Over the past few years, investors have learned -- at great cost -- that a dollar in corporate profits may not be a dollar at all. Depending on how a company interpreted or perhaps circumvented the rules, that dollar could be $2, 50 cents, or sometimes even a loss. Buried deep in financial reports, investors could find a nugget or two that would help them grasp the real earnings figure. But often, the necessary data were obscured or just not there.
Now, that's all changing -- and in a big way. Congress, the Securities & Exchange Commission, and makers of the rules for both U.S. and international accounting are all engaged in writing or implementing standards that could force companies to recast their results and disclose much more information. It's the biggest advance in public company accounting since the securities laws of the 1930s.
The scope of the issues the regulators have taken on is broad. Collectively, they're working through changes in how companies account for employee stock options, pension plans, corporate restructurings, off-balance-sheet obligations, asset values, pro forma earnings, and the presentation of the income statement itself.
The issues have a common thread. Better reporting of each item could help investors be more discriminating about the earnings that companies announce, even those of companies playing strictly by the rules. Investors need to get enough information from financial reports to sort reported earnings into what is enduring, what is sporadic, and what is never-again.
Distinguishing lasting from fleeting earnings is critical in today's economy, when growth is low at best. If a company's earnings depend on something like a one-time cost cut or an accounting assumption that can't be sustained, the stock could be headed for trouble. "In a low-growth environment," says Trevor Harris, an accounting analyst at Morgan Stanley, "there are going to be some serious losers. You have to be careful."
Harris assembled a set of 23 earnings quality checks for Morgan Stanley analysts and investors to apply to company reports two years ago. For instance, analyst David M. Togut took Harris' criteria and adapted them to rate the computer services companies that he follows. Electronic Data Systems Corp. (EDS
) recently scored 3.2 out of 10 possible points on his scale. Fiserv Inc. (FISV
), one of its competitors, scored 8.2. Among the key differences, EDS has taken numerous one-time charges, and management argued that they should be excluded from earnings; Fiserv hasn't. Also, free cash flow from EDS operations has tended to run about 60% of its earnings, while Fiserv's has topped 120%. Togut does not say EDS did anything wrong, but lagging cash flow often foretells a drop in earnings. Indeed, such scrutiny helped persuade Togut to downgrade EDS shares in August, 2001. They're down 75% since then, vs. an 18% decline for Fiserv shares. EDS stock recently carried a price-earnings ratio of 7, compared with Fiserv's 23. The message here: The higher the quality of earnings, the better valuation the market will give the company.
Earnings analysis will never be easy, but the accounting reforms will help. So far, the results of the drive are promising, though incomplete. For example, investors reading the new crop of annual reports filed in recent weeks are already seeing changes. They know much more about how IBM's (IBM
) pension-plan investments will affect future earnings than they could have deduced from its annual report a year ago. They can see now that Ford Motor Co.'s (F
) business has included making nearly $500 million in off-balance-sheet guarantees and that it has been benefiting from an accounting loophole that let banks finance some car loans off their balance sheets. Now, that loophole is being closed and the financing may become more expensive.
How much progress the regulators make will be critical to restoring investor confidence. Here's the status of reforms in many of the key areas:
Pension plan income. Under current accounting rules, defined-benefit pension plans lifted earnings of companies in Standard & Poor's 500-stock index by 2% in 2001. It was an amazing feat since plan assets dropped 5% and liabilities rose 8% at the same time. The imaginary income was based on self-serving estimates and remnants of paper gains on equity investments that the plans logged during the bull market. The gains lasted into the bear market, thanks to rules adopted in the 1980s at the behest of corporate lobbyists.
Investors have struggled to screen the distortions out of earnings. Now, the SEC is helping by pushing for more disclosure, like IBM's. On Mar. 12, the Financial Accounting Standards Board (FASB) voted to draft disclosure requirements that will probably reveal the actual year-by-year performance of pension plans. The International Accounting Standards Board (IASB), which may one day supersede FASB, is leaning toward making companies count current pension plan results in earnings. Companies would likely fight any such move because it would reveal more of the volatility of their profits.
Pension plan funding. Companies are now pumping billions of dollars into their pension plans to satisfy government funding requirements. Often, the payments reduce the cash flow that investors expected to fund business reinvestment and stock buybacks, both of which can be key to future earnings per share. But companies are not required to say ahead of time how much they'll have to pay into their plans.
Institutional investors and the SEC have been coaxing companies to make additional disclosures of their pension plans' cash needs, and several have, notably General Motors Corp. (GM
), in investor conference calls. Meanwhile, companies are lobbying the government to relax funding requirements.
Stock options. Because all but a few companies failed to report this form of pay as an expense, stock options exaggerated the earnings growth that some investors thought justified buying stocks during the bull market. Earnings of S&P 500 companies would have dropped about 18% if options had been counted as an expense in 2002, according to S&P.
FASB took a preliminary step on Mar. 12 toward requiring that options be expensed. The IASB has a requirement pending. Tech companies are trying to derail both moves and have recruited members of Congress to help. They say it is impossible to measure the cost of options accurately and consistently. Still, some 175 companies have said they would expense on their own. Some of them are switching to restricted stock that can be more precisely expensed. Either way, the momentum is toward making it easier for investors to track compensation trends that limit future earnings.
Pro forma earnings. Over the past 12 years, earnings announced by companies as if they were free of costs counted under generally accepted accounting principles (GAAP) were about 20% higher than if they had played by the rules. Perhaps half of those adjustments wouldn't wash with investors today if they were clearly spelled out. The SEC, under an order from Congress, imposed rules effective on Mar. 28 to require that companies clearly explain and justify any non-GAAP numbers to investors. For any real change, investors will have to punish companies that don't give up their pro forma spins by selling the stocks.
Restructuring charges. When a company closes a factory, it often takes a restructuring charge. Companies generally have been successful in getting investors and analysts to brush off these charges as one-time events rather than as an ongoing cost of business. The SEC and FASB have been tightening their rules on restructuring charges for several years and will continue to do so. The question is whether the regulators can keep up the pressure.
Securitizations. Egregious off-balance-sheet dealings were critical in the rise and fall of Enron Corp. But banks and other companies have used these securitizations less aggressively to move assets and liabilities off their books, boosting their returns on capital. In January, FASB tightened its rules. Now, companies are deciding whether their structures will have to be replaced by July or consolidated on their books.
Diminished assets. Last year, FASB began requiring companies to check the value of intangible assets regularly and mark them down if necessary. The tests have generated multibillion-dollar hits to earnings, like AOL Time Warner Inc.'s (AOL
) recent $45 billion charge.
The requirements fit in with a broader move by regulators to make companies revalue assets on their books and subtract the changes from earnings. As the charges mount in size and frequency, they will probably bring more complaints from companies. Still, many of the charges will help investors track investment follies by management.
Opaque earnings. In their effort to satisfy investors' dream of one true tell-all earnings number, accounting regulators have made the bottom line an amalgamation. It mixes results from recurring business with sporadic changes in asset values. In some cases, it mixes results from operations, over which managers have a lot of control, with results from financing, which are often a consequence of the market.
FASB and the IASB recognize the problems. They are looking for ways to redesign income statements to break out more of the different ways earnings are created. They are talking about adding columns and perhaps constructing a matrix. They are asking investors what formats would allow better analysis of what companies are really worth.
Crafting new income statements could take years. But after all investors have been through, any efforts to show earnings for what they are really worth will be welcome.
MARCH 24, 2003
By David Henry in New York
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