Tweaking Numbers to Meet Goals Comes Back to Haunt Executives
By ALEX BERENSON
The New York Times
6/29/02
On Wall Street, it is called backing in.
Each quarter, analysts at securities firms forecast the profit per share of the companies they cover. Companies whose profit falls short of the consensus estimate can be severely punished, their stocks falling 10 percent or more in a day.
So some companies do whatever they have to to make sure they do not miss that estimate. Instead of first figuring out their sales and subtracting expenses to calculate the profit, they work backward. They start with the profit that investors are expecting and manipulate their sales and expenses to make sure the numbers come out right.
During the last decade's boom, as executive pay was increasingly based on how the company's stock performed, backing in became both more widespread and more aggressive. Just how much so is only now becoming clear.
Just yesterday, Xerox said it was reclassifying $6.4 billion in revenue from the late 1990's.
That announcement followed WorldCom's report Tuesday that it had hidden $4 billion in expenses in 2001 and this year. Since the collapse of Enron prompted investors to scrutinize corporate accounting more carefully, scores of public companies have admitted overstating earnings.
For years, Wall Street has known that companies manage their earnings. Academic studies have found that actual earnings do not fall randomly around the consensus estimate. Instead, they tend to come in at or just above the forecast. Some companies, like General Electric, almost always seem to beat estimates by a penny or two a share, no matter what the economic climate.
"Did Microsoft manage earnings? Does G.E. manage earnings?" said Jon Brorson, who oversees $65 billion in stock investments for the Northern Trust Company in Chicago. "Sure, we all know that. If G.E. needs to make a penny this quarter, they'll take it out of next quarter."
That fact in and of itself is not particularly surprising or disturbing, Mr. Brorson and other money managers say. Managements try to give investors what they want, and companies whose earnings are predictable are prized on Wall Street, which does not like unhappy surprises.
But the current wave of financial fraud is very different, professional investors say. Analysts and investors always assumed that earnings management happened on the margins, as companies pushed earnings higher or lower by a penny or two a share to mask the normal volatility of their businesses.
Now it seems that many companies took advantage of loopholes in accounting rules to make their reported profits seem much bigger than the cash they were really generating. Others went further, committing outright fraud.
The difference between earnings management and the multibillion-dollar gimmicks acknowledged by WorldCom and Xerox this week is like the difference between speeding and murder, Mr. Brorson said.
But the slope from earnings management to earnings manipulation to fraud is a slippery one, and during the boom the incentives to cheat became ever more compelling.
As companies like Cisco Systems and Microsoft reported year after year of booming sales and profits, investors began to believe that the surest route to riches was to buy stocks of companies with rising sales and profits, whatever their price.
A company that became a favorite of these new investors could have an extraordinarily quick rise in its stock. As stock option packages became more lucrative, top executives could make tens or hundreds of millions of dollars after only a year or two of good performance.
Unfortunately, many of those new investors were highly fickle, and companies that disappointed them by missing earnings targets could see their shares plunge.
As for executives at companies that had not shared in the boom, they became eager to win a share of investors' largess by showing that they, too, were running fast-growing businesses.
So more and more companies took advantage of loopholes in the accounting rules. That task was made easier because many investors, even professionals, do not understand how much flexibility companies have to alter their results under standard accounting rules.
One hedge fund manager recently compiled a list of 20 tactics that can be used to make sales or profits seem better than they are. The list is far from comprehensive, but it offers a glimpse of the many ways companies can manipulate.
They can book sales several years before they will be paid, as Computer Associates did, according to some current and former employees. Computer Associates says its accounting is proper.
They can use closely related companies to conduct research and development for them, moving those expenses off their books, as Lernout & Hauspie, a Belgian software company in bankruptcy, did.
They can claim that operating expenses, which should immediately be deducted from revenues, are actually capital expenditures like investments in factories and equipment, which are deducted over many years, as WorldCom did. They can increase revenue by offering incentives for wholesalers to buy more of their products than retailers are selling, as Bristol-Myers Squibb did.
Sometimes, these strategies create telltale signs on corporate balance sheets or income statements. Other times, investors have little way of knowing.
After being scalded so many times, investors are wary of any company whose accounting appears less than pristine. Entire industries — including telecommunications companies, energy trading companies and cable companies — are now having difficulty selling new issues of bonds and stocks. The Standard & Poor's 500-stock index has fallen 15 percent since March, even though the economy appears to be solidly in recovery.
Mr. Brorson said he would like to believe that this week's announcements were the high-water mark of the post-boom accounting scandals. But he said he was not sure.
"You hope," he said, "that this is the edge here." |
