truly reflect the reality of the company.
This can be achieved by claiming that some expenses are “extraordinary” or “non-recurring” although they are just the consequence of the economic downturn caused by the outbreak.
Dr. Singh, who is also a full-time educator, advises investors to stay on the lookout when it comes to analyzing financial reports during the pandemic. No one should rely on any one metric, such as adjusted earnings, to make decisions.
Instead, everyone should take extra time to go through the numbers to see what is it that companies are including or excluding and why. If something seems part of the business’ regular activities, then chances are that the company is trying to overstate its earnings to underpin the impact of the pandemic.
Interesting related article: “What is Creative Accounting?“