(FORTUNE Magazine) – PROFITS ARE formidable statistics. They stare out from annual reports with an air of finality. They weigh heavily in our decisions to invest or sell. They even influence our language and our thought. The figure that graces the bottom line of an income statement has become synonymous with the kernel of truth that remains after all the detritus has been scraped away, all superfluous matters dispensed with. How disconcerting it is, then, to be reminded once again at annual report time that profits, like sausages and laws, are esteemed most by those who know least about what goes into them. Take, for example, CUC International, a Stamford, Connecticut, company that helps millions of consumers shop at home, either by computer or telephone. Until last month CUC's performance dazzled Wall Street. Then CUC admitted that its profits had been inflated by aggressive accounting, including a policy of deferring over several years the costs of attracting new customers. In March the company wrote off all the deferred expenses in a single dramatic stroke. The $51 million charge wiped out not only last year's profits, but also every dollar of profit the company had reported for the past three years. Scrupulous honesty in financial reporting is at an all-time low. Says Thornton O'glove, editor of the Quality of Earnings Report, a respected newsletter: ''To most companies today, managing earnings is almost irresistible.'' The proof is in this year's annual reports, which are laden with obfuscations, special items, and accounting gimmickry. The figures carry the sanction of generally accepted accounting principles (GAAP), the accounting industry's body of guidelines. But no less renowned a financial detective than Warren Buffett observes, in his 1988 Berkshire Hathaway annual report, ''Many managements view GAAP not as a standard to be met, but as an obstacle to overcome.'' Small, fast-growing companies stretch the truth most consistently, but the temptation strikes corporations of all sizes. The award winner for 1988 was General Motors. ''Roger Smith is very fond of pointing out that the company had record earnings last year,'' says David Healy, a security analyst at Drexel Burnham Lambert. ''Of course, if they had stayed on the same bookkeeping methods, they wouldn't even have come close.'' Healy calculates that about $1.8 billion of GM's $4.9 billion of profits came courtesy of its finance team. The biggest chunk -- about $790 million -- represented a decision to depreciate GM's auto plants the way Ford does: over 45 years instead of 35. About $480 million came from a change in accounting for its pension plan, $217 million from a shift in policies regarding the value of its inventories, and $270 million from rethinking the assumptions about the residual value of the cars leased out by the company. Nipping at GM's tires was General Electric, which just about buried some $430 million of unusual charges in its annual report. In the fourth paragraph of his letter to shareholders, CEO Jack Welch admits that the biggest operating challenge GE faced last year was the cost of repairing compressors on its refrigerators. A mere 69 pages later, in the notes to its analysis of quarterly performance, GE mentions that the compressor fiasco cut its profits by just under $300 million. The exact size of the pretax hit is left unclear. At one point the annual report puts the cost at more than $429 million; at another it offers a formula that suggests the charge was $427 million. Nowhere does GE explain how much it actually paid to repair refrigerators last year or how much it set aside as a reserve against future losses. Since the pretax loss equaled 80% of the operating profits of NBC, another GE subsidiary, investors might have expected more candor, even if it didn't make the nightly news. With so many managers stretching or obscuring the truth, getting to the bottom of the bottom line is more difficult than ever. Herewith a guide to some of the common abuses: -- Taking the big bath. It's a lousy quarter. The chief executive looks ahead and realizes that a few of those sure-fire investments of three or four years back are running out of steam. Why not drop all the bad news into a single quarter, take a big hit to earnings then, and get it behind you? The big bath represents the corporate equivalent of two weeks at a fat farm. It rids the company of excess expenses and may eventually firm up profits. New chief executives are especially keen on the tactic because it allows them to blame the bad news on the old CEO. While many of the big bath's benefits are illusory, it has recently gained renewed celebrity helping chief executives make a success of restructurings and leveraged buyouts. Companies don't always get it right. Consider Honeywell. In 1986 it took a $400 million bath when it wrote off its computer business. Last quarter it was back in the tub again. The $480 million plunge provided special reserves for tax problems and the discontinuation of another product line -- solid-state electronics, this time around -- and covered the costs of layoffs and other restructuring unpleasantness. Should an investor feel comfortable? Not necessarily. Observes Wayne Kolins, director of accounting and auditing for BDO Seidman: ''A tremendous amount of judgment goes into deciding what a restructuring write-off should be.'' -- Smoothing quarterly profits. CEOs know that investors hate surprises, so they try to keep net income trending up a nice straight slope. But what happens if the company gets lucky and lands a huge one-time gain? The CEO can either report a sharp rise in quarterly profits -- hard to top next year -- or he can call on the guys in the back room to store some of the windfall in corporate cookie jars, typically labeled special reserves. Last month BankAmerica, which has a long history of stashing a little something away, set up a special reserve against possible losses on loans to vocational students. Thanks to a computer breakdown at a loan servicing company, the loans lost their federal guarantee, and BankAmerica, though only the trustee for the issuer, could be stuck with the losses on loans that go bad. The potential cost: as high as $600 million. But not to worry, the bank told shareholders. It just so happens that income from certain special items will be enough to offset any blow to profits. You can also disguise the cost of restructuring by timing big one-time charges to coincide with gains on the sale of major assets. In 1987 GE played down a $1 billion write-off this way. Last year United Technologies offset a $149 million write-off of slow-moving inventory with a $137 million gain from the sale of subsidiaries. -- Deferring costs. CUC International's losses resulted from a too aggressive policy of deferring costs. The company's customers usually sign up for a year, but a large percentage reenroll at year's end. GAAP allowed two alternatives: Either recognize the expenses entailed in getting customers as those expenses are incurred or spread them over the likely life of the membership contract. Relying on its experience, CUC elected to spread its costs over three years. This became a problem when the deferred expenses came to far exceed the company's reported income. Computer and software companies face a similar dilemma. They may spend years developing a software program, but don't generate any income until the product is on the market. Should they recognize development expenses as they are incurred or defer some of them until revenues start to roll in? Management's < choice can make a big difference in profits. Sequent Computer Systems, an Oregon maker of workstations, reported a 50% jump in per share profits for the first nine months of its 1988 fiscal year. The entire gain derived from Sequent's decision to defer rather than expense about $2 million of software development costs. -- Gathering revenues while ye may. Another sticky question -- some would say opportunity: When to recognize income under a long-term contract? Consider the plight of Organogenesis, a highflying biotech company near Boston with a promising system for creating a living-skin equivalent for burn victims and another system for creating artificial blood vessels and organs. The company is spending millions developing its products, with support from Eli Lilly and a Pittsburgh hospital. Since 1987, Organogenesis has recorded $4.5 million of revenues under its two long-term contracts. Included was all the income from the hospital's research grant, about $1.2 million, even though Organogenesis has neither received all that money nor successfully completed its trials. The rest of the $4.5 million came, apparently, from the Lilly contract. How could Organogenesis report income it hasn't been paid? More accounting magic. The most common way of accounting for long-term contracts is the method called percentage of completion. Management determines how much of the contract work has been done and recognizes the income and expenses related to that portion -- even though it may not get the money until the job is finished. Cautions Loren Kellogg, who publishes Financial Statement Alert: ''The percentage of completion method is fraught with peril.'' -- Hiding inventory. Manufacturers may record a sale every time they ship a product to a retailer or wholesaler. So it is very tempting when profits start to flatten a little to just keep shipping the stuff, even when retailers' shelves are chockablock. The manufacturers with the most stuffing power are automakers, which sell to captive dealers and finance the sales themselves. Drexel Burnham's Healy says that over the past six months auto companies have been pushing iron out faster than dealers wanted, thus keeping Detroit's sales up even while final sales to Mr. or Ms. Carbuyer softened. Says O'glove: ''Companies can do wonders for their earnings by manipulating inventories.'' His list of possible offenders in this regard: Egghead Inc., a software retailer, the Pep Boys auto supply chain, and Harley-Davidson. | -- Dabbling with depreciation. Last year Blockbuster Entertainment, the biggest chain in videocassette rentals, tried to shake an industry bogyman. The major variable affecting profits reported by cassette rental outfits is their policy for writing down the value of the tapes they rent out. The useful life of a cassette, according to the rental companies, ranges anywhere from two to six years. The longer the write-off, the higher reported profits. Heeding the critics among its investors, Blockbuster decided to write off its big hits over just nine months, the period in which they earn the bulk of their rental revenues. Too conservative, objected the Securities and Exchange Commission, which forced the company to change back to three-year write-offs. The feds' argument: Blockbuster's nine-month policy allowed it to understate current earnings, to the benefit of earnings in later years. -- Touting one-time gains. A company that sells a large real estate holding or a subsidiary usually reports the proceeds as a special one-time gain, carefully segregating it from normal operating income. But Prime Motor Inns, which operates hotels and motels, sells property each year. Those sales are so much a part of normal operations, the company says, that they should not be listed as separate nonrecurring items. Over the past few quarters, however, Prime's sales of assets have increased while its revenues from hotel and motel operations remained flat. Is Prime up to something? Some investors think so; the stock's price-to-earnings ratio has declined.

All of these devices are at least arguably legal. Most CEOs don't feel a need to head off into the darker regions beyond accepted accounting practices. But executives at Regina Corp., a New Jersey-based manufacturer of vacuum cleaners, clearly did. Last September the company admitted to manipulating its numbers. Five months later, in a settlement with the SEC, the agency said Regina had inflated sales, profits, and revenues by omitting from its financial statements an annoying detail: While buyers normally return about 5% of all vacuum cleaners sold in the U.S., Regina's customers were returning 20% to 25%. Regina's senior management hid returns of at least $13 million of vacuums, and falsified other financial reports as well. Investors may buy management's bright sketches of a golden future for a while, but if the tints prove fake, the market will be unforgiving. Regina's stock dropped 50% on the day it disclosed the company's financial hanky-panky. CUC's shares dropped 10%. The gains their CEOs hoped to obtain through sleight of hand proved illusory, the hits to the stock price quite real.