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2. The Production of Dubious
Reported
Earnings
through
“Creative” Accounting Procedures
A firm’s income statement may be likened to a bikini—
what it reveals is interesting but what it conceals is vital.
Enron, one of the most ingeniously corrupt companies I have
come across, led the beauty parade in this regard. Alas, Enron
was far from unique. During the great bull market of the late
1990s, companies increasingly used aggressive fictions to
report the soaring sales and earnings needed to propel their
stock prices upward.
In the hit musical
The Producers
, Leo Bloom decides he
can make more money from a flop than from a hit. He says,
“It’s all a matter of creative accounting.” Bloom’s client Max
Bialystock sees the potential immediately. Max fleeces
buckets of money from rich widows to finance a Broadway
musical,
Springtime for Hitler
. He hopes for a total flop, so
that no one will ask questions about where the money went.
Actually, Bloom doesn’t begin to match the tricks that
have been used by companies to pump up earnings and to
fool investors and security analysts alike. In chapter 3, I
described how Barry Minkow’s late 1980s carpet-cleaning
empire, ZZZZ Best, was built on a mosaic of phony credit
card billings and fictitious contracts. But accounting abuses
appear to have become even more frequent during the 1990s
and early twenty-first century. Failing dot-coms, high-tech
leaders, and even old-economy blue chips all tried to hype
earnings and mislead the investment community. As he left
the chairmanship of the SEC in 2001, Arthur Levitt warned,
“We see greater evidence of [accounting] illusions or tricks
than has ever been true of the past.”
Here’s but a small number of examples of how companies
have often stretched accounting rules like taffy to mislead
analysts and the public as to the true state of their
operations.
In September 2001, Enron and Qwest needed to
show that their revenues and profits were still
growing rapidly. They figured out a great way to
make their statements look as if business was
proceeding well. They swapped fiber-optic network
capacity at an exaggerated value of $500 million, and
each company recorded the transaction as a sale. This
inflated profits and masked a deteriorating position
for both companies. Qwest already had a surfeit of
capacity and, with an enormous glut of fiber in the
market, the valuation put on the trade had no
justification.
Motorola, Lucent, and Nortel all boosted sales and
earnings by lending large amounts to their customers.
many of these accounts became uncollectable and had
to be written off later.
Xerox boosted its profits in the short term by
allowing its overseas units in Europe and Latin
America, as well as Canada, to book as one-time
revenue all the cash to be paid over several years for
long-term copier leases.
“Chainsaw Al” Dunlap, the CEO of Sunbeam,
needed a boost during the winter quarter to satisfy
Wall Street’s need for steadily growing earnings. He
hit upon the ingenious idea of convincing retailers to
buy backyard grills in the middle of winter. Chainsaw
sweetened the deal by saying that the retailer would
not have to actually pay for the grills until later and
that all purchases could be stored in Sunbeam
warehouses. Eventually, Dunlap ran out of tricks and
fled, leaving Sunbeam a cutup wreck that finally went
bankrupt.
Eastman Kodak availed itself of “big bash”
accounting
write-offs.
Kodak
took
six
“extraordinary” charges during the 1990s totaling
$4.5 billion, equal to all the company’s profits over
the preceding eight years. By charging off years of
expenses at once, the company could make future
earnings look that much better. It’s like an individual
making several years of mortgage payments in
advance and then claiming that his income has grown.
Then there is the pension gambit. Many companies
estimated that their pension plans were overfunded,
and therefore they eliminated the companies’
contribution to the plans, thus boosting profits.
Often these gains were hidden in the footnotes. When
the market suffered a sharp decline during the early
2000s, the companies discovered that their plans
were actually underfunded and what investors
assumed were sustainable profits turned out to be
transitory.
A major problem that the analyst has in interpreting
current and projecting future earnings is the tendency of
companies to report so-called pro forma earnings as opposed
to actual earnings computed in accordance with generally
accepted accounting principles. In pro forma earnings,
companies decide to ignore certain costs that are considered
unusual; in fact, no rules or guidelines exist. Pro forma
earnings are often called “earnings before all the bad stuff,”
and give firms license to exclude any expenses they deem to
be
“special,”
“extraordinary,”
and
“non-recurring.”
Depending on what expenses are considered to be improperly
ignored, companies can report a substantial overstatement of
earnings. Small wonder that security analysts have
extraordinary difficulty estimating what future earnings are
likely to be.
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