Companies use every trick to pump
earnings and fool investors. The latest abuse: "Pro forma" reporting
simply a matter of creative accounting," says Matthew Broderick, playing
bean counter Leopold Bloom in the hit musical The Producers. "Under
the right circumstances, a producer could make more money with a flop than
he could with a hit." Max Bialystock, Bloom's client, immediately sees the
potential for solving his money woes. He raises as much as he can from rich
widows to finance a new Broadway musical, Springtime for Hitler. He
blows the money on himself, intending for the show to bomb so that nobody
will ask awkward questions.
For all the hoopla on the Great White Way, Bloom is a primitive in the
numbers game. He's operating without pro forma accounting, which allows all
kinds of fictions in the way companies present their earnings. In the great
bull market of the 1990s, companies and their CEOs used aggressive tricks to
deliver the continually rising sales and earnings that Wall Street wanted to
see. It's gotten far worse in the market slump. The pricking of the Wall
Street bubble has stepped up pressure on desperate CEOs to shore up earnings
ravaged by the sudden economic slowdown. Whether it's boom time or bust,
companies have cast aside constraints on how they report sales and earnings
to the public. They are dodging accounting rules built up over decades,
choosing instead a slew of unconventional and often questionable practices
that would turn Bloom green with envy.
Sure, companies have always tried to present themselves in the best possible
light. But some of today's practices, though perfectly legal, sail close to
the wind: They seem designed to mislead unwary investors about the real
financial state of companies that use them. Fading dot-coms, new tech
giants, and venerable blue chips all hype their earnings. Cisco Systems Inc.
subtracts payroll taxes on employee stock options in its earnings-per-share
numbers. IBM lifts its earnings by assuming it would pay less into its
pension fund, and Motorola Inc. boosts sales by lending huge sums to
customers. "CEOs were obsessed with growth," says Christopher M. Davis,
portfolio manager at the family firm of Davis Selected Advisers. "They, as
in the past, tortured accounting to produce income statements that would be
applauded by Wall Street."
The full extent of bad stuff that happened during the boom is only now
becoming clear--and it is worse than anyone thought. Ordinary investors and
Wall Street pros alike are beginning to cry foul.
What's alarming them is that the games affect the stock market and its
integrity every day. It's getting harder to answer the basic questions that
underlie rational investment decisions. What is a company's bottom line? Is
it making money or not? What is the price-earnings ratio on its stock? The
answers are all over the place.
Variations in how companies report their results make it harder to know if
their valuation is cheap or rich compared with their peers and the rest of
the market. Chipmaker Intel Corp. includes gains from stock investments in
its preferred earnings measure; Cisco does not. And with inconsistent
numbers seeping into calculations of p-e's for the major indexes, it's
harder to gauge whether the market is valued high or low compared with the
past. Companies "are destroying the credibility of the profits they are
producing," says Robert Olstein, manager of Olstein Financial Alert, a
mutual fund. "There is no way some of these companies were growing at the
rates they were representing."
CREDIBILITY GAAP. The emergence of pro forma accounting is what
enables companies to play the numbers game to the hilt. Tech companies in
particular discovered a powerful new way to obscure what was really
happening in their often shaky businesses. Traditionally, pro forma accounts
were a way of giving an idea of what earnings would look like in completely
new businesses or in those that would result from a merger. But real New
Economy companies now conjure up a second set of figures--created outside
generally accepted accounting principles, or GAAP, which still must be used
in reports to the Securities & Exchange Commission--and call them pro forma.
"It is open season [for companies] to say what they want in press releases,"
says Chuck Hill, research director at Thomson Financial/First Call, an
earnings tracking service.
GAAP is a set of accounting rules hammered out by regulators, companies, and
their auditors over decades. It aims to give a fair and true picture of a
company's financial position and make it harder for executives to hype their
results. GAAP rules are applied to every company, no matter what its
business or stage of development. A small biotech startup with little more
than patentable ideas is treated the same way as a fast-food empire or a
giant auto maker with billions invested in plants. Some companies argue that
GAAP isn't always the best way of measuring how they're doing. And on some
points, even skeptical investors agree with them. But the virtue of GAAP is
that it is the most consistent and objective way to compare results across
companies and industries.
That can't be said of pro forma. Each company uses it any way it wishes.
Yahoo! Inc., one of the first to emphasize pro forma, in January, 1999,
presented results 35% better than GAAP by excluding a variety of costs of
buying Internet companies. In its latest set of results, issued on Apr. 11,
Yahoo excluded yet more items, such as payroll taxes on stock options. Data
center operator Exodus Communications Inc., in its version of pro forma,
also excludes some acquisition costs, but apparently not options taxes.
Network Associates Inc. (table, page 106), meanwhile, conveniently drops a
loss-making 80%-owned subsidiary, McAfee.com Corp., in working out its pro
forma results, which show only half the loss reached under GAAP. In a Mar.
27 press release, software company Xcare.net Inc. reported revenues before
subtracting the cost of warrants to buy Xcare shares that it gave to a
customer. The value of the warrants was given lower down in the release, but
the headline numbers boosted the company's apparent sales by 69% and cut its
losses by 40%. Xcare Chief Financial Officer Gary T. Scherping says he
wasn't trying to fool anybody. "I could probably have come up with another
three things that I could have excluded had I wanted to play those
games...that other people regularly do," he says.
Amazon.com Inc. can't even settle on a single definition of pro forma. In
its Apr. 24 results announcement, it reported a "pro forma operating" loss
of $49 million in the first quarter of this year. Confusingly, it also
reported a "pro forma net" loss of 21 cents a share, equivalent to $76
million. Investors had to pick carefully among a slew of numbers to see that
Amazon actually had a net loss of $234 million, or 66 cents a share, using
GAAP. Among the items excluded from pro forma operating losses were a net
interest expense of $24 million and a $114 million charge for restructuring
costs, such as closing a warehouse. "The pro forma numbers are how we think
about our business" and how Wall Street analysts follow it, says Amazon
spokesman Bill Curry, emphasizing that the GAAP numbers are included.
The magic of pro forma can turn losses into profits. That's just what
happened at Computer Associates International Inc., whose accounting was
challenged in an Apr. 29 story in The New York Times. By changing the
terms of its software sales and how it accounts for them, CA reported 42
cents of pro forma earnings per share in the final quarter of last year, vs.
a 59 cents loss under GAAP. Company officials say the new presentation is
actually more conservative and not done to enhance growth. Similarly, giant
telecom carrier Qwest Communications International Inc. reported $2 billion
in quarterly earnings before interest, taxes, depreciation, and
amortization, or EBITDA, an early version of pro forma, in a Jan. 24
release. Shareholders had to wait weeks to find out, in a footnote to the
annual results, that Qwest actually lost $116 million, according to GAAP
rules. Qwest says the variation is extreme because of adjustments for its
takeover of US West Inc.
Some companies with profits can really give themselves a lift. Take
Quintiles Transnational Corp., a number cruncher that sells statistical
services to the drug industry. In press releases, it excludes the costs of
Internet operations when it reports earnings from "core operations." The
result: a 77% higher net income. Quintiles' investor relations officer, Greg
Connors, says there's nothing wrong since GAAP results are attached: "We
thought this was the best way to describe ourselves to the market."
Including the cost would make it hard for investors to compare Quintiles
with rivals that don't invest so much in the Net, he says, calling the cost
"unusual." But the expenses aren't a one-time event: They have been going on
for a year, and they are continuing.
The spread of pro forma earnings has plunged investors into an
Alice-in-Wonderland world. SEC Chief Accountant Lynn E. Turner calls pro
forma results "EBS earnings"--for Everything but Bad Stuff. "Way too often,
they seem to be used to distract investors from the actual results," Turner
says. Wall Street, of course, is happy to play along: First Call's Hill says
more than 260 companies have persuaded a majority of top financial analysts
to abandon GAAP when making earnings estimates.
Pro forma is the most egregious of the numbers games. But new variants of
old accounting tricks are also flourishing throughout the corporate world.
Here are the gambits for which investors should be on the lookout:
-- VENDOR FINANCING. Pressure from Wall Street for ever increasing
sales generated lots of bad numbers as high-tech companies took to
overstating their revenues by lending big to customers. In moderation,
vendor financing is a sound selling technique; abused, it's a dangerous way
to do business. Just ask some telecom-equipment suppliers: By the end of
2000, they were collectively owed as much as $15 billion by customers, a 25%
increase in a single year. Effectively, they were buying their own products
with their own money, exaggerating the size and sustainability of their
sales and earnings growth. "It is only now, in hindsight, that it is turning
out that it wasn't real revenue growth at all, just bad receivables," says
Hank Herrmann, chief investment officer at Waddell & Reed Financial Inc., a
Investors were spooked to discover, deep in a company filing to the SEC on
Mar. 30, that Motorola is owed $1.7 billion by Turkey's No. 2 wireless
carrier, Telsim. In a Feb. 3, 2000, press release announcing a $1.5 billion
order from Telsim, Motorola made no mention of any loans. "That is a risk I
would have liked to have known about years ago," complains portfolio manager
Davis. The risk is not just that the customer won't pay, but that the
customer won't buy more products unless Motorola lends it more. Since the
original announcement of the Telsim order, Motorola stock has fallen 69%,
losing about $75 billion of its market value. Motorola says it properly
disclosed its financing practices in filings to the SEC. The loan is backed
by a claim on "significantly" more than half of Telsim's stock, says
spokesman Scott Wyman.
Employee stock options have proved useful throughout the economy in
recruiting and holding staff. But companies don't have to deduct the cost of
options from their income, as they must for wages paid in cash. So they have
a powerful tool to pump up profits in the short run--at the cost of diluting
ordinary shareholders' equity as employees exercise their options. A handful
of companies, such as Boeing Co. and Winn-Dixie Stores Inc., decline to play
that game, and charge the estimated value of options immediately. But most
don't expense the costs--some to terrific effect. At coffee chain Starbucks
Corp., for example, expensing the value of options would have reduced
reported net income by $28 million, or 30%, in the year through October. At
Cisco, it would have reduced reported income by $1.1 billion, or 42%, in the
year through July. Furthermore, the compounded annual growth of Cisco's
reported net income for the three previous years would have sunk to 33% from
41%, according to Bear, Stearns & Co. accounting analyst Pat McConnell.
Veteran short-seller James Chanos of Kynikos Associates Ltd. calls the
treatment of options "a national outrage... an ongoing shame."
Aggressive options accounting makes overall corporate profits look much
higher than they really are. McConnell of Bear Stearns figures the average
earnings growth rate for companies in the Standard & Poor's 500-stock index
with options fully expensed would have been cut from 11% to 9% for the three
years to mid-2000. But the information is hard to come by. Companies are
required only to disclose their option costs in a footnote to their annual
-- SQUEEZE AND STRETCH. Companies that need to show earnings growth
can help themselves by booking sales early or costs late. For instance,
software company MicroStrategy Inc. reported revenue in three quarters in
1998 and 1999 based on contracts it did not complete until after the
quarters had ended, the SEC found. The company restated three years' worth
of profits to losses and settled the matter with the SEC, neither admitting
nor denying the allegations. Three corporate officers agreed to pay
penalties totaling $1 million.
More companies than ever are boosting earnings by changing assumptions that
will lower their reported expenses, says the SEC's Turner. Typically,
executives use stratagems such as extending the expected life of assets to
reduce depreciation charges or betting that they'll have fewer bad debts.
Reader's Digest Association Inc. became more optimistic about the number of
customers who would pay their bills on time and gained about 16 cents a
share in last year's December quarter, says fund manager Olstein. Reader's
Digest spokesman William Adler says the company's collection estimate "is
not put in to affect income in any way." He says the estimate was raised
properly, because its mix of business had shifted from books toward
subscriptions, which are more likely to be paid.
In some cases, there has been no change in assumptions at all, but a
questionable judgment from the start. The SEC recently took issue with
Verizon Wireless Inc.'s decision to amortize the cost of its wireless
licenses over 40 years instead of 20 years or less. The longer amortization,
which Verizon says is appropriate because the licenses are renewable, helps
earnings, but assumes the licenses will never lose value because of another
Company pension plans can become a fruitful source of extra earnings.
Companies can't generally take money out of their pension funds, but by
juggling several factors, including the actuarial present value of benefits,
interest rates, and expected returns on assets, they can reduce or even
eliminate what they have to pay into their plans in any given year,
according to Gabrielle Napolitano, accounting maven at Goldman, Sachs & Co.
For example, IBM picked up $195 million--1.7% of pretax income--in 2000,
when it raised the expected rate of investment return from 9.5% to 10%.
Companies, of course, would rather have investors imagine that all their
earnings are coming from their businesses. So some try to disguise the
pension lift by lumping it with other retirement benefits costs, says Jack
T. Ciesielski, publisher of the Analyst's Accounting Observer
newsletter. General Electric Co.'s annual report says 6.5% of its $12.7
billion net earnings in 2000 were from "post-employment benefit plans,"
which cover everything from pensions to retiree health plans. Take out the
cost of retiree health- and life-insurance benefits, which are found in
footnotes, and the boost from the pension plan leaps to 9%. With the stock
market in a funk, companies may not be able to count on the same gains in
the future. Indeed, they may have to cough up to keep their plans whole.
-- BIG BATH. The slowing economy is giving a maneuver known as the
big bath a whole new lease on life. A company takes a huge restructuring
charge one year, often when it's making losses or much lower profits than
before. It may sound crazy to make losses look worse, but the ploy gives the
company big help in reducing expenses and enhancing earnings in the future.
On Apr. 16, Cisco announced two whoppers. One charge, of up to $1.2 billion,
is for the cost of laying off workers, closing buildings, and erasing
goodwill from its balance sheet. The other is to write off $2.5 billion of
excess inventory, primarily raw materials that Cisco says have zero value.
Will Cisco sell the inventory, or use it in products later? A Cisco
spokesman said the inventory is worthless and "we have no plans to use it,
Worried about the possible abuse of the big bath technique, the SEC in late
1999 directed companies to disclose sizable charges in more detail. But the
facts are still sometimes hard to find. Even before Computer Associates'
issues with revenue recognition surfaced, analysts were suspicious of its
earnings numbers. Last year, Sterling Software Inc. apparently took a charge
right before being acquired by CA, a move that may have accelerated
operating expenses to the benefit of CA's later earnings, according to
Howard Schilit, head of the Center for Financial Research & Analysis, an
earnings watch service. CA says the charges were described in its filings to
the SEC and notes that it reported lower-than-projected earnings following
How did earnings reports slide into such chaos? It's tempting to finger the
auditors, who after all are supposed to be the first line of defense against
financial chicanery. But that would be too simple. "Auditors are really not
responsible for doing analysis on financial reports," says Schilit. A more
serious problem is that strict accounting is losing its champions within
companies. Fewer and fewer chief financial officers are certified public
accountants, notes the SEC's Turner.
"Everybody is to blame here," says a veteran hedge-fund manager, who admits
that he, too, was buying rising stocks with little regard to how companies
were spinning their numbers. Mutual-fund portfolio managers learned in the
bull market that if they took time to check details in financial reports
before buying a stock, competitors would have already bid up prices.
Analysts at Wall Street investment banks started spending more time
soliciting underwriting business and less time verifying what managements
were telling them, complains Philip T. Orlando, chief investment officer at
Value Line Asset Management Services, a money manager.
AOL'S PAYOFF. Today's abundance of ways of calculating earnings has
its roots in the 1980s heyday of the junk-bond market and, ironically, in
deliberations by the Financial Accounting Standards Board, the major
accounting rulemaker. Purveyors of junk made EBITDA part of Wall Street's
daily vocabulary because it measured how much debt a company could carry in
a leveraged buyout. LBO firms then used it to promote sales of stock back to
the public in the mid-1990s. FASB responded to the interest by considering a
rule under which companies would also report something to be called "cash
earnings" that would have been similar to EBITDA. FASB ultimately dropped
the idea but by then had opened a Pandora's box, encouraging companies to
ignore GAAP as the prime measure of earnings.
But now, with the renewed skepticism that comes amid big stock market
losses, investors and regulators are much less inclined to tolerate
aggressive accounting. "We're going to force better disclosure," promises
money manager Herrmann.
Trouble is, it takes the regulators ages to clamp down on questionable
practices, allowing companies to hoodwink investors in the meantime. For
years, America Online Inc. aggressively deferred the marketing expenses of
sending out millions of computer disks to potential customers. That enabled
AOL to look more profitable than it really was, helping it issue securities
for cash and acquisitions that fed its growth. By the time AOL submitted to
an SEC settlement on May 15, 2000 (without admitting or denying any
wrongdoing), paid a $3.5 million fine, and restated its former income to
losses, the company was home free. It was an Internet giant. Now, AOL owns
communications giant Time Warner and is called AOL Time Warner Inc. "If AOL
were by itself today, its stock price would be a lot lower... [so] the
accounting aggressiveness paid off," says David W. Tice, a money manager who
publishes the earnings watch bulletin Behind the Numbers.
Under former Chairman Arthur Levitt, the SEC started a campaign against
numbers games in September, 1998 (table). Among the results: a financial
fraud task force, which SEC enforcement chief Richard Walker says has been
"working on some very, very substantial matters, which the public will learn
about shortly." They involve some of the largest companies in the country
and the biggest accounting firms, he says.
Private groups are getting involved, too. At the behest of the SEC's Turner,
Financial Executives International, an organization of financial officers,
on Apr. 26 issued guidelines aimed at reining in the excesses of pro forma
reporting. At the New York Society of Security Analysts Inc., a discussion
group has focused attention on the way Amazon reports its results. Gary
Lutin, an investment banker and co-sponsor of the group, says: "I hope we
are helping to accelerate the natural process of the cycle" back to
reality-based financial reporting. Apparently, he has made some progress.
Amazon included a table reconciling pro forma and GAAP data in its latest
Still, cleaning up financial reporting won't be easy, given that the stakes
for companies are so high. But so are those for ordinary investors whose
wealth and retirement prospects are ultimately on the line in the numbers
Unless they and their advisers want to end up as thoroughly fleeced as Max
Bialystock's rich widows, they need to pay a lot more attention to the
numbers than they did during the bull market.
Corrections and Clarifications
In "The numbers game" (Cover Story,
May 14), a table incorrectly stated that the Securities & Exchange
Commission was expected to revise its revenue-recognition guidelines.
With Christopher H. Schmitt in Washington
Copyright 2000- 2007 by The McGraw-Hill
All rights reserved.