"Today, American markets enjoy the confidence of the world. How many half-truths, and how much accounting sleight-of-hand, will it take to tarnish that faith?"  Arthur Levitt, September 28, 1998

Spotlight:  May 25, 2001
 Message To SEC: Attack Pro Forma Accounting
 Corporations, and Wall Street will not suddenly agree on which set of numbers to report.  They must be told.
By Brady Willett

To begin with, the recent advent of fair disclosure appears to be working well: acting SEC Chairman Laura S. Unger notes, "so far companies seem to be releasing information more often. By one count, the number of conference calls open to individual investors tripled in the past year. Webcasts of those meetings quadrupled."  This is good news for the investor for two reasons: 1) a greater amount of information is being disseminated, and 2) this information is being absorbed at the same time by all market participants.  Additionally, FD is good news for the SEC, as it should readily limit investigation efforts into company/analyst shenanigans; prior to FD insiders could eat and be merry with Wall Street analysts, now a handshake or phone call may be suspect. Suffice it to say, FD's arrival has been both timely and effective. With this in mind the SEC, and related governing bodies, would do well to duplicate this effective initiative.         

In strict contrast to the quick impact of FD is 'pooling of interests': a slippery method of accounting that can artificially augment earnings results.  As well, a method of accounting that has been allowed to linger for many years*: after its September 1999 proposal the FASB reassured us on January 24, 2001 that the elimination of pooling was upcoming, but only on May 16, 2001 was a date finally set for June 30, 2001.  As Warren Buffett astutely pointed out in March 2000, "the Financial Accounting Standards Board ("FASB") has proposed an end to pooling, and many CEOs are girding for battle. It will be an important fight…".  Suffice it to say, after nearly two years of deliberations this important fight will soon be over.  Question is why did it take so long to resolve in the first place?1 

In sum, FD was a successful initiative because it altered the balance of power between Wall Street and Main street by providing a new schematic for the dispersal of corporate information.  Contrarily, the elimination of pooling of interests will likely fail in its goal to increase accounting transparencies, because it is inevitable that other misleading accounting practices are on the horizon.  With this in mind, a recent speech from Commissioner Isaac C. Hunt, Jr. pinpointed 3 area of concern that the SEC may soon be attacking. These items include the use of 'smoke and mirrors' to prop up earnings/revenues, channel stuffing, and pro forma information. After reviewing each issue there is only one conclusion to be made: stop pro forma!  Let us first look at channel stuffing.

Channel Stuffing
You are a CEO, it is near the end of the quarter, and you calculate that you will miss estimates by a penny.  What do you do? 

The reason why channel stuffing should not be an immediate concern for the SEC is because even if companies can promote lopsided quarterly advances, these gains are unlikely to continue into the future unless the business itself is sound.  Mr. Hunt comments that "Some companies have announced that they will not meet their year-end earnings targets, apparently because they have been, in effect, reaching ahead into next quarter's sales to meet their quarterly targets."  My tepid response to this statement is – so what?   If the company's practices are legal you cannot stop a business from aggressively trying to increase activity near quarters end. That said, there is some question over the legality of certain company practices.

"senior managers (at Sirena Apparel) reset a computer clock in order to hold a quarter open to meet a target. Employees of that company even placed bets with each other over how many additional days it would take to make the numbers!"

 "Smoke & Mirrors"
A 1999 study from the Treadway Commission revealed that over half of financial reporting frauds involved overstating revenue. Remembering this, the topic of 'smoke & mirrors' quickly becomes too extensive to expect an immediate resolution. As well, even as the SEC, and/or FASB adopt new policies to limit revenue trickery it is a foregone conclusion that new and improved tricks will take the place of the old.  Often time's accounting practices are better (or more transparent to the investor) when left alone. In the case of intangible assets, what once seemed like a good idea (to increasingly accept new ways of thinking when it comes to intangible assets)2 has quickly become a nightmare for regulatory bodies: countless papers, and reports on everything from goodwill to trademarks have been issued, yet the value of something that has no hard value has yet to be pinned down.

Whats New
The SEC recently passed a set of new revenue recognition rules that many companies have had a difficult time complying to (SAB 101 – Extension request #1  #2 ).  When these types of company/SEC conflicts arrive it is usually a sign that the SEC is doing their job.  As well, those companies that resist new revenue recognition laws usually have a good reason to do so: that being that they are misrepresenting earnings/revenues to investors, and are unwilling to stop reaping the rewards seen in a rising stock price.  On such company may be Pre-Paid Attorney's (PPD).  After a plethora of lawsuits, and recent SEC comments something will soon develop concerning PPD's revenue recognition practices.3

Pro Forma
While broadly based regulatory measures would be required to eradicate channel stuffing, and smoke and mirrors concerns, a more simpler and decisive action is needed to ease SEC apprehensions on the topic of pro forma results.

 

Pro Forma Loss

Net Loss (GAAP)

Amazon.com  Q101

$49 Million

$234 Million
                                Does it matter which set of numbers receives the most attention by Wall Street, and investors?

 The reason why pro forma financial results have been allowed to proliferate in recent years is because the SEC has done nothing to the stop them.  You can not expect companies to willingly stop using this style of reporting if it helps them reach expectations, and/or cushions the blow from compensation costs, restructuring fees, and/or presumably miscellaneous 'one time' charges.  A simple recent example of how pro forma methodology enhances earnings results can be seen in a General Electric release:

 "GE Reports Record First-Quarter 2001 Results - Ongoing Earnings Up 16% to $3.017 Billion"
GE.com

 Fact is, since January 2001 companies must report derivatives, and hedging practices on the balance sheet at fair value, and any changes in fair value must be immediately recognized in earnings.  When doing this GE actually had $2.573 billion in earnings in the first quarter, down from $2.592 billion in 1Q01.  Question is, what looked better to investing public: 'Up 16%' or 'down $19 million'?

GE, and numerous other companies have slowly, but assuredly, been switching over to the 'pro forma' method of reporting.  However, while GE talks of a 16% earnings increase it should be noted that these are not the final results that they send to the SEC.  Rather, pro forma results are not audited, and can be manipulated at the company's discretion.  To put it plainly, pro forma means 'professionally formed' financial results. 

It should be remembered that GE did not break any accounting laws when highlighting 'ongoing earnings' under the pro forma dogma.  Rather, GE simply decided to downplay SFAS 133 as if it is an accounting flaw that does not impact their business.  The SEC and FASB should recognize that when companies like GE report pro forma results in this manner they threaten to undermine regulatory policies; at root, pro forma reporting can nullify or put into question new accounting rules.  As such, why spend the time creating new policies if they will only be thrown to the bottom of reports in a convoluted set of footnotes?  Does this help the investor?  As an extreme example: what if companies continue (past June 2001) to use pooling practices in pro forma results while footnoting the real numbers?  Would not two years of FASB study have been wasted?  Lastly, and it goes without saying, Wall Street has accepted pro forma results: an ominous trend that has been ongoing for some time.
 
"It's snowballing -- we're seeing more and more companies reporting their earnings in numerous different ways, and analysts are going along with it".   Chuck Hill, 1999

 Conclusion

The SEC should overtly focus its attention on the differences between financial reports sent to Wall Street and PR firms versus those sent to the SEC. While the same set of numbers are being manipulated, all too often those numbers that are likely to lend to an increase in share price receive significantly more attention.  The conflict rests not with Wall Street analysts who have readily accepted new accounting measures, but with the regulatory bodies who have myopically been attempting to regulate the macro while ignoring the micro: it does not matter what new accounting procedures come to pass if companies can report predisposed pro forma results come judgment day (Earnings day).

For the elimination of pro forma financial results to become a reality the SEC need not begin the process by diving into a cumbersome set surveys, reports, and theories.  Rather, they need only fashion one simple document that informs the financial world that GAAP results are non negotiable.  They then need to ensure that net income and revenue, for better or worse, become straightforward indicators that include all costs, take into account all new accounting policies, and relegates optimistic corporate opinions of accounting practices to the footnotes.   To be sure, pro forma results are a subjective opinion a company crafts within its quarterly results - an opinion that all too often omits what is financially terrifying, and highlights what is pleasant looking.  Lastly, the SEC needs to tell investors4 that they are still looking out for their interests.  They can only succeed in doing this by altering the balance of power yet again: by attacking the pro forma conundrum with extreme prejudice. 


* Warren Buffett touches on the pooling/purchasing conundrum back in his 1983 letter to shareholders.

1. The FASB's mandate to 'end pooling' has not wavered since September 1999.  Moreover, the FASB Chairman Jenkins claimed back in September 1999 that "We estimate that our process will be complete and a final statement issued by the end of 2000".  No comments have been made as to why the proposal is running at least 6 months late.
Two years may not seem like a long time, but try telling this to those investors who purchased pooling king pin Cisco Systems during this time frame. Cisco shares may not have initially begun to drop directly because of the expected end of pooling practices.  However, it is certain that as its share price fell more investors took notice of what, in large part, has helped the company achieve statistical success: that being acquisitions, and a pooling rather than purchase method of accounting.

2.  "Back in 1994, Jenkins led the American Institute of CPAs in conducting a study of how companies could do a better job of reporting financial information to their investors...Businesspeople assailed Jenkins. The last thing they wanted were rules that would force them to disclose levels of customer satisfaction, patents, and other intangible assets...When Jenkins was named chairman of the FASB in July 1997, he found himself in the odd position of receiving his own report as an action item...Jenkins has earned a reputation for generating new thinking on intangible assets"
Intangible Assets Plus Hard Numbers Equals Soft Finance

3.  Herb Greenberg on PPD back on December 6, 2001.

4.  "Investors need transparency. They need to see the results of the business through a clear glass, not a rose-colored glass, not through a kaleidoscope of unnecessary or misleading complexity, not through the eyes and words of a novelist, but through straight, non-fictional reality. And the words and numbers chosen to be disclosed are of tremendous importance to the investor in predicting future performance. Nothing less will do."
Lynn E. Turner - Chief Accountant - U.S. Securities & Exchange Commission



 

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