Not-so-special charges
In spite of regulators' efforts, corporations continue to push huge expenses into the background, encouraging investors to focus on operating results
chicagotribune.com
By Andrew Countryman
Tribune staff reporter
October 26, 2003
As the earnings season winds down, investors once again are seeing the "unusual" become routine.
U.S. companies are recording billions in so-called one-time charges to profits for store closings, layoffs, lawsuit settlements and for the ever-popular corporate restructuring.
Despite new restrictions by regulators, firms still push huge costs into the background, encouraging investors to look beyond them and focus on their operating profits.
In recent years the gap between the true bottom line and operating profit has widened dramatically, although it shows some signs of narrowing this year. Critics say some firms are inappropriately labeling routine costs unusual and should not be reporting non-recurring events quarter after quarter after quarter.
Indeed, critics have dubbed these profits excluding one-time items, known as pro forma results, as "earnings before the bad stuff."
"The expectation is that the investor should ignore this," said Ram Ramakrishnan, an accounting professor at the University of Illinois at Chicago. "Companies abuse this so much."
Firms that break out special items note that they also report the actual bottom line, and that shareholders want to know how the core of the business is doing.
"We do separate out special charges because it's the most meaningful way of separating out strategic events for our investors," said Hoffman Estates-based Sears, Roebuck and Co. spokesman Chris Brathwaite.
In the third quarter, Sears took a $141 million pretax charge related to closings and other changes at its Great Indoors stores.
In the previous three years, Sears took more than $900 million in pretax items, including $111 million for Eaton's store conversions in 2002, $205 million to shutter its HomeLife stores in 2001 and $136 million for store closings and staff reductions in 2000.
Some critics say store closings are a routine part of a retailer's business, but Brathwaite said such charges are common among its competitors, and Sears takes them only as part of a strategic shift.
"We do open and close stores and we don't separate them out," he said.
Sears is far from alone with one-time items.
In the Chicago area, the 25 largest companies took more than $4.8 billion in such charges last year, according to Tribune research--on top of nearly $10 billion in 2001.
The largest charges have come from Schaumburg-based Motorola Inc., which separated more than $6 billion in after-tax special items in 2002 and 2001.
The tech giant has identified more than $1.6 billion in pretax severance charges during 11 of the past 12 quarters, including $48 million in the third quarter, its largest one-time item.
Motorola spokesman Bill Parke said the company provides results without one-time items to help improve comparability of results from its core operating business from quarter to quarter. He said it has specific guidelines on what qualifies as special items, based on circumstances relating to specific restructuring efforts.
These one-time items, Parke said, "require a rigorous analysis specified in accounting rules related to the specifics of the restructuring action."
SEC requires reconciliation
A new Securities and Exchange Commission rule requires firms to reconcile pro forma data with results under generally accepted accounting principles, or GAAP, which prohibit excluding expenses from the bottom line.
But the rule only covers in general terms what can be included in the pro forma results. The more expenses that companies lump into one-time items, the better the core business looks, justifiably or not.
Accounting rules require a cost to be unusual and infrequent to be deemed an "extraordinary" item, and the rules have been tightened significantly in recent years.
But, experts say, firms have far more latitude in separating "unusual" or "non-recurring" items. Layoffs or restructurings in different divisions, for example, are used to justify several charges.
"Anybody can call anything non-GAAP," Ramakrishnan said.
The decisions as to what goes into the charges, and what doesn't, give companies wiggle room to help show more stable growth in operating profits, Ramakrishnan and others said.
Revenue, of course, is the same in GAAP or pro forma results. But firms, for example, can dampen or eliminate one-time items when times are good--making next year's comparisons easier--or bulk them up to reduce expenses and meet earnings targets during a downturn.
"If you keep on doing this, a series of non-recurring items ... it reduces the quality of earnings in a huge, huge way," said DePaul University accounting professor Kevin Stevens. "It's clear they're managing the earnings."
Sunbeam an example
Take the case of Sunbeam Corp.
Last year, former Chief Executive Al Dunlap and former Chief Financial Officer Russell Kersh settled charges they used improper accounting to mislead investors. The SEC alleged that, shortly after Dunlap was hired to turn around the company, it improperly padded a $337 million restructuring charge to create a reserve which it then used to boost results over several quarters.
The Financial Accounting Standards Board is working to head off this sort of activity by preventing firms from taking huge "big bath" restructuring charges upfront.
Most issues around one-time charges, however, are more subtle.
"It's a presentation issue," said Rebecca McEnally, a financial reporting expert and vice president of advocacy at the Association for Investment Management and Research. "If these are a normal and recurring part of business, they shouldn't be broken out and characterized as something they are not."
Charges often ignored
But it's clear investors and even analysts who provide research on which investments are made frequently look past charges.
Earnings growth data and price-earnings ratios often are calculated without one-time items. Indeed, though Motorola reported a net loss of $2.5 billion, or $1.09 per share, in 2002, analysts tracked by the widely followed Thomson First Call service used results excluding special items--a profit of 14 cents per share.
"The crux of the matter is whether firms use this practice to exaggerate earnings and thereby mislead investors," Cleveland Federal Reserve experts wrote in a study this year.
Evidence suggests larger one-time items are associated with lower future cash flows, they said: "The experience of the late 1990s suggests that investors were too credulous."
Regulators react
That has prompted regulators and rulesmakers to step in.
The rule requiring firms to reconcile pro forma and GAAP results, McEnally said, provides "a certain discipline" for executives, making them more circumspect in the use of one-time items.
She said the SEC also wants firms to describe one-time items in more detail, rather than lumping them together and labeling them non-recurring.
The SEC has told companies it is dubious of charges that have occurred more than once in two years, or are likely to occur again within two years.
"Merely labeling an item non-recurring does not make it so," the SEC staff advised firms this year.
But the SEC and various experts concede that breaking out one-time items has value, in part because it can actually improve transparency if the costs are described in detail.
"It started very gently," McEnally said, with firms "justifiably" providing numbers that better illustrate ongoing trends.
"That's very legitimate. But then we discovered that companies decided that mechanism could be used to improve their performance."
When truly non-recurring events increase net income, the SEC wants investors to know.
Last week, for example, two former executives of Houston-based Waste Management Inc. settled SEC allegations they misled investors by not disclosing that 1999 first-quarter results were "inflated" by millions in non-recurring gains.
Some firms back away
As the spotlight on one-time items has intensified, some firms are backing away.
Procter & Gamble Co., which took $3.6 billion in after-tax charges over four years during a long restructuring, said this summer the program is largely finished, and it will no longer report "core" results.
Although it will have more productivity initiatives, it said, "Charges associated with these future projects will be absorbed in normal operating costs."
Some companies have been doing it that way all along.
One is Glenview-based Illinois Tool Works Inc., which does not separate out one-time items on its income statement.
"We make it real simple: Our comparability is our actual performance," said spokesman John Brooklier.
"I think it really shows the intrinsic value of the company, and it gives us an operating discipline that we have been practicing for years and years here."
ITW, however, is an exception.
A study earlier this year by the National Investor Relations Institute found that more than half of companies surveyed report both GAAP and pro forma results, and another 16 percent have only recently stopped using pro forma results.
Cracking down on abuses in one-time items is no easy task.
As long as firms report GAAP results, probing what's included in one-time items is hardly the SEC's top priority.
The solution, DePaul's Stevens said, is to have experienced auditors willing to challenge management.
"I need to know a heck of a lot about the business before I can go to the CFO and say, `That's not unusual,'" he said.
"Ultimately, the auditors are absolutely the last line of defense in this," he said. "It has been the big disgrace in my profession--which I'm very proud of--that we have fallen down on this."
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