abcnews.go.com
Counting Down
As Earnings Fall, Some Wonder: Has Accounting Inflated the Entire Market?
By Peter Dizikes
ABCNEWS.com
N E W Y O R K, April 22 — When General Electric sneezes, corporate America often catches cold. And that, in turn, may yet send a chill throughout investors everywhere.
Indeed, the stir created by GE's announcement this month of a decline in quarterly earnings — its first in seven years — concerns more than just the difficult economic climate of 2002.
For one thing, the simple fact that a company many investors regard as the bluest of blue-chips would announce an earnings decline may make other firms more comfortable doing so as well.
Additionally, the announcement came amid pointed questions about GE's accounting practices — particularly its supposed habit of "managing earnings," which the firm routinely denies.
And in the post-Enron business world, with investors bringing a new level of scrutiny to corporate governance, market watchers are examining the ongoing earnings season for bookeeping trends, because of a growing suspicion that the sensational rise in U.S. corporate profits during the 1990s was not just a function of the decade's economic boom, but resulted from dubious accounting practices as well.
Putting these elements together, some observers think publicly traded companies may now be less interested in developing or using controversial bookeeping arrangements that allow them to hit their quarterly projections.
Instead, public companies may now have "a greater inclination to come clean with the truth and then use that as the basis for future earnings expectations," says Anantha Nageswaran, Regional Head of Investment Consulting for Credit Suisse's Asia-Pacific operations, via e-mail.
Nageswaran adds, "I will not be surprised if an increasing number of companies even stop giving so-called 'earnings guidance,'" the quarterly projections stock analysts use to make their recommendations.
Stock Market Still Overvalued?
Two recent studies draw detailed conclusions about the effects of corporate accounting in the 1990s.
The Centre for Economic and Business Research (CEBR) in London has claimed that even after plummeting earnings in 2001, U.S. corporate profits were still overstated at year's end by 27 percent, or $130 billion — and points to suspect bookeeping as a prime cause.
"The figure is likely to reflect a gradual loosening of accounting discipline during the long economic upswing," states the CEBR report.
Given traditonal Price/Earnings ratios and a correction for inflated profits, that would put the Dow Jones Industrial Average in the 5,500-7,500 range, far below its perch above 10,000 in recent months. (See bottom sidebar)
Additionally, a March study by analyst Albert Edwards of investment bank Dresdner Kleinwort Wasserstein suggests that starting specifically in 1997, bookkeeping practices began to have an enormous effect on profits reported by U.S. companies. Like the CEBR study, Edwards compared the earnings public companies announced to the U.S. economy's so-called national-accounts profits — essentially, those reported on companies' tax returns. And he reached a similar conclusion.
"The curious divergence between the stock market and whole economy profits … can be explained by the appetite in the U.S. for creative accounting," writes Edwards.
‘The Stress of Making Numbers’
As it happens, 1997 came during the middle of the technology-inspired stock-market frenzy, a year in which the Dow Jones Industrial Average rose a whopping 23 percent and the tech-loaded Nasdaq index increased 18 percent. Experts in accounting ethics say the pressure companies felt to declare breathtaking bottom-line results led some to try new — and potentially suspect — bookeeping techniques.
"The stress of making numbers in the late 1990s got so great, people tried things we had not really seen before," says Wayne Shaw, professor of accounting at Southern Methodist University in Dallas. "They pushed the limit."
Some of the techniques, like the use of special purpose entities (SPEs) to mask debt, or the proliferation of swapping commodities among firms in the same industry, have gained notoriety due to the collapse of Enron and bandwidth-trading telecom firms.
But many people agree the accounting treatment given to executive stock options played a role as well. According to current U.S. standards, options do not have to be tabulated as an expense — and they can provide incentive for managers to inflate short-term earnings to pump up a company's share price, sometimes to the detriment of long-term investors.
"The temptation to do so [inflate profits] will have been particularly strong where executive renumeration depended on the level of declared profits," states the CEBR study.
Will Companies Change Their Ways?
This is not to say that every major company has been using accounting tricks to inflate its earnings — or that companies using rainy-day reserves to meet their projected quarterly numbers are up to something suspicious.
"In my experience, managed earnings have been a reality for decades," says Ronald Gruner, head of the investor-relations firm Shareholder.com, which counts many publicly traded companies among its clients. "The reality is that the marketplace has a very high grow emphasis on predictable growth. A good CFO has for years managed to have reserves in place. Managing earnings but doing that in a visible, explicit manner might be viewed as a sign of strength."
And General Electric, for one, has made well-publicized efforts to disclose more information on its latest financial reports — which could have a trickle-down effect on other companies.
Nageswaran says that because of GE's past success, the company "does set the standard for corporate governance. Hence, any step it takes to become more or less transparent would have the natural effect of setting a benchmark."
In this regard, adds Gruner, "I'd say GE is highly influential." But he also claims a trend toward increased disclosure was visible even last summer, before the Enron implosion.
If increased disclosure does lead to some quarterly shortfalls, it could be painful for shareholders. But Shaw thinks lower earnings expectations would be healthy in the long run, if they forced investors to consider a company's overall health instead of short-term earnings projections.
"You just hope somebody's going to think it's reasonable for a firm to say, 'We're making long-term changes even if it costs us a little bit in the short term,'" Shaw says.
---------------------------------------------------------------------------------------------------------------------------------------------------------------------
BOTTOM SIDEBAR
Where the Market Would Be — And Where It Could Go
If corporate profits have indeed been pumped up by accounting maneuvers in recent years, without investors fully catching on, then where should the major stock indexes really stand?
There is, of course, no "proper" price for a stock, just what the market will bear. But the primary method used for valuing stocks, the Price/Earnings ratio, measures the cost of a share compared to a company's earnings. And by using historical P/E standards, it is possible to estimate where the markets would be without the apparent aggressive accounting of the 1990s.
A recent Centre on Economic and Business Research report says that given traditional P/E ratios, the Dow Jones Industrial Average should be in the 7,000-9,500 range if the reported profits have been accurate. But the study notes, "if our conclusion about over-statement of profits is correct, this range [becomes] 5,500 to 7,500. The likelihood must be that there are more Enrons, accounting black holes and document shredding to come."
Anantha Nageswaran, regional head of Investment Consulting for Credit Suisse's Asia-Pacific operations, has recently suggested that pumped-up accounting has kept the U.S. stock markets high (along with factors like investor confidence in an economic rebound). Correcting for accounting, S&P 500 index of major companies could be valued in the 885-1,042 range, according to its current P/E ratio of 22. That would drop to the 644-758 range, using the long-term historical P/E average of 16.
The Dow closed Friday at 10,527.11, and the S&P 500 closed at 1,125.17.
Those kinds of plummets would futher pain investors who have already seen the market drop from its historical highs of two years ago. But some observers believe they would be more in line with traditional economic reality.
"You're still seeing the market using multiples that still don't make a lot of sense," says Wayne Shaw, professor of accounting at Southern Methodist University in Dallas. About the role accounting may have played in jacking up reported profits, he adds: "It's not clear to me that everybody understands that yet."
— Peter Dizikes, ABCNEWS.com
---------------------------------------------------------------------------------------------------------------------------------------------------------------------
KJC |
