7 deadly sins of corporate accounting
Here’s a look at who’s likely to ‘fess up as the new, more virtuous era of bookkeeping begins. Expect earnings to take a hit.
By Michael Brush
Even if there are no more disasters like Enron (ENRNQ, news, msgs) lurking out there, one thing’s for sure: We’re moving into an era of stricter accounting standards that will clip the earnings outlook -- and stock prices -- for lots of companies.
As an investor, you need to get familiar with the most common accounting ploys – like the ones outlined below -- so you can steer clear of companies abusing them. Pressure from Congress and regulators is likely to make executives get religion on accounting and back away from aggressive practices over the next few quarters.
“I think we are going to see hundreds of companies restate their earnings,” says Joseph Whall, of the Auburn Hills, Mich.-based Whall Group, which specializes in forensic accounting. “I am not suggesting we will see egregious fraud across the board, but we will see substantial changes in the accounting process.”
“We don’t even know what we don’t know,” agrees Mike Mayo, who covers the banking sector for Prudential. But that will start to change soon, he says -- in part because the Securities Exchange Commission (SEC) is asking companies to reveal more of these borderline practices when they release 2001 annual statements. They’re due out by the end of March.
Sectors most likely to get hit, says Harvard accounting professor David Hawkins: technology, especially telecom, and financials. But here’s another way to look at it. “Any company that ever beat the number by a penny is suspect,” says William Fleckenstein, of Fleckenstein Capital in Seattle.
Here are some of the most common pitfalls in this new post-Enron era of accounting.
Pro forma earnings
In plain English, the phrase means “as if.” Companies use pro forma earnings to show what profits would look like if certain “one-time” expenses weren’t there. That’s a good thing -- because investors need to know how the real core business is performing. The problem is, many companies these days boost pro forma earnings by categorizing regular, ongoing costs as “one-time” expenses. “There is nothing wrong with nonrecurring charges,” says Sean Reidy of the Olstein Financial Alert Fund (OFAFX, news, msgs). “But if you have them every year, they aren’t non-recurring.”
As an example, analysts such as Reidy and Prudential’s Nicholas Heymann point to Whirlpool (WHR, news, msgs), which regularly excludes lots of costs for restructuring and product recalls. At the same time, it books income from things such as pension investment returns and foreign tax credits -- items that are not really a part of the core business. This is one reason Heymann has a “sell” rating on the stock.
Prudential’s Mayo says banks are reporting more one-time charges for loan losses that should really be classified as ongoing business expenses. “It is hard to find banks that have not abused one-time charges,” he says. Special charges were 13% of earnings in 2001, up from an average of 5% over the past decade.
Edward Ketz, an accounting professor at Pennsylvania State University, points to ongoing restructuring charges at Cisco Networks (CSCO, news, msgs), Procter & Gamble (PG, news, msgs) and Amazon.com (AMZN, news, msgs) as examples. The SEC recently cracked down on Trump Hotels & Casino Resorts (DJT, news, msgs) for its use of pro forma reports, signaling a tougher stance going forward.
Overestimated pension fund returns
Big companies that manage lots of pension money for employees rely on overly optimistic market returns to come up with rosy earnings projections, say critics. “Any pension plan that has assumed rates of return in the 10% to 11% range is highly questionable,” says Robert Rodriguez of First Pacific Advisors, a value manager in Los Angeles. He thinks combined stock and bond returns in pension funds will be more like 5% to 7% per year, over the next several years. One offender is IBM (IBM, news, msgs), which assumes returns of 10%, says Fleckenstein, who has a short position in the stock. Prudential’s Heymann thinks Whirlpool’s assumed rates -- in the same range -- mean that the company may have to dig into cash to fund pensions at some point.
Use of stock options instead of cash to pay managers
Right now, companies don’t have to book expenses when they pay employees with stock options. Critics say this overstates profits, and they are lobbying for a change. “If options are going to be counted as expenses, you can write off the tech sector,” says David Rocker, of Rocker Partners. A Merrill Lynch study last summer, for example, found that 2000 profits at the top tech companies would have been 60% lower if options were counted as expenses. Even if the rules don’t change, tech companies face another problem, says Rodriguez. “As long as market remains languid, managers will require more cash compensation than option compensation,” he says, pointing out the same thing happened during the market doldrums of 1968-1974.
Off balance-sheet activities
“Special purpose entities,” or independent companies set up to handle some aspect of a company’s business at a safe distance, can be a great management tool. They’re a good for transferring risks from one business to investors who understand and accept them. But the potential for abuse is so great, accounting sleuth Howard Schilit of the Center for Financial Research & Analysis searches legal data bases to find such arrangements he can scrutinize. Enron, of course, abused these off-balance sheet vehicles to the max. You can expect more of these – good or bad -- to surface since the SEC is putting pressure on companies to report them in financial statements.
Prudential’s Mayo points to a troubling rise in exposure among banks to loans that you won’t find on their balance sheets. This stems from deals where clients pay an up-front fee for the right to draw down a loan later. Sounds innocent – until you consider that Enron used these to hit up banks for $3 billion before declaring bankruptcy. Even if banks don’t lose the money loaned in these deals, they may have to add to reserves to offset the hidden credit lines. This can hurt earnings and stock prices -- as U.S. Bancorp (USB, news, msgs) investors learned last October. Banks with the highest off-balance sheet loan exposure are J.P.Morgan Chase (JPM, news, msgs), Comerica (CMA, news, msgs), BankOne (ONE, news, msgs), FleetBoston Financial (FBF, news, msgs), SunTrust Banks (STI, news, msgs), Wachovia (WB, news, msgs), Bank of America (BAC, news, msgs), U.S. Bancorp, PNC Financial Services (PNC, news, msgs), Citigroup (C, news, msgs), and Keycorp (KEY, news, msgs).
“Mark-to-market” accounting
Companies in fields such as energy, banking and insurance make lots money from long-term contracts promising the delivery of something (such as oil or currencies) in the distant future.
The problem is, the value of what gets delivered shifts daily. Likewise, the profits you can expect from these contracts change as well, as companies “mark” those values to market every day. However, often there’s no liquid market for what’s getting delivered. In this case, companies use models to estimate earnings from contracts.
The assumptions behind those models present a potentially big area for abuse that has yet to surface, says Harvard’s Hawkins. “I would get a little nervous if I found that a large percentage of earnings came from mark-to-market accounting, and that a lot of it was coming from these management models. This is where we are going to have a few horror stories.”
Growth through acquisition
Be wary of companies that regularly produce a lot of growth simply through acquisition. There may not be anything wrong, but it’s an area where investors should be cautious. One tactic is to hold down the results of targets just before purchase, then release a backlog of business to “spring load” the performance of the buyer after the acquisition closes.
“If I were today going to creating a portfolio of stocks to short, I would look for companies that have been very acquisitive,” says Schilit. “I would look for the large, lumbering conglomerates that are not showing simple organic growth.” Recently shares of General Electric (GE, news, msgs) and Honeywell (HON, news, msgs) have come under pressure for this reason.
Round-trip revenue recognition
This is when a company sells an asset to book a profit right now, but then buys the same thing from someone else and spreads the cost over several years by booking it as an asset. Telecom carriers have recently been accused of swapping fiber-optic capacity in this manner -- generating fictitious revenue. There may be more revelations in this field, says Penn State’s Ketz.
Here’s an easier way
A simple short cut to find accounting ploys like many of these is to look for cases where cash flow is a lot less than reported earnings. Harvard’s Hawkins offers another tip: Look beyond the Wall Street stock reports and pay more attention to the bond analysts at Wall Street brokerage firms, who typically take a more rigorous look at financials. “The bond market and bond analysts signal problems faster than the equity market,” Hawkins says.
At the time of publication, Michael Brush owned shares in the none of the companies mentioned in this column.
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