Common Tricks Used To Disguise Earnings

Here are some common tricks use to distort or disguise real earnings performance and how the truth is buried in the financial statements.

The Pro-Forma Pretense:

When two companies merge, a "pro-forma" or "as if" financial statements are issued. The aim is to give investors with an idea of what the merged entity's financial numbers will look like - as if it had been operating as one. In the 1990s, pro-forma statements became a favorite tool of companies to obscure shaky finances. It is especially a popular for the high-tech companies as they discovered that using pro-forma earnings announcements could allow them to selectively exclude many types of expenses that reduce earnings to cover up the fact that they had little or no earnings as defined by GAAP. Other companies in many other industries soon followed suit.

Because pro-forma earnings by its very nature are not GAAP-compliant, few rules dictated what went in, or what stayed out, of a pro-forma statement. But with the passage of Sarbanes-Oxley corporate reform law, the law dictates that all pro-forma earnings must be reconciled to the most directly comparable GAAP financial measure. Some companies excluded restructuring costs under the excuse that they were "unusual" or not part of the company's core operations. Other left out depreciation and amortization expenses, and yet others excluded interest and tax payments. So when a company announces pro-forma earnings, make sure you keep reading until you get to the GAAP number, which you can then see if there're indeed any ugly details that pro-forma excludes.

If used properly, pro-forma numbers can make sense as to which really are unusual and which ain't. But some companies went to ridiculous extent. Take the case of SEC case brought against Trump Hotels & Casino Resorts in January 2002. This case highlights how far companies had bent the rules to get investors to focus on pro-forma results. In October 1999, the company issued a press release announcing the third-quarter pro-forma net income of $14 million, and touted that its positive operating result had beaten analysts' expectations. The release also made clear that the pro-forma results excluded a one-time charge of $81.4 million from closing down a hotel and casino in Atlantic City. But the release did not state that the pro-forma earnings included a $17.2 million, one-time gain, which was the result of some termination of lease. The company had simply chosen to include its pro-forma calculation a one-time event that made its earnings rosier, while selectively excluded a much larger charge that would have made earnings look anemic. Next time you see a pro-forma earnings, be sure you know the assumptions behind the numbers. Read the entire press release and don't jump to conclusions based on a headline. Companies usually want you to focus on the headline and ignore the details so that you won't get to the ugly truth.

The Big Bath:

When companies restructure by selling unprofitable units, laying off workers, or closing production facilities, they often take a one-time charge that bundles the costs of the restructuring. Inherently, there's nothing wrong as long as the management views restructuring charges as a last resort to boost efficiency and restore profitability by writing off only those expenses that directly relate to the restructuring. But some companies use restructuring exercises like a cemetery - to bury all kinds of everyday operating expenses - to clean up its balance sheet. By taking "one big bath" in a single year, companies can pretty up an otherwise desultory earnings into better earnings in the future years. Why would companies want to take restructuring charges that overstate costs even though that makes losses look worse? Because managers and analysts have convinced investors and Wall Street to that one-time loss doesn't matter and look to future earnings. Once Wall Street is convinced, the analysts will tell you that a restructuring charge is all about the past and that it matters little, or nothing, to the company's future prospect. For companies, the beauty of restructuring is that they can front-load several years of expected future expenses into one big package which allows the company to boost future earnings by not offsetting income-producing activities with their associated expenses. Investors who ignore big bath accounting is ignoring at their own perils. Investors should dig out the underlying reasons for the write-off, which may be a signal to sell.

Cookie Jars and Channel Stuffing:

Warren Buffett warns us companies that cannot make the numbers may eventually chose to make up the numbers. Companies can deceive investors with a number of accounting shenanigans. Two of the more common tricks are called "cookie-jar reserves" and "channel stuffing."

• Cookie-jar reserving or accounting occurs when a company intentionally overestimates future liabilities for items such as loan losses (for banks), warranty costs, loss and loss adjustment expenses (for insurance), or sales returns. By doing so, a company can stash money in cookie jars during good times and reach for them when needed in bad times.

• Channel stuffing is the business practice where a company inflates its sales figures by stuffing or forcing more products through a distribution channel and thus loading the channel with more than it is capable of selling. To entice customers to load up with more than they really need, the company often offers discounts, below-market financing, extension of payment terms, or easing of return policy. While such hurry-up sales rob revenue from future quarters, they help cover up a bad quarter so that management can boast that it met analysts' estimates.

Channel stuffing are not without its consequences, by easing the selling policy of the company, the potential for higher default in payments, or return of sales, increases. Besides, it is illegal. In May 2001, Sunbeam Corp. (now part of Jarden Corp.) is alleged by the SEC that the company used both methods in a fraudulent attempt to trick the market into believing that the company was worth more than it really was. According to the allegation, Albert Dunlap, the former CEO and Chairman, was hired by Sunbeam's board in 1996 to restructure the ailing company. As a so-called turnaround specialist, Dunlap set to reorganize the company and promise shareholders quick results. After taking a restructuring charge and reporting huge losses for 1996 - which Dunlap was able to blame on the previous management - the company then reported a record profit of $189 million from continuing operations. But the SEC alleged that the feat was achieved in part by reaching into the cookie jar that was reserved in 1996. In addition, the company is alleged that the record profit was achieved at the expense of future results by inducing customers to buy merchandise they didn't need. Sunbeam had used a scam called "bill and hold," in which it recorded the sale of merchandise but held them in its own warehouses because the customers didn't yet need, or didn't want, the goods. Under GAAP, a bona fide sale takes place only when the customer takes possession of the goods or requests that they be stored. Of that $189 million, the SEC alleged that at least $60 million came from accounting fraud. Because Sunbeam robbed from future results in 1997, it became increasingly desperate to make its numbers in 1998, and was forced to repeat its sins. This time not only did Sunbeam engaged in channel stuffing, but it also deleted certain records to conceal pending returns of merchandise. Now only the sales, and not the returns, appeared on the books. Such case is not unique to Sunbeam, larger companies like Bristol Myers Squibb also engaged in such alleged frauds, though not to the extent of destroying records. In the end, both cases were settled with the SEC without admitting or denying the allegations - which seems a commonality.

There are other ways companies can cook their revenue books by recognizing revenue before the service or product is delivered. For example, a company may sell computers along with a five-year servicing contract along. Under GAAP rules, the service contract must be spread evenly over 5 years as the company "earns" it, or 20% of the service contract value each year. The computer sales however must be recognized immediately once it is delivered. But when the computer and the service contract are sold together for a single "package" price, separating the components can be subject to manipulation. Booking revenues prematurely results in inflated sales figures and misrepresents earnings result - in fact it is similar to "robbing Peter to pay Paul" when companies rob revenues from future periods and recognize it in the current period.

Write-downs and Reversals:

When a company stockpiles on goods it can't sell, and the value of the goods declines below what it will be sold for, accounting rules require that the company writes down the value of the inventory on the balance sheet. In a well-run company, write-downs should be minimal because managers pay proper attention to the supply chain signals of customers and inventory levels and the timing of new product introductions.

In 2001, the telecom and internet-gear companies wrote down massive amounts of equipment because they missed warning signs that their sales forecasts were overly optimistic. Cisco Systems shocked investors when it took one of the biggest such write-downs in April 2001. The company took a over $2 billion of write-down. Instead of liquidating the unnecessary inventory, Cisco kept it in warehouses and denied it ever intended to use or sell the goods in a future quarter. In a press release, instead of proclaiming a loss of $2.7 billion under GAAP, Cisco touted its pro forma earnings of $230 million by burying the $2.2 billion in excess inventory charge. Not only did the managers miscalculated the supply and demand - the crux of their job - they also treated the error as a book keeping exercise by downplaying the loss of real shareholders' wealth because real money were spent.

And by keeping the written-down inventories, the company would be able to report far better results by comparison to its outsized loss in 2001. If a company ends up using or selling the inventory it has written down, the offsetting expenses associated with those sales will be vastly lower, and thus profits can appear healthier than it really is. Eight months after Cisco's write-down, the company did just that and revealed in its 1Q02 earnings report: it had sold or used in production or research $290 million in "excess inventory" that it had previously termed worthless. The upshot was that the net loss of $268 million in the first quarter of 2002 would be much worse without this benefit.

Vendor Financing:

Companies sometimes lend their customers the funds to make purchases in order to boost sales. By doing so, the company is basically buying its own products. Motorola gives a good case that vendor financing can backfire. In February 2000, the company announced that it had sold $1.5 billion of equipment to Turkey's wireless carrier, Telsim. But investors had to wait more than a year to read in Motorola's proxy statement of March 30, 2001, that the company had lent $2.8 billion to customers to finance their purchase of Motorola wireless gear. Of that, $1.7 billion had gone to Telsim alone - a big exposure for such a significant amount lent to a single customer. A little over a month later, Motorola revealed that Telsim's debt was even deeper at $2 billion, out of a total of $2.9 billion in so-called finance receivables, or customer loans. It is also revealed that out of the $2 billion, $728 million was past due. However, the proxy left the strong impression that it had adequate collateral if Telsim failed to repay in 30 days - Telsim had pledged 66% of its stock to Motorola in case of default. In the next quarterly report in July 2001, shareholders got a shock when the entire $2 billion is in default. When Motorola notified Telsim that it was in default, Telsim issued more shares in the Turkish stock market and diluted the Telsim shares that Motorola held as collateral from 66% to 22%. That left Motorola with little recourse but to write off the loan. The following quarter, Motorola took a $1.3 billion charge against earnings.

The lesson is investor must be vigilant. Had an investor been so, they would have spotted clues in Motorola's financial statements. The first hint of any exposure was buried on page 53 (of 104) in Motorola's March 2001 proxy statement. It referred to "one customer in Turkey" responsible for $1.7 billion out of $2.8 billion in long-term finance receivables. In the next three quarters, the company slowly dribbled out information about the Telsim loans, ultimately hitting investors with a two-by-four when it announced the $1.3 billion charge.

Goodwill Games:

Until 2001, accounting rules allowed companies to account for business acquisitions in two ways: Pooling of interests or purchase accounting. When companies evaluate the value of an acquisition, they forecast the cash it expects the acquired company to generate. It also places a price on each of the assets such as equipment, plant and inventory. Assets can also be intangible, i.e., they have no physical form, such as intellectual properties like patents, brand names, quality of personnel and market share. When one company acquires another and pays a premium in excess of the value of its identifiable assets, the premium is called goodwill.

In the past, the far more popular accounting selected to account for acquisition is pooling of interest, in which companies simply combined their assets and liabilities by declaring their combination as a mere uniting of shareholder interest, as if no resources were used up and no goodwill was involved. The other method, purchase accounting is far less popular. Using the purchase method, companies could allocate the amount paid to all the assets acquired, including goodwill: the amount in excess of the identifiable assets is allocated and recognized as goodwill which must be amortized as an expense each year over a period of not more than 40 years. So you can see why companies elected the pooling method over the purchase method because the purchase method reduces reported earnings (though not economic earnings).

However, in 2001, the FASB changed all that when it ended the use of the pooling method. All acquisitions must be accounted under purchase accounting. But, at the same time, it lifted the requirement for companies to amortize goodwill. This means goodwill will no longer have to be expensed and thus no reduction of earnings tied to amortization of goodwill for years to come. Instead, companies must determine on an annual basis if the value of goodwill is impaired, or lost value, since the acquisition took place.

The merger of AOL and Time Warner, at the height of the internet frenzy, is an instructive case. It quickly showed how goodwill accounting changes can affect shareholders' interests, and expose the misjudgment of managers. Upon the combination of the two companies in 2001, it carried $127 billion in goodwill on the balance sheet. The large amount reflected both the inflated stock prices of the era and the excessive prices companies paid for acquisitions. Under the new FASB rule, the company announced that its goodwill is no longer worth $127 billion. As a result, it took the largest write down in history of $54 billion charge, in the 2002 first quarter earnings report. The company downplay the write-down as merely a paper correction, cheered on by most analysts, because it involves no hard cash, and have no effect on future earnings.

But is such huge write-offs really meaningless or pen-pushing events? This shows both companies hugely overvalued themselves and caused shareholders to overpay when the two companies merged. The truth is, goodwill write-offs and not amortizing goodwill allow companies to artificially lift their return of assets and return on equity, two key measures of a company's profitability. For example, AOL, expects to generate as much as $6.8 billion in additional profit in 2002 because it won't have to amortize any of the goodwill it carries on its balance sheet. By not deducting goodwill from earnings, it simply boost future earnings, until one fine day, the company finds it advantageous for them to take one big bath of impairment charges and wave it off as an insignificant event that does not affect cash flow.

Now, you can see, how far companies can bend backwards to use all kinds of accounting tricks to make earnings glossier than it really is. Most companies are not committing frauds even if they resort to smoke and mirrors accounting. Some of the more aggressive accounting path taken may even be legal because GAAP, even at its best, has plenty of built-in flexibility that allows companies to take liberties. And this is the real travesty. Nothing will change corporate managers from doing what they do.

No doubt any company that overplay the numbers game will have to restate earnings and losses will follow for not only the company, but shareholders as well. But for shareholders, it may be too little too late. So to avoid it, we, as investors must change our behaviors: 1) Never follow the herd and grab shares just because the headline suggests so and never sell just because the company falls short of analysts' expectations; 2) Read the footnotes and if you don't, the managers will be happy; 3) It's your responsibility to dig deeper to see what the true economic prospect the company has.