Managing Naked
from Winter 1999
by William S. Rukeyser
Many companies may soon have to ask themselves an embarrassing, even insulting question: Can we succeed in business if investors understand us? Right now, businesses have wide leeway in deciding how to powder and paint their operating results for public display. But accounting maneuvers that can make corporate weaklings look like lean, mean earnings machines are in jeopardy, and some of the most popular may not survive 2000.
The military role model inspiring certain chief financial officers seems not to be Patton, the traditional favorite, but Eisenhower, who once assured his press secretary just before a presidential news conference: “Don’t worry, Jim—if that question comes up, I’ll just confuse them.” Financial obfuscation presumably is as old as finance. It became an art form in the United States after the Securities and Exchange Commission began issuing disclosure requirements in the 1930s; previously, when asked for timely financial details, corporations generally just said no.
The smoke tends to thicken during periods of high activity in mergers and acquisitions, which offer accountants unique opportunities to call a cabbage a four-leaf clover. And the temptations have only increased in the ’90s bull market. For whatever reason, but possibly having something to do with the transformation of professionally managed corporate pension funds into millions of do-it-yourself 401(k)s, credulity is rampant. How else to explain the recent faith that businesses can not only grow forever but can do so at a constant rate without faltering even momentarily by even a penny a share?
This is the market environment in which questionable accounting has blindsided shareholders of Cendant, Livent, Sunbeam, and Waste Management. Warren Buffett, both a CEO and a mega-investor, complains that too many CEOs think “manipulation is not only OK, but actually their duty.”
Buffett differs. So does Arthur Levitt, the chairman of the SEC, who called in 1998 for an end to “earnings management” and added: “Managing may be giving way to manipulating; integrity may be losing out to illusion.” Since then, the SEC has brought scores of enforcement actions alleging accounting abuses, including charges that Fran Tarkenton, the former scrambling quarterback, helped fraudulently inflate the income of KnowledgeWare Inc. to meet earnings targets. Without admitting or denying guilt, Tarkenton paid a $100,000 fine and gave back a $54,187 bonus.
Managements that stay on the lawful side of the line between wishful accounting and fraud may not have to fear Levitt’s cops, but may still be scared by changes in the accounting rules. After decades of pondering, the CPA industry’s rule-making body, the Financial Accounting Standards Board (FASB), seems serious about making it harder to hide, smooth, or magnify earnings. A specific target is Hollywood, where studio accounting has long been one of the town’s most dazzling special effects. More far-reaching is FASB’s campaign to eliminate the merger-accounting option known as pooling of interests and instead to treat all business combinations as purchases, as most other industrial countries do. The change would, for example, force acquirers who use their high-multiple stock to buy companies for huge premiums over so-called fair value—that is, most of the acquirers you read about in the financial pages—to charge those premiums against their reported earnings as “goodwill” over no more than 20 years.
The concern of those who worry most about the proposed rules is for appearances. None of the changes would directly affect a company’s cash flow. The fear is that securities analysts and investors will eternally fail to perceive business realities. In other words, as an old saying has it, beauty is only skin-deep, but who skins ’em? Yet evidence to the contrary is already accumulating.
Emerson Electric has reported 166 quarters of uninterrupted profit growth, yet its stock has lagged behind the S&P 500 for the past five years; some money managers fault the company for being too risk-averse. By contrast, Genentech shares rose after goodwill created in a complex transaction with Roche AG turned a reported 1998 profit into a reported $223 million loss. According to the Wall Street Journal, Roche persuaded analysts that Genentech should be valued on “cash EPS”—per-share earnings excluding amortization of goodwill, a number FASB will allow all companies to report alongside net earnings if pooling dies. Already First Call, the collector of earnings forecasts, uses cash EPS if a majority of analysts forecast a company’s earnings that way.
More consistent accounting rules that better illuminate the underlying business reality promise to encourage investors and prolong the bull market. Executives and directors who think their company’s success depends greatly on the practices now under pressure probably should be worrying about matters closer to home than FASB.
