Accounting
Gimmicks
Keeps Investors In The Dark
By Richard Moroney, editor
Dow Theory Forecasts
Profits
don't mean what they once did.
You will not hear this
from company managers or Wall Street accountants, but a company's
publicly proclaimed bottom line often bears little relevance
to its true performance. Everybody knows about the many financial
exaggerations of Lucent Technologies (NYSE: LU). And e-commerce
company PurchasePro's two downward revisions of its March-quarter
earnings were widely reported as an example of Internet bubble
accounting gone disastrously wrong.
But in most cases,
accounting shenanigans are more subtle. Companies can use a variety
of tricky but legal financial maneuvers to make the bottom line
look better.
Some of the legerdemain
requires the cooperation of analysts who accept a company's questionable
numbers as Gospel. In recent months, much has been written about
the lack of objectivity among analysts, partly because they work
from brokerages that have financial interests in the companies
they cover. Often these complaints are valid. What can you do
about it? Simple: Do not routinely accept analysts' statements
and opinions as fact.
Under public pressure,
brokerage houses are taking baby steps toward self-regulation.
The Securities and Exchange Commission, too, could produce new
rules. But an investor's best protection is a combination of
knowledge and a sharp eye.
Below we explain several
financial reporting gimmicks and tell you how best to deal with
them.
Pro-Forma Follies
Internet
portal Yahoo's June-quarter earnings report made for lousy reading.
Net income was $8.7 million, or $0.01 per share, down from $69.1
million, or $0.11 per share, during the same quarter in 2000.
Bad news. Unfortunately, it was much worse.
The above profit numbers
are "pro forma." In the past, companies generally used
such numbers to adjust existing financial statements to compare
them to current results. Such action is necessary when a company
makes a large acquisition and the two companies' results are
combined to provide a more accurate measurement of year-over-year
performance. But now companies are moving far beyond the traditional
practices. Here is what Yahoo means by pro forma.
"Pro-forma net
income and net income per share calculations...exclude acquisition-related
and restructuring charges, amortization of intangibles and stock
compensation, employer payroll taxes on gains realized by employees
from non-qualified stock option exercises, derivative and impairment
gains and losses from certain assets, income related to contract
termination fee, and gains or losses from the exchange or sales
of certain equity investments.
In
order to post that $0.01 profit, Yahoo had to ignore a lot of
bad stuff. Acquisition and restructuring charges are typically
excluded, but it is easy to argue that amortization, payroll
taxes, and investment gains or losses should be included in operating
income. Take away the "pro forma" cloak, and the company
lost $48.5 million, or $0.09 per share, compared to a profit
of $53.3 million or $0.09 per share, a year earlier.
Inherently, there is
nothing wrong with pro-forma numbers, also called "normalized"
or "core." A study by two Georgia State University
professors indicates they might even be more useful than statements
prepared according to Generally Acceptable Accounting Principles
(GAAP). But there are no official rules regarding pro-forma financial
reporting, and that has the SEC worried. The regulatory agency's
chief accountant said pro-forma numbers can offer a "tilted,
biased picture to investors."
Barring new SEC regulations,
companies will continue to use pro-forma numbers in financial
statements, and many analysts will continue to pass the results
on verbatim.
What you can do:
As an investor, your best option is to read the company's
explanation. While some firms simply report pro-forma numbers
with no discussion. Consider those omissions when you assess
the value of the company's earnings. If you don't like what the
company excludes, ratchet down the profit figures and make investment
decisions based on the revised numbers.
Big Bath Write-offs
When
inventory or receivables decline in value, companies can write
off or charge off the change in value.
This is a noncash charge
against net income, and companies have routinely excluded it
from profit numbers used on Wall Street. But what should investors
do when the write-off represents a large portion of operating
income?
Such charge-offs are
called "big baths," and investors certainly get soaked.
Perhaps one of the biggest "baths" this year was taken
by Cisco Systems, the networking giant. Its April-quarter pro-forma
earnings of $230 million excluded the usual suspects. In fact,
the company had a net loss of $2.7 billion for the quarter. Much
of that loss came from a $2.2 billion write-down of inventory.
Asset write-downs are
noncash charges, but any time a company has spent $2.2 billion
to acquire something and later admits that those items are valueless,
it has implications regarding management's ability. Unfortunately,
Cisco's disclosure reads as it the company routinely discards
billions in inventory.
Over the past several
years, Microsoft (Nasdaq MSFT) and Intel (Nasdaq
INTC) boosted their earnings with investment gains. That policy
came back to bite Microsoft in the June quarter, as it had to
write off a $3.9 billion impairment of some investments, resulting
in a net investment loss of $2.6 billion. The company's earnings
release treated the investment loss the same way it treated investment
gains subtracting it from operating income to result in net earnings
of just $66 million, or $0.01 per share. It was useful, straightforward
disclosure, but pointless from an investment standpoint, as analysts
backed out the charge and reported that Microsoft met earnings
targets of $0.43 per share.
What you can do:
Look at the write-offs, and if you do not like them, do not
figure them into the earnings, irrespective of what analysts
do. Also consider a company's track record in growing per-share
book value, since write-offs will reduce book value.
When In Doubt, Leave It Out
Sometimes
earnings statements simply exclude line items that are relevant
for valid comparisons. Philip Morris (NYSE MO) said its
June-quarter "underlying diluted earnings per share"
rose 8% to $1.03. The company used results from recently acquired
Nabisco for 2001, but not for 2000.
Excluding Nabisco in
2000 gave Philip Morris' Kraft subsidiary an operating-revenue
increase of 26%. In the text of its earnings release, Philip
Morris offered a pro-forma number, which indicated that operating
revenues of the combined companies actually declined when Nabisco's
2000 sales were included.
What you can do:
Read the whole earnings report. Corporate executives know
that not all investors read the earnings report, and most of
those who do probably stop after the first page. If you actually
read the text and see where the company derives its revenue,
you will understand those numbers better, which will help you
properly value the company.
Bogus Earnings Surprises
Nobody
seems to mourn the departure of the vaunted "whisper numbers,"
those amorphous targets a penny or two above consensus estimates
that growth companies had to meet to avoid the wrath of the bull
market gods. But exceeding expectations had never gone out of
style.
Hewlett-Packard
(NYSE HWP), maker of computers and printers, has been hit
hard by a general economic slowdown as well as company specific
operational difficulties. It also blasted past profit estimates
in the July quarter.
Excluding goodwill
amortization and a loss on the sale of its VeriFone unit, H-P
earned $0.11 per share during the quarter, nearly three times
the $0.04 expected. But this surprise came in the wake of a series
of earnings warnings from the company over the last several quarters.
The stock barely moved, as nobody was impressed that H-P beat
drastically lowered numbers.
But investors looking
at historical earnings data a year from now will just see a 175%
surprise.
What you can do:
Unfortunately, historical data for earnings-estimate revisions
is hard to find. Your best weapon here is to compare results
in a given quarter to results in that same quarter for the last
several years. If the company tops estimates in a down year but
not in up years, you could be looking at a case of lowered estimates.
Other Trouble Spots
Here are a few more common accounting gimmicks:
- Nonoperating income: Often companies will use litigation awards or other sources of nonoperating income to fatten profits.
- Inflated pension returns: General Electric (NYSE GE) projects that its pension fund will generate a 9.5% annualized return. That seems rather high for a conservatively managed investment vehicle, and any shortfall will have consequences for predicted earnings.
- Constant currency: Because the dollar has remained strong for so long, many companies like to report their revenue or earnings in constant currency, ignoring the adverse impact of exchange rates on their foreign operations. So watch for firms that report constant-currency numbers at the top of the earnings statement and then switch to GAAP numbers several pages later.
Editor's Note: Richard Moroney is editor of Dow Theory Forecasts, 7412 Calumet Ave., Hammond, IN 46324-2692, 1 year, 52 issues, $259. Visit the web site at www.dowtheory.com.
