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Anyone follow earnings?
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December 20, 2001: 10:11 a.m. ET
Accounting blowups, pro-forma numbers leave investors wondering what earnings mean.
By Paul R. La Monica
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NEW YORK (CNN/Money) - The Easter Bunny, Loch Ness Monster and Tooth Fairy do not exist. This we know to be true. Unfortunately, many investors learned only this year that corporate earnings are also sometimes a product of overactive imaginations.
Who hasn't heard of the Enron debacle? The energy trader collapsed once it came to light that management used partnerships set up by its chief financial officer to keep debt off its balance sheet. Enron wound up firing its CFO and restated its earnings from the third quarter of 1997 to the present after the Securities and Exchange Commission (SEC) announced it was investigating its accounting practices. The company subsequently filed for bankruptcy - the biggest corporate bankruptcy in U.S. history -- and its stock has plunged 99.5 percent this year, as of Wednesday's close.
Enron may have been the year's biggest accounting blow up, but it wasn't the only one.
Customer relationship management software developer BroadVision (BVSN: Research, Estimates), which was added to the S&P 500 in October 2000, said in April it had neglected to include $4 million in expenses in a report on results for the quarter ended the prior December. As a result, the earnings reported in January were double what they were once the expenses were included. BroadVision's stock has plunged 75 percent so far this year and the company was removed from the S&P 500 in August.
PurchasePro (PPRO: Research, Estimates), a business-to-business software firm, announced in May that the revenue for its first quarter was substantially less than what it had reported a month earlier. Its stock has plummeted 93 percent this year.
Earnings fiascos cost shareholders billions
These are just a few examples of how accounting mishaps have caused significant shareholder pain. The reputations of brand-name companies like Cendant, Sunbeam and Xerox have been tarnished by accounting problems in recent years. In March, former SEC chief accountant Lynn Turner estimated that corporate accounting fraud has cost shareholders $100 billion over the last eight years. And that was before Enron (ENE: Research, Estimates) imploded.
Nell Minow, editor of shareholder activist Web site the Corporate Library, says that the way some companies massaged earnings results reminded her of the cartoon character Wile E. Coyote. "He runs off the cliff and then realizes there's nothing underneath him," she quips. In the bull market, it was easy to get away with creative accounting practices but once the stock market tanked it became increasingly difficult to cover up transgressions.
So what now? Will the SEC enact meaningful reforms in order to make it easier for investors to understand earnings reports? Minow says high-profile meltdowns like Enron will put pressure on companies to report their earnings in a clearer fashion.
Wall Street, scared of looking foolish again, will be more cautious. And yes, regulators are likely to crack down more on companies that issue confusing earnings reports.
Meanwhile, Congress is investigating the Enron nightmare. And two Senators introduced a bill Tuesday that calls for more diversification in employee 401(k) plans after thousands of Enron employees were left holding near worthless Enron stock in their retirement accounts.
While rumblings from Congress can easily be dismissed as political grandstanding, it is the SEC's mandate to protect individual shareholders. And there is evidence that the Enron fiasco is in fact propelling the SEC into action.
For a definition of pro forma, click here
Witness its recent warning about pro forma earnings. In December, the SEC issued a statement about so-called pro forma numbers. These earnings tend to back out certain one-time charges associated with asset write-downs, mergers and joint ventures and discontinued businesses. As such, pro forma earnings usually portray a company in a more positive light than earnings that comply with Generally Accepted Accounting Principles (GAAP).
Companies ranging from Amazon.com and Yahoo to Qualcomm and JDS Uniphase have all reported pro forma numbers for various reasons. The problem isn't that companies are reporting these numbers per se but that the more favorable pro forma numbers tend to get a far more prominent placement in company announcements about earnings than the actual "bottom-line" GAAP numbers.
"We are concerned that 'pro forma' financial information, under certain circumstances, can mislead investors if it obscures GAAP results. Because this 'pro forma' financial information by its very nature departs from traditional accounting conventions, its use can make it hard for investors to compare an issuer's financial information with other reporting periods and with other companies," said the SEC in a written statement.
To read more about employee stock options, click here
Glen De Valerio, a partner with Berman De Valerio Pease Tabacco Burt & Pucillo, a Boston law firm specializing in securities fraud, says this is a step in the right direction and that the SEC now has a golden opportunity to enact meaningful reform in order to prevent another wave of accounting debacles. De Valerio says that within the next six months, the Enron disaster will remain fresh in investors' minds. After that, it might be difficult to encourage less use on pro-forma numbers.
Still, the best hope for meaningful accounting reform may just be good old-fashioned capitalism. "Other countries, both in the emerging and established markets, are doing major overhauls of accounting procedures. The U.S. has been smug for nearly a century. Other markets are going to lap us and if that happens more capital will start flowing abroad," the Corporate Library's Minow says.
To that end, the International Accounting Standards Board has proposed that companies report the granting of options as an expense. Currently, companies can grant as many options as they like without having to report it as an expense. But of course, options do have an effect on shareholder value since the exercising of options causes an influx of more shares on the open market, thereby diluting a stock's value.
This became particularly problematic during the technology boom as companies handed out big option packages to high-ranking executives and directors without eyeing the effect it might have on other shareholders. Forcing companies to report option grants as an actual expense might make them think twice about doling out an excessive number of options.
"This would add additional transparency and make the decision to grant options a lot more costly," says De Valerio of the Boston law firm.
Accounting irregularities aren't new
But even if the SEC takes action soon, it might be too late to prevent some earnings disasters that are already looming.
"There are still an awful lot of assets that have been evaporated but not written down. People are looking for a quarter with bad news so they can write it all off at once," says Aaron Brown, CEO and co-founder of eRaider.com, a shareholder activist site. Brown adds that investors should be especially skeptical of reported earnings from companies in the struggling technology and telecom sectors. "Asset quality is lower than it has ever been," he adds.
Chuck Hill, director of research for earnings tracking firm First Call, also says there are probably more earnings blowups waiting in the wings. But this is nothing new.
Hill, a former analyst, recalled a meeting he was in with the chairman of Memorex during the recession of the early 1970s. The chairman was discussing Memorex's lease accounting. After several questions from confused analysts, Hill says the chairman finally threw his hands up and exclaimed that he couldn't explain the accounting either.
"In the waning part of the cycle people stretch to make the numbers. They push the envelope on the accounting. We've certainly seen the typical pattern," Hill says. "This doesn't mean that it shouldn't happen but you can't really say that it's a surprise." 
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