Like most investment banks, Bear, Stearns & Co. trots out its top analysts to visit valued clients or speak at industry conferences. But until the collapse of Enron, accounting analyst Patricia McConnell wasn't exactly a box-office draw. "You used to have to coax clients to listen to an accounting presentation," she recalls. "They'd rather be at the dentist."
Nowadays, clients hang on her every word. BusinessWeek Personal Finance Editor Susan Scherreik recently met with McConnell in her Manhattan office to ask her
which accounting issues should investors be paying attention to right now.
Q: What are your clients asking about?
A: The two hottest topics are pension accounting and accounting for employee stock options. Both can obscure a company's true earnings.
Q: How?
A: Take stock options. Companies don't have to count employee stock options costs as an expense, which inflates earnings. We figure that the companies in the Standard & Poor's 500-stock index would have reported profits that would have been 20% lower in 2001 if they had included stock options as an expense. However, that impact is not as great as it seems, because corporate earnings were depressed in 2001. If corporate profits in that year were at their higher 2000 levels, the costs of stock options would have lowered their earnings by around 10%.
Q: How about for technology companies, which liberally hand out employee stock options?
A: We estimate that their 2001 earnings would have been 35% lower than reported.
Q: How can investors tell what the impact is?
A: Companies are required in their quarterly financial statements to include a footnote that states how much lower earnings would have been if employee stock option costs had been counted as an expense. That's a brand-new requirement this year. Previously, companies only had to include such a footnote once a year, in the annual report.
Q: How about pension accounting?
A: Pension accounting largely affects Old Economy companies, where defined-benefit pension plans are still common. It's very complex, but essentially, accounting rules let companies boost earnings by applying the gains in traditional pension plan investments to their bottom line. During the boom years, investors weren't separating out this pension benefit from operating earnings, and so they overvalued companies.
Q: How about now?
A: We're about to see the opposite happen. Because of the bear market in stocks, pension investment assets are showing much lower gains or even losses, which will start showing up as a drag on 2003 earnings. That's going to make a company's bottom line look worse than it really is and cause investors to undervalue companies. In both cases, it's poor-quality earnings.
Q: What if the stock market rebounds?
A: Another point that many investors miss is that even if the stock market recovers, it's going to take three to five years for the negative effects of pension investment losses to wash through earnings?
Q: Why?
A: Companies are allowed to use a smoothing mechanism in pension accounting. For instance, if a company had investment losses in its pension assets in 2000, only one-fifth of those losses would have showed up that year because of the averaging effect of big gains in the prior four years.
MARCH 24, 2003
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