Storm Watch Update
LET THE 2002 GOODWILL GAMES BEGIN!
round-1 first quarter earnings
by Jim Puplava
www.financialsense.com
March 22, 2002

It happens every quarter and its occurrence has become part of the financial cycle. Like weather, it is just as predictable. I call it "The Earnings Game” and it begins every quarter with much aplomb and acclaim. Some have likened it to a play with the same stage, props, and actors. The participants are the usual suspects: major corporations, analysts, and anchors with investors as the audience. When the curtain opens, the play begins and the same melodrama unfolds. Nothing really changes. As I wrote in my November 9th Storm Watch Update, ”The curtain always falls with the same predictable finale. Companies beat estimates, analysts look good and the media has something to talk about with viewers. Investors enjoy the ride and the monetary thrill as stocks rise and fall on earnings reports that meet or beat estimates by a penny less or a penny more a share.”

The only problem for the producers of this play is that attendance has been waning. Thanks to Enron, K-Mart, and Global Crossing, the audience is getting wise to the plot. They understand companies and Wall Street want the audience to accept an inflated version of earnings. The inflated earnings plot is no longer getting the same applause. The entertainment business deals with illusions, and "The Earnings Game" is no different. Analysts, anchors, and accountants repackage the same old drivel for the investing audience, but with a new twist and/or theme each quarter. But make no mistake, even in today's suspicious environment, what investors now hear, see, or read as earnings is still an illusion. The "new" earnings numbers no longer reflect the bottom line. They have become the creative figment of imagination from the actors.

Accounting 101 - A Quick Review

For the novice or the uninitiated, it might be useful to describe what the SEC and accountants call earnings according to GAAP (Generally Accepted Accounting Principles). The income statement under GAAP does not specify the format. It may appear in a quarterly or annual report in a variety of ways depending on the industry and the creativity of management. However, the reader should have some familiarity with the two formats listed below. Understanding how the game is played will help you to know how to avoid what is recommended and reported by analysts and anchors as earnings and thereby avoid the hazards of earnings-of-the-third-kind.

When analysts are scrutinizing the operations of a business, they usually reclassify income statements to portray a better understanding of the business. The analytical version is widely followed by many analysts and may be more useful to investors. It is as follows:

Real Earnings

The importance of understanding the real meaning of earnings is that your financial well-being and your portfolio depend on it. The numbers reported in media and press statements can be entirely different. That is why before you invest, you need to understand what the term “earnings” means. Unless you understand this concept, you may be making investment decisions on incomplete information. The numbers given out in company press releases and reported by network bubbleheads are usually the pro forma numbers. These are the numbers reported above as pretax income from continuing operations or EBITDA (earnings before interest, taxes, depreciation, and amortization). This is the number before the company’s dirty laundry of expenses and charges. In the majority of cases, the numbers you hear are variations of the above standard format. Very seldom do they reflect the bottom line.

In fact, as shown above, there are five different Earnings Per Share (EPS) numbers based on different lines on the Income Statement. There is an EPS based on net income from operations, an EPS on income from discontinued operations, an EPS on extraordinary items, an EPS on cumulative effect of accounting changes, and finally, EPS numbers based on net income. So, when you hear an analyst, anchor, or CEO talk about a firm's earnings per share number, you need to know which EPS number they are referring to. Unless you know this, you can't make a valid investment decision. Most firms want to present their earnings in the most favorable light. The analysts and anchors have their own agenda to promote.

GAAP or CRAP?

The problem with company press releases is the profit numbers portray the company’s earnings in a favorable light. The real bottom line appears in the company’s 10-Q, which is filed with the SEC 45 days later. The SEC numbers reflect earnings in accordance with GAAP. What investors receive in press releases are numbers according to what I call CRAP (Cloudy Reporting Accounting Principles) which are not the real bottom line. There is often a chasm between these two numbers. When the real numbers are released in the 10-Q reports with the SEC, no one pays attention to them unless there is a new revelation buried in the pro forma numbers. Then there will be hell to pay. Those big surprises can cause a company’s stock price to crater. Even the GAAP numbers can be misleading since there are allowable differences under GAAP. These gray areas allow companies to manipulate earnings. For example, the earnings numbers that are reported under GAAP do not reflect the cost of company stock options. The Financial Accounting Standards Board (FASB), which determines what GAAP should be, now requires companies to report the cost of stock option grants in the company footnotes.

Finagling With Stock Options

The difference in accounting for stock options can make a world of difference in the actual earnings. Remember, when a company issues stock options, those options have the potential to dilute earnings as well as your shareholder ownership in the company. Companies have fought hard to kill the inclusion of stock options in earnings because they know that they are dilutive and detrimental to earnings. Companies have also fought hard to prevent their costs from the income statement because they would lower net income. Stock options granted to executives are really a payroll expense and to exclude them from the expenses of running a company creates the illusion of greater profitability. Therefore, you need to back them out from the net income figure if you really want to know the bottom line.

Un-Legislating Honesty

In the past, companies and accounting firms have lobbied against reporting stock options as an expense to the detriment of shareholders. Companies and the accounting industry have found a friend in Connecticut Senator Joseph Lieberman who killed reform legislation that would have corrected this abuse. This same Senator now presides over a Senate subcommittee investigating Enron. Even as recently as yesterday, Harvey Pitt, the current Chairman of the SEC and a former lawyer whose firm represented the big “five” accounting firms, tried to discourage lawmakers from passing a bill requiring companies to treat stock options as an expense following the Enron and Global Crossing bankruptcies. Pitt also urged legislators to delay passing a bill that would prohibit auditors from pursuing lucrative consulting services with the clients they audit. This was a common problem that Arthur Andersen had in its relationship with Waste Management, Sunbeam, and Enron. Arthur received both consulting fees and auditor fees from the same client, a position that compromised its objectivity.

None of this reform legislation would be necessary if the practice of cooking the books wasn’t so widespread. Unfortunately, that isn’t the case today. Today, understanding financial statements requires the investigative skills of a detective and the scientific knowledge of a pathologist. There are so many different ways to report and inflate earnings that it has become mind numbing. I will shortly cover the more common practices. Suffice to say there are a multitude of ways of excluding various charges, expenses, and writeoffs. Investors should process what they see and hear with a healthy degree of skepticism.

Defining Nonrecurring

A favorite ploy used today is the nonrecurring charge. Webster’s defines nonrecurring as “nonrecurrent.” In plain English, it means it doesn't happen again. According to a recent Zack's report, close to one-half of the S&P 500 companies reported negative nonrecurring items in their earnings reports in 2000. This compares to only 31 companies in 1992. [Bloomberg] Many companies have a habit of treating ordinary expenses of operating a business like closing plants, changing product lines or exiting a market all together as nonrecurring expenses, when in reality, they are actually an ordinary expense of doing business. This game of nonrecurring expenses is also used to set the stage of an earnings improvement in the future. Therefore, as this new season of the earnings game begins, investors should be on the lookout for various red flags that provide clues to possible earnings manipulation by management. Remember, your best form of protection is knowledge. After all, it is your money. Therefore, it becomes your responsibility. Either do the work yourself or find someone you trust. These markets have become too manipulative for the average investor. Even the pros can be taken advantage of through the lack of clear disclosure by company management. [See other articles on abuse: “The Earnings Game” and “A Penny Less - A Penny More”.]

5 Red Flags on Balance Sheet Manipulation

Some of the most common abuses deserve repeating with greater detail. They are 1) top and bottom line discrepancies, 2) accelerating sales or revenues, 3) delaying expenses, 4) accelerating expenses, and 5) off-balance sheet debt.

#1  Top and Bottom Line Discrepancies

Essentially, nothing happens until a sale is made in business. Revenues or sales are the drivers behind earnings. Without sales, there would be no business as many dot com investors have learned the hard way. The problem with many of the earnings miracles so prevalent in the 1990’s is that they had more to do with financial engineering than top-line sales growth. This revenue or sales manipulation enabled many mature companies to pose themselves as growth companies to investors. This is obvious with companies such as IBM and GE. In the case of GE, their industrial businesses grew at below-average rates. The real growth in GE occurred through its financial division, GE Capital, because it has metamorphed into a financial company.

IBM - A Case In Point

In the case of IBM, the double-digit earnings growth under Gerstner were the result of financial engineering. IBM’s magic was in its accounting - not in its products or sales. In fact, IBM had moved from a high margin hardware manufacturer with 60% gross margins into deriving a greater portion of its business from services. This was a brilliant move on Gerstner’s part, because it helped the company transition from a business that was becoming a commodity into one that captured ongoing revenues or an annuity stream from service. However, this transition wasn’t the magic bullet so widely hailed by analysts and the financial press. IBM’s earnings secret was pure financial engineering. Gerstner’s IBM relied on five basic techniques for enhancing its earnings as follows: 1) stock buybacks, 2) pension plan earnings, 3) lower tax rates, 4) revenue accelerators, and 5) expense reduction enhancers.

Buying back stock was an obvious accounting trick since it reduced the number of shares outstanding, and therefore drove up earnings per share (EPS). Gerstner spent $44 billion buying back IBM stock which amounted to a shade less than the company’s entire earnings during the same period. The company also increased earnings through management of its pension-plan earnings. Recently, IBM increased the expected rate of return of its pension plan assets to 9.5% during a period of double-digit stock market declines. IBM employees didn’t take this practice too kindly. The earnings of a pension belong to the employees not the shareholders. IBM used other techniques such as including asset sales as income and royalties in its expense charges in an effort to make the company look more efficient.

As the table below indicates, IBM’s sales grew at a rate of less than 3% over a 10-year period. Over the 8-year period where its earnings were positive, the sales growth was 3.73%. In the 8-year period where the company recorded actual positive earnings, the EPS growth rate was 16.87%, nearly four times its actual top line growth rate.

The second table shows the year-over-year changes in the number of shares outstanding. The first number shows the number of shares outstanding decreasing due to $44 billion in share buybacks. The next column shows the number of dilutive shares outstanding because of stock options and other financial options that increased potential share dilution.

[Note: Those of you who use Value Line Investment Survey won’t find the same numbers because
Value Line excludes nonrecurring charges. The numbers used in this analysis were taken
from Bloomberg analytics, institutional services.]

During this same 10-year period, IBM’s gross margins dropped from 46% to 37%. The number of employees initially fell during the early restructuring years from 344,396 to 219,839. Headcount grew as the company embarked on expanding its service business to 319,876 as of 2001 year-end. As the company began to manuever into the service sector, it became necessary to hide expenses by making them less visible. The company began to include everything from asset sales in income to crediting royalties and licensing fees towards its expenses. The result was to make IBM’s cost management look more effective. Another problem with IBM’s service business is that service revenues are based on long-term contracts with large headway for companies to determine how much of those revenues are recognized up front. How aggressive the revenue recognition becomes is a matter between IBM management and its accountants, PricewaterhouseCoopers LLP. Only the two of them know the real numbers.

IBM is the best example of earnings management performed by an old-line blue chip company. Others practice many of the same tricks used by IBM to manage earnings. The point to glean from these numbers is this: IBM really wasn’t the growth company depicted by Wall Street and the financial media. It was the product of the financial engineering so widely practiced by companies during the 1990’s.

#2  Accelerating Sales or Revenues

Another technique that is used to spruce up the bottom line is accelerating sales or revenues. This strategy involves everything from recording revenue in one quarter (that should be booked in the following quarter) to delaying expenses associated with sales. The most common practice is to book sales for services or merchandise in periods in which a company receives upfront cash payment. The company records the sales immediately; while postponing the recognition of expenses associated with that sale to a later period. This pumps up the current period earnings. Many of IBM’s skeptics suspect this practice at IBM, which gets 37% of its business from its global services division. Essentially, this is a violation of the matching principle of accrual accounting. Investors need to be aware of situations where revenue and costs are treated differently over different time periods. More recent examples of this are Global Crossing and Qwest who used this technique to pump up the bottom line. The fact that Congress is so quiet over what happened at Global Crossing is amazing. The scandal at Global Crossing is just as big as Enron, if not bigger.

#3  Delaying Expenses

A third method of earnings management can be found in delaying expenses. Under this treatment, companies delay recognizing expenses on their income statements associated with revenues recorded during the period. A favorite technique used by companies is to capitalize expenditures that are really current expenses. By capitalizing an expense, the expense is taken off the income statement, which enhances earnings, and is transferred to the balance sheet as an asset. Many of the companies in the technology industry used this approach to produce spectacular earnings growth. They are now writing off those expenses through impairment charges and other writeoffs that reflect some of these expense deferrals.

#4  Accelerating Expenses

The fourth technique of balance sheet doctoring is accelerating expenses and loading them into one quarter. This practice is better known as "The Set Up" or "Big Bath." Companies try to overload one period with expenses so that the next accounting period, by comparison, shows an improvement in earnings. Sometimes companies can set up an earnings reserve that can be used to draw on in future periods when they need the extra income to meet their earnings estimates. Examples might be writing off all the expenses of closing down a plant, a store, or exiting a product line in one accounting period. Normally the operation takes place over multiple accounting periods. However, by taking the “big bath “charge in one year, the stage is set for an earnings recovery the following year. In other words, by overstating expenses in one year, the company is setting up a reserve for future earnings. If expenses turn out to be less than estimated, then those costs can be transferred back as earnings in another accounting period. Cisco and Tyco are notorious for using this approach to make their earnings target. Investors should be on the alert for this practice commonly used by companies who use acquisitions to grow their earnings. Under this scenario, the acquiring company uses its inflated stock price to purchase a company, which immediately enhances their dollar earnings. Later on, to avoid the dilution in earnings per share because of large takeover premiums paid on acquisitions, the company takes a huge restructuring charge.

The Truth About FAS 142

You are going to see a lot of this "Set Up" manipulation in this year thanks to a new accounting rule, FAS 142, that went into effect in 2002. This rule did away with the amortization of goodwill. This feature alone could give several companies an earnings lift this year. However, companies must now review these charges once a year and write off any assets that it considers impaired. In my opinion, this new rule may be the main reason S&P and other analytical firms are no longer using net income figures. The impairment charges this year could approach $1 Trillion. The acquisition binge of the 90’s is now coming home to roost. A major portion of a company's book value is going to disappear in smoke this year. Equity is going to be wiped out resulting in the greatest writeoffs and destruction of shareholder net worth in history. This is the real story the companies, their analysts, and the anchors don’t want you to know. It is the main reason why nobody wants to talk about book value, net income, and shareholder value anymore. Ultimately, it will be the final act of the 1990s earnings mirage. There are many analysts and media cheerleaders who dismiss this as, "No big deal."

Another way of understanding this earnings manipulation is to think of goodwill as your portfolio. Let's say you bought a stock at $100 a share during the tech mania of 1997-99. Today those shares are trading at $5 a share. You can pretend that the stock is still worth the $100 dollars you paid or face the truth of its current market value of $5. Whether you want to or not, the market has made that decision for you. FAS 142 forces a company to come clean by writing down an impaired asset. Because of FAS 142, companies are going to take their hit this year. The bill has a special provision that allows companies to treat the expense as a non-operating expense and not count it towards a reduction of EPS. If the company hesitates or waits too long, that special provision expires and forces the company to treat it as an operating expense, which will reduce EPS in the future. Now you know why there is a hush over net income this year. Everyone in the financial industry -- the accountants, the analysts, the anchors, and especially management -- hope you don’t notice what’s going on this year. This is the year of forgiveness. Indulgences are allowed by the high priests of finance.

#5  Off-Balance Sheet Debt

Another tell-tail sign of earnings management is found when companies use off-balance sheet accounting to remove assets and liabilities from the balance sheet. It also involves removing income and expenses from the income statement. There are three specific techniques for accomplishing this. They are Special Purpose Entities (SPEs), spinoffs, and leases.

Special purpose entities have become well known as a result of Enron. These separate legal entities are jointly financed by the parent company and independent, outside investors. In the case of Enron, company executives that were involved in these entities or partnerships, as they were known, clouded the independence factor. These type of entities are allowed under GAAP as a means of protecting investors by moving risk away from the parent and shareholders and transferring that risk to independent investors. Done properly, they benefit both private investors and public shareholders. Done improperly, they can spell disaster. Unfortunately, this is what happened in the case of Enron. Enron gave these special purpose entities a bad name by manipulating earnings through transferring company losses in trading derivatives and business ventures from the parent to the SPEs. In the case of Enron, there were no independent outside partners that would have exposed the risks that were being transferred. In many ways, Enron was a more sophisticated version of the Barings fiasco.

Spinoffs are another way of creating an SPE. The difference between spinoffs and SPEs is that the spinoff is publicly owned. In many of these situations, the parent still stands behind the debt of the newly created entity.

Leases is a way for a company to purchase an asset, such as a building or plant, and keep the debt off its balance sheet and thereby improve its financial performance ratios. Keeping the debt off the balance sheet makes the company look financially healthier than it really is. It also allows a company to improve earnings by not having to depreciate the asset which increases expenses. The company usually pays only a small lease payment which reflects the interest rate on the loan. A recent example of this management technique is Krispy Kreme. The company used a synthetic lease to keep the $35 million dollar cost of building a new plant off its balance sheet. The company is now including the cost of the plant on its balance sheet. The interest rate costs will be the same, but the company must now depreciate the cost of the new plant.

It's Time to Do Your Homework

There are many other examples of earnings management that have not been elaborated in this Storm Watch Update. Read my previously articles, "The Earnings Game” and “A Penny Less - A Penny More,” for more insight on how this game is played. For the sake of brevity, I have touched upon the main examples of these abuses. The use of derivatives will be covered in more detail in a future installment of Powershift. For now, you can find traces of these abuses in the “other revenue” or “trading revenue” sections of the income statement. You will also want to study the footnotes accompanying the financial statements. They make for interesting reading. This is where you will find the missing elements of the earnings game not covered in the financial statements. They are required reading for any astute investor who wants to gain a better understanding of the company he chooses to invest in.

For the more experienced investors with a background in accounting or finance, I have included a checklist of accounting "Minefields" to use in evaluation of financial statement quality. These guidelines have been taken from PricewaterhouseCoopers CFODirect Network. They represent additional measures that can be used to evaluate the earnings quality of financial statements. It should be pointed out that in today's complex world of global finance and fast-paced technological change, no number on any of the three major financial statements can be taken at face value. Most earnings management starts with an earnings estimate. Management then works backwards through the accounting process to achieve that goal. Your job is the same as management's. You start with the bottom line and then reconstruct the financial statements to arrive at a number that reflects a truer measure of earnings and the financial soundness of the enterprise. You are trying to understand how management achieved its results. This process removes the fluff that is so often found in today's earnings reports. In essence, you are trying to find out what lies underneath the numbers that are distributed to the herd for mass consumption.

Finally, investors may want to start familiarizing themselves with the Survey of Current Business, published by the U. S. Department of Commerce/Bureau of Economic Analysis. It tells a completely different story about company profits as a whole and the shape of corporate business. Their survey is much different than the one that is reported in the press. On that note, you may find it helpful to read Howard Kurtz’ book the “Fortune Tellers: Inside Wall Street’s Game of Money, Media, and Manipulation” and Nicholas W. Maier's “Trading With The Enemy: Seduction and Betrayal on Jim Cramer’s Wall Street.”

Beware of the financial advice from cable financial news shows. They aren’t reporting news. Their shows are infomercials in disguise. March 18th's Barron’s carried a story by Phil Demuth called "Happy Talk at CNBC: Its analysts are always upbeat; its anchors don't probe." His piece sums it up my thoughts best, “CNBC is a giant infomercial masquerading as a news channel. Business news is larded with stock tips, but it is never made clear where objectivity leaves off and the happy talk about stocks begins. The problem is compounded by principles of finance, and the inexcusable lack of disclosure of the interests and the track records of all parties involved…CNBC is often compared to ESPN, but it’s really more like the Home Shopping Channel - without the integrity."

So much emphasis has been placed on quarterly earnings numbers that it has led to companies trying to levitate earnings each quarter by whatever means necessary. They do this in an effort to meet Wall street expectations. Because earnings estimates have become the single focus of the markets and investors, it has given way to the rise of the shareholder equity cult and the abuses we are now seeing in the management of earnings. As I have written in "Breakdown: Greed, Complexity, and Conflicts of Interest and the Moral Hazard," the financial system is in need of a fix. Either it gets fixed now, or it will collapse under its own weight.

Caveat Emptor. Buyer, beware. It’s a big world out there full of illusions. Unfortunately for the investing public, earnings has become one of them. ~ JP

Survey of Current Business U. S. Department of Commerce Bureau of Economic Analysis

Nicolas W. Maier

PricewaterhouseCoopers CFODirect Network "24 accounting minefields that drive management to question financial statement quality."

Please refer to today's Market WrapUp for Jim's stock market summary.

© 2002 James J. Puplava
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