When Goldman Sachs became a bank holding company in 2008, it changed its fiscal year-end from November to a calendar year-end in December— a fairly typical move for holding companies. Based on its numbers, Goldman recorded a pre-tax loss of $1.3 billion for December, which was not counted in its reported first-quarter 2009 after-tax profit of $1.8 billion.
Goldman was certainly not alone in using what some might call fuzzy accounting at that time. Morgan Stanley also also changed its financial reporting year end at that time, with both moves resulting from the requirements accompanying their new status as bank holding companies to change to calendar-year fiscal reporting. But how many other firms had so-called “missing months” of reporting? And was it common in other industries?
A recently published paper in the May issue of the American Accounting Association’s The Accounting Review attempts to answer those questions. The study, “Orphans Deserve Attention: Financial Reporting in the Missing Months When Corporations Change Fiscal Year,” found that out of the 1,786 public firms reviewed from 1993 to 2008, 45.4 percent of the firms shifted their fiscal year-ends by intervals such as one month, two months that could fly under the radar of investors and regulators— or even change it by a longer duration that is not a multiple of three months. (The three-month multiple is important since those intervals would normally show up in the next quarterly reporting periods for companies.)
When a corporation switches its fiscal tax year backward or forward by a few months, it typically does so to improve the look of its financials. Companies tend to report disproportionately high recurring operating expenses, such as the cost of goods sold, as well as high selling, general and administrative expenses (SGA) in the missing months, the study found. In fact, a subset of 224 companies in the study reported an an average extra after-tax loss equal to 4.7 percent of beginning book value of equity per month in the missing-month period. The loss, the report states, lasts on average for 1.78 months.
The missing months, moreover, are not always tracked by sell-side analysts, so these companies’ actions tend to go unnoticed. “Our results suggest that firms tend to report lower income in the missing months without drawing attention from various constituencies,” the report said. And usually companies “are more likely to meet or beat earnings targets in the quarter after their switch.”
With results like that, CFOs and other senior executives are not likely to stop using the practice anytime soon. Zhang says that “more and more companies are choosing this technique.” Executives, he notes, have an incentive to do so. “They want to report an earnings number that will beat analysts’ forecasts,” he says, noting that the missing months can offer management an opportunity to manage earnings.
Certainly, there are legitimate reasons for switching one’s year-end reporting. They include before an organization forms as a real estate investment trust (REIT) or when business partnerships make demand it in such fields as the natural gas industry, the authors say. They note, however, that the earnings discrepancies that do exist in the financial reports of companies in their study warrant more attention by investors.
Yet since standard data vendors do not typically collect information on the missing months, according to the report, investors don’t even know such data is missing when they look at a company’s financial statements.
Companies continue to switch at a brisk pace. Recently, consumer electronics retailer Best Buy changed its fiscal year beginning with the first quarter of fiscal 2013. Its new fiscal year will include 53 weeks of reporting, while its re-evaluated fiscal tax year of 2012 as a result of the change will include 52 weeks. Further, Bombardier altered its fiscal year end in 2011 and Truli Media Group are among those that did so in 2012.
The list could go on. But with no repercussions for those firms that have missing months of data, Zhang thinks more regulatory scrutiny of financial reporting might be needed. “There’s no law forbidding this kind of behavior. Going forward it is a bigger issue—how should we interpret these earnings numbers? Should we regulate this kind of earning-switching behavior?”
About 90 percent of firms in the study did not disclose reasons for fiscal year changes. That might be because most firms do not have to disclose the information even when they request a change from the IRS.
The IRS, for its part, has to approve a firm’s tax year change. By IRS standards a fiscal tax year is one that is 12 consecutive months and ends on the last day of a given month other than December—which would classify as a calendar tax year.
But while the IRS has some particular qualifications for switching tax status when it comes to S Corps (firms whose earnings are taxed at the individual shareholder level rather than at the corporate level), tax-exempt organizations or controlled foreign corporations, it does not request a reason or an explanation from a firm for changing its financial reporting year. If a company thinks it may not get approval by the IRS, it can, however, request a discussion with the IRS.
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