Interesting article in San Diego Union-Tribune "Camelot? Or Fudge-a-Lot?"
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Dubious accounting could spoil earnings view
March 22, 1998
Camelot? Or Fudge-a-Lot?
The stock market keeps rising, seemingly oblivious to warnings from many companies and analysts that first-quarter earnings will be quite disappointing.
Investors are "looking over the valley" to brighter profits in this perfect economy later in the year, the optimists say.
Never mind looking over. The problem may be overlooking -- that is, overlooking the fact that corporate profits are vastly inflated through dubious accounting.
It's astounding that the Standard & Poor's 500 is selling for about 27 times earnings, which will only grow around 1.7 percent in the first quarter and, at most, 6 percent or 7 percent for the year. Usually, the price-earnings multiple will be equal to the growth rate of earnings.
That's Standard & Poor's operating earnings -- not actual earnings. Operating earnings exclude one-time charges, often related to restructurings and acquisitions.
Too many companies take so-called "one-time" restructuring charges over and over again. Really, they often should have been expensed and subtracted from actual operating earnings.
That is just one of the accounting abuses in vogue today.
How much of a difference do these one-time charges make?
In last year's fourth quarter, profits of 665 large companies followed by The Wall Street Journal rose only 1.3 percent. But without the nonrecurring charges (as well as some nonrecurring gains), operating profits rose 11.7 percent in the quarter.
And that's what Wall Street looks at.
Similarly, Business Week magazine found that in the fourth quarter, net income didn't grow at all. Without special charges, however, operating net was up 10 percent.
And Wall Street just looks at that operating figure.
It's like sinners: They cheat, steal and raise hell all week, and then get atonement Sunday morning, the only time the preacher sees them.
In its March 23 edition, Forbes magazine has an excellent story about phony accounting, called "Pick a number, any number."
The story quotes William Leach, an analyst for Donaldson Lufkin & Jenrette: "The accounting has really gotten perverted. It's reached the point where managers earn what they think they should earn."
Forbes says: "Restructuring charges are today's favorite. A nice, fat write-off can help your stock. If it is big enough, it can make your return on equity look better. Since one-time charges don't penalize current or future earnings and don't hurt stock prices, it is tempting to overstate them."
Later, when things slacken, you can restore some of the write-off, thereby boosting profits. It's called "Big Bath Accounting," Forbes says.
The Big Boys do it. Forbes says General Motors recently took a fat one-time charge -- its fourth in seven years. In the last 11 quarters, Kellogg has taken nine streamlining charges.
As I have related in previous columns, the ledger-demain takes a number of forms.
The merger and takeover movement is a major factor in the stock market's run, and also a major reason why earnings are overstated: One company will buy another on the last day of the year and then put its full-year earnings onto the books.
Also in acquisitions, two companies with disparate fiscal years will combine and perhaps just dump a month or two out on to the cutting floor, as if they never had existed. And a lot of bad news may be tossed into the months to be erased.
In San Diego, we have seen biotechs setting up off-balance sheet financing so that research and development spending doesn't hurt earnings (or make losses worse). Similarly, companies on madcap acquisition sprees write off the costs of buying and integrating other companies.
Depreciation and inventories are often manipulated. Sales may be booked as soon as a product is shoved out the door, rather than when a customer has made a firm commitment, backed up by funds.
"Anyone in this business has a strong feeling that the earnings we see reported today are overstated and even engineered," says Tom Clutinger of the money managers Clutinger Williams & Verhoye. "Along comes a big write-off and it's viewed as a positive thing. But when something like that comes year after year from the same companies, it becomes nonbelievable."
Clutinger asks: "How can it be an extraordinary item? Maybe the earnings were poor all along; management should have known something was wrong. Earnings might have been 20 to 30 percent overstated per year."
Indeed, historically, earnings have grown at the rate of nominal (noninflation adjusted) economic output. In the 1990s, profits have been growing at two, three or four times that rate. Some of this reflects outsourcing, job reductions and productivity, but some reflects hanky-panky.
Barton Biggs, global strategist at Morgan Stanley, has exposed much accounting corruption. Biggs recently wrote:
"It is well known that the S&P 500 sells at the highest valuations of earnings in history. But it is less well recognized that the index's earnings are overstated."
So maybe you're paying 27 times earnings for earnings that in actuality are declining. Economist David A. Levy of the Jerome Levy Economics Institute in Mt. Kisco, N.Y., thinks earnings are inflated by 10 percent because of accounting monkey business. |
