Where's the outrage? Companies report "pro forma" earnings that are deceptive, unwarranted, and down-right dangerous to the financial system--and no one complains. During the boom, chief executives pumped up earnings by casting aside any constraints on how and when they booked sales and calculated costs. And people turned a blind eye to accounting shenanigans as long as stocks moved ever higher. Then came the bust, and corporations played the same numbers game to soften the blow to earnings, hoping again for investors' complicity. But this time, the market is showing signs of punishing companies playing the numbers game. CEOs should recognize this switch in investor sentiment and jettison anything-goes accounting quickly. It's time to get back to generally accepted accounting principles (GAAP), which have the virtue of transparency, comparability, and a decent dose of honesty.
Some gaming of earnings has been around for a long time. A small number of companies have always played around the edges of Securities & Exchange Commission standards. But now nearly all companies stretch GAAP standards to make up their own. The latest wave of "creative accounting" began in the 1980s with the rise of EBITDA--earnings before interest, taxes, depreciation, and amortization--an early form of pro forma accounting. By the 1990s, pro forma had been stretched to include virtually any gimmick by earnings-deficient companies--especially in high tech. With pro forma accounting, companies just make up the numbers, including what they want, excluding what they don't. Yahoo! Inc., for instance, excludes the cost of buying Internet companies and of payroll taxes on stock options. Exodus Communications Inc. excludes some acquisition costs but not options taxes. Amazon.com Inc. simply excluded from its first-quarter pro forma operating losses a net interest expense of $24 million and a $114 million charge for restructuring.
This anything-goes accounting must end. It is becoming im-possible to compare price-earnings ratios because companies define their earnings in so many different ways. Stock indexes are increasingly suspect. Investors are at sea. Companies still must publish true figures according to GAAP, but they are usually hidden somewhere in quarterly reports, often in obscure footnotes. News releases and TV programs tout pro forma "headline" numbers. The market is beginning to express outrage at this abuse. Wise CEOs should take note.
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