John - I got this from Forbes mag FYI.
It's getting to the point where reported earnings
in many cases are whatever management wants
them to be. If you overstate, no sweat. Just take
a writedown later.
Pick a number, any number
By Bernard Condon
IN EARLY OCTOBER 1997 a
Connecticut-based food-service
company called Fine Host
Corp. was flying high. Going
public in 1996 at $12, it was at
$42 barely a year later. A
half-dozen analysts followed the company,
including Michael Mueller at underwriter
NationsBanc Montgomery Securities. All were
rhapsodic over its future.
Two months later Fine Host warned investors
that its accounting in recent years was
"aggressive." That day the stock hit $10,
culminating a long decline that wiped out more
than 75% of its alltime-high price.
Just how aggressive the accounting was became
clear in mid-February: Even before going public,
Fine Host had failed to book expenses properly
and recorded profits on food-service contracts
earlier than was proper. Sorry, a new
management said, we'll restate earnings.
Restate is putting it mildly. For the 33/4
preceding years Fine Host had reported total
earnings of $13 million. Ooops! Make that a loss
of nearly $18 million. Nasdaq delisted the shares
for almost three months. They began trading
again March 3, fetching $3.63 each.
Accounting fraud? Not necessarily. The new
management is investigating what went on, as is
the Securities & Exchange Commission. But
nobody's calling it fraud.
That Fine Host's doings may not involve fraud
makes it even scarier than if they had. If the
company was simply stretching the rules, how
many Fine Hosts lurk out there?
Plenty, we suspect, and a lot of them much
bigger than Fine Host. Last month giant Waste
Management, Inc. went as far back as 1992 to
"restate" its earnings. It wrote off $3.5 billion. In
effect, the waste management colossus admitted
that it had earned almost 40% less from 1992 to
1996 than it had originally reported.
"Companies are not getting
penalized for big writeoffs. In
fact, their executives are getting
fat bonuses."
Okay, Waste Management has had a checkered
history. Take respected Kellogg Co. of Battle
Creek, Mich. Last quarter the cereal maker took
an aftertax $126 million charge, or 31 cents a
share. For what? "Streamlining initiatives" in
Europe and "other parts of the world." This was
the ninth time in 11 quarters that Kellogg had
taken a charge to streamline operations.
Shouldn't such expenses be recognized as a
business cost reflected in operating earnings?
Richard Lovell, Kellogg's spokesman, waffles:
"This is unprecedented in the history of the
company. We certainly have no intention of
continuing these one-time charges. This doesn't
mean that if a situation comes up where the
accountants indicated that's the way to treat the
charges, we wouldn't have one."
Writeoffs can make a new management look
good. Jack Ciesielski, author of the Analyst's
Accounting Observer newsletter, points to IBM.
In 1994, the year after Lou Gerstner arrived with
massive restructuring charges, IBM would have
reported a loss of $19.72 a share if the charges
had been expensed as incurred instead of taken
all at once. Big Blue's apparent turnaround didn't
really begin until the next year, and not in earnest
until 1996.
Sighs William Leach, an analyst at Donaldson,
Lufkin & Jenrette: "The accounting has really
gotten perverted. It's reached the point where
managers earn what they think they should earn."
It's not yet at the point where management
decides what it wants to earn and then works
back to achieve it, but there are any number of
plausible games going on.
Restructuring charges are today's favorite. A
nice, fat writeoff can help your stock. If it is big
enough, it can make your ROE return on equity
look better.
Some companies take enormous writeoffs when
business is going gangbusters. Boeing Co. has
taken charges of $4 billion in the last two
quarters, $2.6 billion in costs because it couldn't
keep up with record orders. The company's
"program accounting" makes it estimate future
costs of planes and take writedowns if it
underestimates. Lots of wiggle room. ROE
should climb next year because the charge cut
shareholders' equity by some 20%.
Despite its recent tightening of some accounting
rules, the Financial Accounting Standards Board
(FASB) has left definitions of "one-time" and
"restructuring" vague. Managements would be
less than human if they did not exploit the
ambiguities. "Companies are not penalized for
big writeoffs," says Lee Seidler, a CPA and
former accounting analyst at Bear, Stearns. "In
fact, executives are getting big fat bonuses. So
other companies' executives say, 'What the heck,
let's call it a restructuring.'"
In its most recent quarter, for example, GM said
it was taking an aftertax restructuring charge of
$4 billion to write down assets, close three
factories and lay off some 3,000 workers. That's
$5.75 per share. GM thus took $5.75 a share in
future costs all last quarter. Sizable, given GM's
reported earnings over the past five years added
up to about $30 per share. But what the hell.
The past is past.
Since one-time charges don't penalize current or
future earnings and don't hurt stock prices, it is
tempting to overstate them. Why? Because you
can later restore some of the writeoff, running it
through the P&L statement, thereby bolstering
reported net income in a year when you might
need it. "Big bath accounting," it is called.
GM's most recent "one-time" charge will be the
fourth major one it has taken in seven years.
GM's charges total a staggering $7 billion, about
one-third as much as the company earned during
the period. Examining GM's reports, it is darned
hard to figure out just how much the company
earned or lost over the last decade.
Among smaller companies you see even more
questionable practices. Ashworth, Inc., an $89
million (sales) sports apparel maker, cut reserves
for inventory obsolescence by 70% in 1997,
accounting for 7 cents of its reported 37 cents
per share in earnings. What if the company can't
sell last year's golf shoes? A big one-time loss.
In October vacation time-share seller Signature
Resorts announced third-quarter earnings in line
with analysts' estimates. Signature's sales,
marketing, general and administrative expenses
as a proportion of sales fell six percentage points
from the prior year, but it wrote off "merger
costs" of $4 million, 8% of the deal's total price.
The company hiked this special charge twice,
well after the deal was completed. Did Signature
shift operating expenses into the one-time
charge? The company says there's nothing
extraneous in the merger charges. Stay tuned to
see if its lower administrative costs were as
one-time as the merger fee.
Penske Motorsports, a $110 million (sales)
owner of racetracks, had seen its stock price fall
by one-third from its August high. With that kind
of pressure, you can't afford to miss even a
penny in earnings. In the 1997 fourth quarter
Penske quietly began lengthening the
depreciation schedule for its California racetrack.
This reduction in depreciation charges delivered
an extra 4 cents per share in the quarter, helping
Penske hit analysts' consensus estimate of $1.19
per share for the year. Its stock rose $1.50, to
$28.25.
Penske is also aggressive in recognizing the
income it receives from selling $1,200 lifetime
licenses to seats in its stadium. Instead of
booking a certain amount each year over the
presumed life of the seats, it enters the entire
amount into income over two years.
Banks? No way they've escaped the epidemic of
doing what they can to improve the looks of their
books. NationsBank boss Hugh L. McColl is
known for meeting or beating Wall Street's
estimates. In the last quarter, NationsBank hit
The Street's consensus of $1.12 a share.
Nice work, Hugh, but may we ask a question?
NationsBank is a big mortgage lender-$28
billion worth is on your balance sheet. Falling
interest rates mean mortgage refinancing is at an
alltime high. Prepayments have doubled, making
the loans less profitable.
"A lot of people have made a lot
of money in this bull market, so
they don't ask too many
questions."
Our question: Does that prospect of early
repayment explain why you repackaged $7
billion in residential mortgage loans into
investment securities on your balance sheet in the
first three quarters of 1997? Is that why you put
these mortgages into a so-called
available-for-sale account, so you can retain
interest income from the loans and yet not have
to draw from net income to increase your loan
loss reserve?
"We feel very comfortable with our interest rate
position," says Susan Carr, NationsBank's
spokesperson. "Compare us with other banks."
We did. And we found the practice prevalent
across the industry. Indeed, Charles Peabody,
independent industry analyst at Mitchell
Securities, believes many banks are dumping
loans into available-for-sale accounts, created in
1993. "When you want to find out how well a
company is doing, you look to see if they are
doing these accounting things," says Peabody. "If
they are starting to stretch, that's a warning sign."
No account of bookkeeping hocus-pocus would
be complete without a look at the bag of
accounting tricks used in the merger game. Last
year there were a record 11,000 announced
mergers and acquisitions, 21% more than in
1995. Miller Industries, a $300 million (sales)
towing outfit, has added some 60 companies to
its roster in just two years. Temporary hiring
agency Corestaff, Inc. has acquired more than
30 companies since going public 21/2 years ago.
Does this frenetic activity make business sense?
It will be years before we know, but it creates
lots of opportunities for creative accounting.
When those opportunities run out, so does the
stock's run of luck. Miller Industries stock has
dropped more than 50% since September as
earnings have disappointed.
Central Garden & Pet is a distributor that has
bought 28 outfits in ten years, growing in the
process from $100 million in sales to $840
million. Chief Executive William Brown says: "I
see us as a $2 billion company by 2001." He's
counting on using a strong stock to raise cash for
use in acquiring more distributors and
manufacturers of garden and pet supplies. And
indeed his stock has been strong, up nearly 75%
in the last year.
Brown capitalizes, rather than expenses, nearly
all costs associated with inventory, such as
warehouse rent, shipping and dock-workers'
wages. This is required for tax purposes, but not
for financials prepared for investors. Brown,
unlike most companies, does it for both.
Central Treasurer Gregory Reams says: "Since it
accounts for such a small amount, it's really not
an issue." Oh, no? Capitalized expenses at
Central have typically been 2% to 3% of
inventory; and when a new company is acquired,
inventories leap. In the six months through March
1997, for example, Central acquired two
businesses with some $10 million of inventories.
Capitalizing inventory expenses allowed the
company to boost its net income per share by
some 40%. This, just before the company sold
$127 million of new shares to the public.
In the merger game, pooling-of-interest
accounting is getting more popular all the time. A
decade ago only 2 poolings were done. Last
year the number exceeded 500. The SEC now
spends more time answering questions about
pooling than on any other accounting rule.
Here's why: Pooling enables companies to avoid
amortizing goodwill. Since almost any worthwhile
merger these days is at a price well in excess of
book value, it inevitably produces goodwill. If
this is written off over 40 years, the maximum
FASB now requires, it can take a steady toll on
reported earnings. Pooling avoids this.
Suiza Foods is a good example. Over the past
three years this Dallas-based food processor and
distributor has grown sales from $430 million to
nearly $2 billion, mostly through acquisitions.
How much would Suiza's earnings suffer if it
considered its acquisitions as such rather than as
mergers? Plenty.
Last year, for example, Suiza paid $777 million
for distributor Morningstar Group, stated book
value of $107 million. Under purchase
accounting, assuming the same book value, there
would have remained $670 million in goodwill to
be amortized, $17 million a year for 40 years.
That would shave 50 cents a share off each
year's earnings. This year's consensus estimate of
$2.91 a share would be $2.41.
Many mergers work out well; in these cases
perhaps it is gilding the lily to avoid goodwill. But
in other cases the acquiring company overpays
grossly. One aftermath of the current binge must
inevitably be another wave of restructurings as a
result of overpriced mergers.
It takes two to create a deception-deceiver
and deceived. Plenty of the latter are around
these days. Fifteen years of nearly unbroken bull
markets have made people willing, eager to
believe in financial miracles. "A lot of people
have made a lot of money in this bull market, so
they don't ask too many questions," says
Howard Schilit, an accounting expert who runs
the Center for Financial Research & Analysis in
Rockville, Md. "As long as you're up 90%, you
don't care if a company is using a little aggressive
accounting."
The bull market has put a premium on deception
because it pays so well. Listen to J. Terry
Strange, head of auditing at KPMG Peat
Marwick, the fourth-largest accounting firm:
"There's probably more pressure to achieve
results than at any time that I've seen." Not only
do bonuses and stock options depend upon
earnings growth, so does a company's ability to
do mergers, raise money and survive as an
independent entity.
Chief executive compensation is usually tied to
corporate results-operating income, net
earnings, stock prices. A few pennies more in
per-share earnings can translate into millions in
option gains and bonuses.
Even for professional investors, it's not easy to
see through the deceptions: Look at Oxford
Health Plans. In theory, stock analysts should be
on the alert for deception, but as FORBES has
pointed out (Dec. 15, 1997), too many analysts
are essentially on management's side.
Robert Olstein, president of the $255 million
Olstein Financial Alert Fund, has been writing
about accounting tricks for over 30 years and is
a former coauthor of the respected newsletter
Quality of Earnings Report. "Accounting tricks
are always going on," he says. "What's changed
is that companies are getting away with more
now because analysts aren't paying any
attention."
It's been a great bull market, but one that's full of
dangers and getting more dangerous all the time.
By Bernard Condon
On The Cover
From March 23, 1998 Issue |
