Earnings Management
Accounting Red Flags

How can investors protect themselves from companies that spend more time managing earrings than managing their business? As shown by "Enrongate," it is very difficult to determine a company's real profitability even if a company complies with generally accepted accounting principles and with Securities and Exchange Commission regulations. At best it can be done in hindsight. The best protection for investors is knowledge, independent thinking and portfolio diversification.

Assuming a properly diversified portfolio, investors can further protect themselves by knowing where to look for signs of earnings manipulation. (We can't help you with the independent thinking bit.) Many companies exploit gaps in the generally accepted accounting principles (GAAP) and, although the specific techniques may be deemed acceptable under accounting and tax regulations, the results can be dire for shareholders if economic reality does not match the accounting.

What follows are five of the most abused techniques. Click on anyone to read an explanation.

Accelerating Revenue | Delaying Expenses | Accelerating Expenses | Off Balance Sheet Accounting | Pro Forma EPS

Accelerating Revenue

This technique allows companies to record revenue in the current quarter (accelerating revenue) while delaying recognition of the related costs (delaying expenses) for several quarters or years. This can boost revenue for the early quarters, but if business activity slows (due to a recession), earnings will drop significantly as revenue growth falls and expenses remain unchanged.

Global Crossing (otc: GBLXQ - news - people) is currently being criticized for selling long-term contracts (sometimes called indefeasible rights of use) that allow other telecommunications companies to use their fiber routes. Global booked the lump sum payment as revenue in the quarter it received the cash payment, although the service was, in fact, supposed to be delivered over a period of several years. Global also entered into separate contracts with another (or possibly the same) telecom to buy capacity on their fiber and recorded these costs as a capital expense that was spread out over the life of the contract (also several years) and which resulted in small quarterly expenses. In essence, Global was accounting for all the revenue from providing a service in a single quarter, while accounting for the cost of providing that service over several years.

In general, watch out when revenue and costs for the same product are accounted for over different timeframes. In Global's case, companies were willing to enter into these contracts while the economy was booming and the dot-com bubble was growing. As both collapsed, these companies faced falling prices, excess capacity and nobody wanted to enter into any more long-term agreements. As a consequence, Global's and many other telecoms' revenue growth slammed to a halt and these companies now face high fixed costs or are forced to write off these expenses.

Introduction | Delaying Expenses | Accelerating Expenses | Off Balance Sheet Accounting | Pro Forma EPS

Delaying Expenses

Under certain circumstances, companies are allowed to delay recognizing expenses on their income statements. For example, if a company makes a major investment in a plant or large machinery (a capital investment), the benefit of that investment will be returned over a number of years. In order to match the benefit with the expense, GAAP allows companies to depreciate the investment over the useful life of the asset.

In recent years, however, companies have gotten creative by delaying expenses by capitalizing them. For example, a few years ago AOL (before it purchased Time Warner) capitalized the costs of producing the millions of CDs it gave away to market its online service. As people started to sign up, profit and revenue grew rapidly, but the cost of making and distributing the CDs were being spread over a longer period of time. Eventually, the regulatory bodies required AOL to restate results and expense the cost of the CDs over a much shorter period of time.

Another example of delaying expenses was the way telecoms would buy the right to use the capacity of another carrier over a long period of time. The buyer of the capacity would classify the transaction as a capital expense, reducing the impact on earnings. Combining this with selling capacity to another carrier and booking the revenue up front (see: Accelerating Revenue) would result in astronomical earnings growth.

Introduction | Accelerating Revenue | Delaying Expenses | Accelerating Expenses | Off Balance Sheet Accounting | Pro Forma EPS

Accelerating Expenses

In order to improve future earnings, companies will "front-load" expenses and book them in the current quarter. Cisco Systems (nasdaq: CSCO - news - people) and Tyco (nyse: TYC - news - people) have been accused of having the companies they were acquiring write off as much as possible in order to maximize earnings per share (EPS) after the acquisition was finalized. Investors can spot these techniques by looking for "nonrecurring" expenses such as "in-process R&D" charge-offs, and most recently, "impaired goodwill" writeoffs. Regardless of what it is called, management decided to take an earnings "hit" instead of recording the expense over a number of quarters, as was previously planned.

"Nonrecurring" Expenses

Nonrecurring expenses is the generic term used for supposedly one-time charge-offs. This technique deserves special mention because it's a classic--and an oxymoron if ever there was one. These one-time charges were meant to take care of extraordinary--in other words, nonrecurring--events in order to separate them from "normal"--in other words, recurring--expenses. But, it seems like some companies take a "nonrecurring" charge each year. During the 1980s, Borden made many acquisitions in the food and chemical sectors. When management started to integrate the operations, it posted a string of one-time charges that were for restructuring charges and severance payments. To be fair, it takes time to integrate new operations and nonrecurring expenses represent management's best guess at any one time. When new information is available, companies adjust their estimates and this creates the "new" nonrecurring expense. I expect many of Wall Street's favorite stocks of the late 1990s to start posting nonrecurring expenses as the downturn in the economy has made many of their investments go bad.

Goodwill Impairment (FAS 142)

Goodwill represents an amount paid above book value to buy something because the buyer perceives a greater value in that something. For example, people go to Starbucks (nasdaq: SBUX - news - people) and pay $3.00 for a cup of coffee when you can get a cup of coffee for $1.50 at McDonalds (nyse: MCD - news - people). The $1.50 more you pay at Starbucks represents the goodwill you perceive in that particular cup of coffee.

Companies record goodwill on their balance sheets when they paid more than book value for an acquisition. The acquiring companies were willing to pay more than the value of the plant and equipment because of the value they perceived in the technology or brand name they were buying. Under the old accounting rules, companies had to periodically expense, or amortize, this goodwill over a period of years. However, a recent change in GAAP will eliminate the amortization of many forms of goodwill, but another change is expected to result in large charge-offs in 2002.

The new accounting rule is called FAS 142 and will generate a flood of "impaired goodwill" charges this year. If the goodwill on the books of a company is greater than the current market value of the asset, then the goodwill is deemed "impaired" and it must be charged off. The best example of this is any dot-com acquisition that occurred in 1999 where the buyer used its stock. After the bubble bursting and stock market crash, the value of that "business" is much less than the millions in stock that was paid for it and which is sitting on the balance sheet. Under FAS 142, it must all be written off. Think of it like your stock portfolio: In 1999, you may have bought tech stocks for $10,000. Today the market value is more like $500. Since you can't keep valuing your portfolio at $10,000, the $9,500 loss represents impaired goodwill that the market has written off for you.

The most recent example of this was AOL Time Warner's (nyse: AOL - news - people) announcement in January 2002 that it will take a $60 billion hit to write down bad assets. Other sectors that will be hit hard by this new accounting rule are the darlings of the dot-com era that acquired other companies at inflated prices and paid with stock. Under the new rules, many of these deals can be viewed as "impaired." The way FAS 142 was written, it behooves companies to take their "hit" as soon as possible in 2002. If the charge is taken now, it will be treated as a nonoperating expense and will not reduce EPS. If a company waits too long, the charge will be treated as an operating expense and will reduce EPS.

"In-Process R&D" Charge-Offs

This is a type of nonrecurring charge that graced many a tech stock's income statement during the 1990s. A large tech firm often acquired smaller companies that were heavily involved in developing new technologies or software. Because the technology was not yet commercially viable (thus "in process") the acquiring company could deem it worthless and write off the related costs. However, there could be some future revenue derived from the technology, otherwise why would the company have been acquired? Any future revenue would thus be recorded without the expense of the related R&D and EPS would be overstated.

You don't see much "in-process R&D" writeoffs these days because it is being replaced by goodwill impairment charges. But it is useful to know that charging off capitalized expenses has been around for some time.

Other Income

This category is especially susceptible to earnings manipulation because it houses a multitude of sins. It is a catchall for other revenue and expenses that aren't classified in the other major line items or are not large enough to be "material" in the eyes of the company's executives. This is the category where companies book any "excess" reserves from prior charges (nonrecurring or otherwise) and offset them with "other" income.

Introduction | Accelerating Revenue | Delaying Expenses | Off Balance Sheet Accounting | Pro Forma EPS

Off Balance Sheet Accounting

Off balance sheet accounting refers to the methods a company can use to remove assets and liabilities, as well as income and expenses, from its balance sheet and income statement. In one sense, off balance sheet accounting is good because, done properly, it can protect investors by moving business risk from the parent company onto independent partners and minimize taxes, both of which benefit shareholders.

There are three main ways companies can move assets, liabilities, income and expenses from their books; special purpose entities, spinoffs, and synthetic leases.

Off Balance Sheet Companies (Special Purpose Entities)

Off balance sheet companies are separate legal entities that are jointly financed by the parent company and supposedly independent outside investors. These companies are sometimes referred to as special purpose entities ("SPE"). GAAP and tax laws allowed these structures as a legitimate way to finance risky business ventures, such as oil exploration or developing a product that is radically different from the corporate parent's main line of business.

Under normal circumstances, off balance sheet entities are legitimate tools that can protect investors. For example, oil exploration is a high-risk/high-return business and one that might not appeal to investors in more steady business, like an oil refinery. In order to facilitate oil exploration, accounting "rules" allow the refinery to establish a separate business to explore for oil and that can be invested in by others who are willing to bear that risk. Removing this exploration risk from the parent actually protects its shareholders who invested in the refinery business and do not want any part of the riskier oil exploration business.

Originally, it appears that initially Enron (otc: ENRNQ - news - people) was using SPE's appropriately by placing nonenergy-related business into separate legal entities. What they did wrong was that they apparently tried to manufacture earnings by manipulating the capital structure of the SPEs; hide their losses; did not have independent outside partners that prevented full disclosure and did not disclose the risks in their financial statements. Or to put it another way, they got greedy.

Any system can be abused and misused. If management uses nonpublic SPEs as a way to hide debt and manipulate earnings, it will lead to Enron-type disasters. Enron has highlighted serious flaws in GAAP that hopefully will soon be corrected. In the meantime, investors should make sure that companies using off balance sheet financing conform to a few simple rules.

There should be no interlocking management: The managers of the off balance sheet entity cannot be the same as the parent company in order to avoid conflicts of interest. This was clearly not the case at Enron.

The ownership percentage of the off balance sheet entity should be higher than 3% and the outside investors should not be controlled or affiliated with the parent: This is necessary in order to prevent the "Three-Card Monte" that was used by Enron. In order to circumvent the outside ownership rules, Enron funneled money through a series of partnerships that appeared to be independent businesses, but which were controlled by Enron management. While this type of Ponzi scheme is very difficult to detect, let's hope that the regulators act fast to plug this gap.

The financial risk of all off balance sheet entities should be disclosed in the parent's financial statements: If nothing else, this must be done in order for investors to evaluate the total risk of investing in any company. Footnote disclosures of the leverage risk and any guaranteed debt would have alerted Enron shareholders of the growing risk they faced.

Under current GAAP, companies are required to disclose (albeit barely) ownership in separate legal entities. If little else is disclosed, take that as a red flag.

Spinoffs

Spinning off a subsidiary into a separate publicly traded entity is another way to establish a SPE. The only difference is that the spinoff is publicly owned and must disclose its financial statements just like the parent. For example, Williams Companies (nyse: WMB - news - people) spun off Williams Communications (nyse: WCG - news - people) in order to separate the business risk of a telecommunications from their shareholders who wanted to invest only in an energy company. As part of the normal process, the parent had to guarantee the debt of the spinoff. With the telecommunications crash, banks are now relying on those guarantees, which are raising the concern about the parent's ability to handle all that debt.

Synthetic Leases

A synthetic lease is a way for a company to finance a new building or plant and improve its financial performance ratios (such as return on assets and return on equity) by keeping assets and debt off its books and boosting EPS by avoiding depreciation expenses. Under the synthetic lease, a company pays a relatively small lease payment for a number of years, which usually represents the interest on the loan used to finance the building. However, at the end of the synthetic lease, the company must take ownership of the building and refinance the debt, which may not be easy if the economy is in a recession or if the company is losing money. (For more information on how Krispy Kreme (nyse: KKD - news - people) tried to use synthetic leases, see: "Debt? Who, Me?")

Introduction | Accelerating Revenue | Delaying Expenses | Accelerating Expenses | Pro Forma EPS

Pro Forma EPS

The words "pro forma" indicate that assumptions were used to derive whatever number is being discussed. Used correctly, pro forma earnings are a good way to compare "apples to apples." For example, if a company doubled its size with an acquisition, investors would want to know how much of the sales and earnings growth was generated by the core business (also referred to as "organic growth") and how much came from the new acquisition. Companies normally use pro forma sales and earrings to compare the core results and avoid the distortion caused by comparing the combined results to the historic results of the original (smaller) company. Likewise, if a company sold a division, it would use pro forma data to compare the results of the remaining business.

Recently, however, pro forma earnings have been used as a way for companies to divert attention from their actual GAAP earnings to a semi-fictional number management thinks will please Wall Street. Amazon (nasdaq: AMZN - news - people) is the pro forma poster child because it raised pro forma reporting to a high art. Most recently, it announced that it "earned" a pro forma $0.09 per share in Q4 of 2001. But the GAAP number was $0.01 (and I even think that number is suspect). In the past Amazon has tried to focus attention on pro forma earnings that excluded expenses that could be considered necessary and which should have been used to calculate EPS. If there is a large difference between pro forma EPS and GAAP reported EPS, this should be a big flag to investors of the need to dig into the financial statements because it generally indicates that the company is trying to divert attention from "real" earrings.