An investor will struggle to even compare the financial performance of archrivals, Coca Cola, and Pepsi. I suggest we ask firm A to report its numbers using the same disclosure practices and accounting policies followed by peer firm B and vice versa.
Accounting rule makers often extol the virtues of comparability between the financial statements of two companies. For instance, the FASB states, “more comparable standards have the potential to reduce costs for both users and preparers of financial statements and make worldwide capital markets more efficient.” The ISSB is understandably even more worried about comparability given the inherent absence of dollars as a common unit of measurement in sustainability reporting: “the provision of rigorous, reliable and comparable sustainability information enables informed investment and economic decisions in the public interest. This approach promotes the proper functioning of capital markets, building trust, resilience, efficiency, transparency, and accountability.”
Coke v/s Pepsi
My friends in the sustainability area usually experience bouts of heartburn about comparability. I am here to assure them that even after decades of regulated financial reporting, we still have a long way to go on the comparability of financial data.
Let’s begin with textbook arch rivals, Coca Cola, and Pepsi. A quick look at their 10Ks for fiscal 2022 tells you that comparability between these two businesses is a non-starter. Why? Coca Cola is essentially a beverage company that sells product in more than 200 products and territories.
Pepsi, on the other hand, is a conglomerate, and reports results for seven different segments: (i) Frito-Lay North America (FLNA), which includes its branded convenient food businesses in the United States and Canada; (ii) Quaker Foods North America (QFNA), which includes their branded convenient food businesses, such as cereal, rice, pasta and other branded food, in the United States and Canada; (iii) PepsiCo Beverages North America (PBNA), which includes beverage businesses in the United States and Canada; (iv) Latin America (LatAm), which includes beverage and convenient food businesses in Latin America; (v) Europe, which includes beverage and convenient food businesses in Europe; (vi) Africa, Middle East and South Asia (AMESA), which includes beverage and convenient food businesses in Africa, the Middle East and South Asia; and (viii) Asia Pacific, Australia and New Zealand and China Region (APAC), which includes beverage and convenient food businesses in Asia Pacific, Australia and New Zealand, and China region.
So, how do I compare the beverage business, aggregated across the world, for Pepsi with that of Coca Cola? Pepsi reports revenue from beverages in its various geographical segments (LatAm, Europe, Amesa, and APAC) but I found nothing in its 10-K about costs and hence profits attributable exclusively to its beverage business.
Perhaps we might have better luck with two relatively similar companies in a somewhat easier to understand business. I was thinking of home improvement retail and Home Depot and Lowes.
Home Depot v/s Lowes
Home Depot’s and Lowe’s numbers are barely comparable for 2022 because they cover different time windows. Home Depot closes its annual books on January 29, 2023, whereas Lowes’, its closest competitor, closed its books on February 3, 2023. Thus, Lowe’s 2022 fiscal year ended February 3, 2023, reported numbers for 53 weeks unlike Home Depot which reports its data for year ended January 29, 2023, for 52 weeks instead. You may laugh this off as a trivial matter, but the average weekly sales of Lowes are a non-trivial $1.5 billion ($79 billion for the year divided by 53 weeks). If you argue that we should simply subtract a week of profit to compare the performance of Home Depot and Lowes, you would have implicitly assumed that all of Lowes’ costs vary with time and sales volume. Do they? Well, that requires deeper work. On top of that, Lowes’ fiscal 2022 data with 53 weeks is not strictly comparable with its own fiscal 2021 and 2020 data presented in the same 10-K covering 52 weeks.
To be fair, Home Depot and Lowes at least report sales for relatively identical segments such as lumber, millwork and so on, unlike Pepsi and Coke. But comparability associated with deeper issues, even for these two relatively simple and closely related businesses, gets complicated. Consider a few examples:
· Cash and cash equivalents: Lowes’ states, “the majority of payments from financial institutions for the settlement of credit card and debt card transactions process within two business days and are classified as cash and cash equivalents.” Home Depot, on the other hand, reports credit card receivables under “receivables,” not cash. This is not a big deal if I knew the dollar number of Lowes’ card receivables so that I can subtract that number out of their reported cash balances, but they don’t seem to disclose that number explicitly.
· Merchandise inventories: From what I can gather, Home Depot relies on the FIFO (first in first out) method of valuing inventory and cost of goods sold. Home Depot uses the “retail” inventory method for around 58% of its inventory and the “cost” method for the remaining 42%. Retail inventory valuation methods involve starting with the retail price of a product from which the average margin on the product is deducted to approximate its cost. Lowes simply states that it uses FIFO and does not mention the use of the “retail” method.
· Revenue:
o Lowes calls out its Canadian revenue clearly ($5 billion) whereas Home Depot prefers to report revenue “outside the US” without telling us how much they sell in Canada and Mexico.
o Lowes recognizes revenue on its protection plans (extended warranty programs) on a straight-line basis over the life of the contract. Home Depot includes the fees it gets from banks that administer Home Depot’s store branded cards in its revenue number. Neither firm appears to disclose the dollar amounts involved so that the investor can compare core revenues of these two businesses related to the sale of products and services.
· Depreciation: Lowes gives us crude indicators of the useful lives of their assets on which their depreciation estimates are based. In particular, they depreciate buildings over a 5–40-year range and equipment over a 2–15-year range. Home Depot reports ranges that are somewhat different: buildings and improvements: 5-45 years, furniture, fixtures, and equipment: 2-20 years and leasehold improvements: 5-45 years. I had written earlier about how opaque these wide ranges of useful lives of assets can be.
But this opens a bigger philosophical concern about comparability. The very idea of comparability assumes that keeping the underlying transaction constant, is the score keeping for that transaction comparable across two companies. What if the underlying transaction itself is different? And how is the investor to distinguish between the two hypotheses: are the underlying transactions different or is the reporting or score keeping different for the same underlying transaction?
· Foreign currency: Both firms state that the use “average foreign currency rates” to report results of operations and cash flows, except neither firm clarifies what average means here: daily average, weekly average, monthly average or what?
Comparability in CEO compensation:
Predictably, Home Depot and Lowes, in their proxy statements, identify one another as peers when they discuss how their CEO’s compensation plans are designed. So do Coca Cola and Pepsi. A prominent compensation consultant is usually hired by the compensation committee to collect data on how peers pay their CEOs and careful benchmarking ensues.
Yet, such enthusiasm for comparability and benchmarking is strangely lacking when it comes to helping investors compare financial performance relative to peers.
What’s a way forward?
Here is my disruptive suggested model to move things forward:
· We ask firm A to identify one closely related publicly traded peer, say firm B.
· We ask firm A to report a “pro forma” income statement and balance sheet whereby firm A reports its numbers using the same disclosure practices and accounting policies as followed by firm B.
· Repeat for firm B and so on.
Otherwise, investors are doomed to constant guesswork and noisy estimates as they try comparing financial performance of peer businesses. I can’t even imagine the difficulties associated with comparing sustainability information across peers.
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