| | Will "Pro Forma" Earnings play roll in Lawsuit?
In this morning's Seattle Times, was a very interesting article regarding the often deceptive "Pro Forma" earnings game," which has become an extremely popular hocus-pocus "earnings" reporting method, increasingly used in recent years...especially among many Internet companies which have little or no "real" PROFITS in their balance sheets. And of the many "COMS" (some might say "Cons") which completely BOMBED, following the "Irrational Exuberance" of Internet Bubble this past year of so, I'm sure we can all think of at least one or two particularly egregious examples.
The entire Pro Forma earnings subject is now being seriously looked at by many, including the SEC. Today's article peaked my interest, as it's main focus is specifically referred in the body of the actual class action lawsuit against InfoSpace and Naveen Jain, first reported on 6/19/2001. Among other things, might this case, and other pending lawsuits, end up being test cases for the entire "Pro Forma" earnings reporting game? Perhaps only time (and litigation) will tell.
For example, if you look at the reported INSP First Qt. 2001 "earnings" Press Release, they boldly highlighted (beating Wall Street's expectations) in their press announcement that they lost ONLY -$.02 per share for the quarter ("Pro Forma")...when their ACTUAL true loss was -$.37 per share (using GAAP, "Generally Accepted Accounting Principles"). Thus, using GAAP, their ACTUAL Net loss widened an additional -27% from their "actual" quarter loss a year earlier (1Q2000, actual loss of -$95.3 million, -$.33 per share), and so INSP's LOSS ACTUALLY INCREASED, from the same quarter the year before (1Q2001, actual loss of -$121.1 million, -$.37 per share).
Today's article doesn't specifically mention InfoSpace, but it does contain several similar examples of "Pro Forma" earnings. I strongly suggest anyone interested in the subject, to read the entire article. A few excerpts (bold added by me):
seattletimes.nwsource.com
Monday, July 02, 2001 - 12:00 a.m. Pacific
Slick Earnings Reports Blur Accounting Rules
By Miriam Hill
Knight Ridder Newspapers
PHILADELPHIA - How much did Ariba lose in its most recent quarter?
Was it $7.60 a share, the number according to traditional accounting rules? Or was it the 20 cents a share the California e-commerce company highlighted in its news release?...
...Increasingly, earnings reports, especially those from once-high-flying technology companies, are turning accounting rules on their heads. Today, the view through the news release often offers a blurry picture of how a business is doing.
The SEC has taken note. Its chief accountant, Lynn Turner, recently tried to jawbone corporate America about the importance of clear disclosure. In a March speech, he attacked company disclosures that appeared to "turn straw into gold."...
....His term for many of the earnings reports: "EBS, or Everything but the Bad Stuff."
These earnings come under a variety of names - cash earnings, comprehensive income - but pro forma is the most commonly used. With the rise of tech companies, pro forma earnings have become more common.
The dictionary says pro forma means "as if," or "hypothetical." Critics say "hocus-pocus" might be a better definition.
"It's a new type of accounting trick," said Howard Schilit, president and founder of the Center for Financial Research and Analysis in Rockville, Md. "The pressure companies face during earnings season is, 'You better have a good story,' so they talk about what a terrific quarter they just had, and they need to have a basis for that conclusion.
"They pretty much decide what they would like to highlight and then they have to come up with a descriptor for that. It's sort of like the person who shoots an arrow at a target but doesn't mark the bull's-eye until after the arrow was shot."
Companies have been coming up with interesting ways to report numbers other than net income, the real bottom line,...
...Many accountants find that argument ridiculous....
...In the end, it's all bookkeeping. But here's a funny thing: The bookkeeping rules were pretty clear before the tech boom began. The accounting industry has labored for decades to develop useful standards, known as generally accepted accounting principles, or GAAP.
Many experts say there is rarely a reason to deviate from the principles. The real problem with pro forma earnings is that companies get to decide what to include and exclude, so there's no standard.
"The problem is, a lot of these firms just don't like the story that GAAP tells, and they've got to delegitimize what's in GAAP," said Jack Cieselski, publisher of the Analyst's Accounting Observer, an industry newsletter....
...He said the emphasis on cash earnings ignores information important to shareholders. If a company uses stock to pay for an acquisition, but pays more than the value of the assets on the books, it can expect lower per-share earnings in the future.
At times it may make sense to pay more than a company's asset value, but generally accepted and current accounting rules at least let shareholders know whether such a decision turns out to have been wise.
Ignoring period expenses for intangible assets overlooks an important cost, said Peter Knutson, an associate professor emeritus at the University of Pennsylvania's Wharton School. That's the cost of using up the intangible: the technology, or the licensing agreement or whatever that has to be replaced when it becomes worthless.
"It's the accounting equivalent of eating your seed corn," Knutson said. "When intangibles are gone, they're gone for good if you haven't provided for recovery of them."
In a review of 120 companies, a Wharton accounting professor, Catherine Schrand, found that those that reported an unusual loss one year often failed to mention it the next, making the most recent earnings appear to grow faster, for example.
And making your numbers look better can lead to a higher stock valuation, Hopkins said. His research shows that stock analysts rely on the per-share earnings number that the company highlights, and that number usually makes the financial news, too.
"It becomes somewhat transparent what the motives are here," Hopkins said.....
..."This is basically hocus-pocus and presto-change-o, and don't look at that man behind the curtain, with the actual accounting statements being the man behind the curtain," Knutson said. "They're reporting wishful thinking."...
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Now, here are just a few actual excerpts from the body of the "Class Action" document, which can be found within "Press Release" links by at least two of the law firms who first filed the lawsuit, on 6/19/2001 (bold added by me):
UNITED STATES DISTRICT COURT
WESTERN DISTRICT OF WASHINGTON
AT SEATTLE
Plaintiff: INFOSPACE and NAVEEN JAIN
Class Action: COMPLAINT FOR VIOLATION OF THE FEDERAL SECURITIES LAWS
NATURE OF THE ACTION
1. This is a securities fraud action brought on behalf of all persons who purchased or otherwise acquired the securities of InfoSpace, Inc. ("InfoSpace" or the "Company") between January 26, 2000 and January 30, 2001 (the "Class Period") against InfoSpace and its founder and chairman Naveen Jain (collectively, the "Defendants") for violations of the federal securities laws arising out of Defendants' misrepresentations regarding InfoSpace's results from operations and expected financial performance for fiscal years 1999-2001.
2. Between 2000 and January 2001, Defendants disseminated false and misleading information concerning InfoSpace's actual FY 1999 and 2000 financial performance and Defendants; expectations concerning InfoSpace's FY 2001 revenue and earnings. Defendants manipulated InfoSpace's reported results and deceived plaintiff and other class members during the Class Period into thinking that InfoSpace's reported financial results accurate and that InfoSpace's prospects were improving. In fact, neither InfoSpace's reported FY 1999 and FY 2000 results nor its projected FY 2001 performance were accurate. Defendants' public representations were the result of Defendants' efforts to manipulate InfoSpace's reported earnings and expected FY 2001 performance and were designed to (and did) allow: (I) Jain to sell millions of dollars of his own InfoSpace shares at artificially inflated prices; and (ii) allow Defendants to complete a series of acquisitions using shares of InfoSpace's artificially inflated stock as currency, including the October 2000 acquisition of Go2Net.
3. On January 30, 2001, after Defendants had completed several acquisitions using inflated InfoSpace shares as currency, Defendants disclosed that -- contrary to the representations made by them during 2000 that InfoSpace was experiencing strong revenue growth during 4Q99, and FY 2000 and that InfoSpace would continue to post strong revenue growth through FY 2001 -- InfoSpace would report no revenue growth or EPS for FY 2001, but rather would report declining revenue and significant loss for the year. As Defendants began to reveal some of their improper conduct, including the fact that Defendants' projected revenues and earnings estimates were false, InfoSpace's shares fell to less that $6 per share, a 95% decline from their Class Period high of $138-1/2 per share. (1) Thereafter, as the extent of Defendants' accounting chicanery and other false statements reached the market, the price of InfoSpace shares continued to decline, reaching just $2-1/4 per share on April 6, 2001, when it was revealed that InfoSpace's financial statements had been overstated as a result of Defendant's refusal to pay its employees overtime they were legally owed and record a liability in connection therewith.
4. During the Class Period, Defendants concealed InfoSpace's true operating performance in order to artificially inflate the market price of InfoSpace securities. Each of the releases, SEC filings and other statements by Defendants particularized herein was false and misleading as it misrepresented and/or failed to disclose that Defendants had caused InfoSpace to overstate its financial performance during the Class Period in violation of Generally Accepted Accounting Principles ("GAAP") by, among other things, artificially inflating InfoSpace's revenues and understating InfoSpace's expenses while knowingly misrepresenting Defendants' FY 2001 revenues and earnings estimates. |
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