Study of Signals

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Study Shines Light on Earnings Statements

By ELLEN SIMON, AP Business Writer Sat Jul 30,10:50 AM ET

NEW YORK - Gaming a financial statement to meet earnings expectations has its own colorful nomenclature: cookie-jar accounting, channel stuffing and "the big bath." If a company's earnings meet analyst estimates, the stock gets boosted. If it doesn't, it's busted. But wise investors remember there are many ways a company can prettify its earnings.

A study by independent research firm RateFinancials, based in New York, concluded that nearly 33 percent of Standard & Poor's 500 companies file financial statements that don't accurately reflect their financial condition. Victor Germack, RateFinancials president, wrote about the study under the headline, "How Good are Those Earnings ... Really?"

A series of $1 billion-plus restatements, including HealthSouth Corp., Computer Associates International Inc. and the nation's largest insurer, American International Group Inc., have driven that question home.

More restatements are coming. Fannie Mae is expected to file a multibillion-dollar restatement once it untangles it books. Even number-crunching tax preparer H&R Block Inc. is working on a restatement.

Adjusting a company's finances to meet expectations is called "earnings management" or "earnings smoothing." In most cases, it's legal, if misleading.

The techniques involved "are endless," wrote John A. Tracy, author of 10 books on accounting and finance, including the classic "How to Read a Financial Report."

"A business can engage in deferred maintenance and not do normal things to keep its property and equipment in tiptop shape," wrote Tracy, an emeritus professor at University of Colorado. A company "could delay these costs until next year, thereby not recording expenses this year, which boosts its bottom-line profit for the year" he wrote. Or, it could put off employee training programs or advertising outlays until the next year.

Other methods of tweaking the books are more questionable.

For instance, there's channel stuffing, when a company makes sales look better than they are by shipping products to customers with the understanding those products can later be returned, or bought at a deep discount, said Itzhak Sharav, an accounting professor at Columbia University.

One of the most notorious channel stuffers was former Sunbeam Corp. CEO Albert Dunlap. Sunbeam shipped $1.5 million in barbecue grills to a distributor in March 1997. Although all the grills were returned at the end of the summer, Sunbeam had already booked the revenue. This was but one bit of Dunlap's accounting artifice. Under an agreement with the
Securities and Exchange Commission, he later paid a $500,000 fine and said he will never again hold a leadership role in a public company.

Another way to doll up the books is the cookie jar reserve. Companies can put aside a reserve of cash when times are good, then use it later.

Or they can take a bigger than needed hit when times are bad. Telecom equipment maker Nortel Networks Corp. did this when it took $18.4 billion charges for restructuring costs, bad customer debts and obsolete inventory over three years at the end of the telecom boom.

When it became clear that the reserves were greater than they needed to be, the company strayed from accounting rules and began dipping into them. Finance employees used the overstated reserves, starting in 2002, to "close the gap" between actual earnings and earnings targets, said a report by an outside law firm and consulting company that Nortel released in January.

A corollary lesson to the Nortel story is that companies can use accounting tactics to make one quarter, or one year, look worse than it really was, often by putting aside reserves. This is the practice called "the big bath." It's also very common for companies to announce big fourth-quarter writedowns, taking charges for restructurings planned the following year, to get the bad news out of the way.

Analysts question companies whose earnings seem as reliable as a collie.

"Be a little bit careful about giving too much credit to companies that are too reliable in meeting the numbers," said David W. Tice, president of Behind the Numbers LLC, an institutional research service. "Sometimes companies get a premium for that because investors feel like they're not going to be disappointed."

Rewards in the market come from risk taking. A wise investor knows there's always a chance of disappointment.

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