July 22, 2001
Bob,
Thanks for the kind
comments. Feel free to post my Terry
Breakfast
presentation at your web
site if you want. I made the
presentation last
Thursday so it won't be
possible to video tape it.
Perhaps you saw this story in the Atlanta newspaper
last fall
It describes a young lady who has started her own
business as a professional “pooper scooper”
The article praises her entrepreneurial spirit
But it also observes that in the final analysis
picking up after dogs isn’t the greatest job in the world
However, it’s not the worst job in the world,
she’s quoted as saying
“I used to be an accountant”
The news about accountants isn’t all this negative,
however
For example, earlier this month New Line Cinema
announced that it has bought a script with the title of “Ballad of Paul Finley,
Accountant”
The story revolves around a meek CPA serving prison
time for a botched robbery
In prison he hooks up with a female pen pal drawn to
the outlaw life
She eventually helps him escape and they embark on a
Bonnie and Clyde style escapade
New Line Cinema said they paid “low six figures” for
the script – I suspect that means $1,000.01
Of course accountants have been used to Rodney Dangerfield, no respect, type
situations for some time
As one of my MBA students said a couple of years
ago, “Don’t worry Professor B, accounting isn’t supposed to be interesting.”
My answer is yes – are there any questions now?
I think it’s clear that accounting does
matter, perhaps even more in the so-called new economy
Saying it a different way, the ultimate success or
failure of a business still rests on its ability to produce positive cash flows
And financial reports still seem to be an excellent
tool to help predict future cash flows
It’s hard to believe that only a year ago a
prominent analyst for Goldman Sachs wrote a report that argued –
The cash burned by dot.com companies was, as he put
it, “primarily an investor sentiment issue” and not a long-term risk for the
sector
It turned out that he was right – cash burn was not
a long-term risk because there wasn’t a long-term for a large number of
those companies
As I said a couple of minutes ago I believe that
traditional accounting measures still do a pretty good job of helping forecast
future cash flows
The first is the practice of many companies trying
to convince investors that alternative measures are superior to normal
accounting results
The other is an important new accounting standard
that deals with a subject where poor economic decisions have sometimes been
made to achieve accounting objectives
As you may have guessed already, the first topic is
the so-called pro-forma earnings phenomenon
And the second is the FASB’s new rules on accounting
for business combinations
The general subject of pro-forma earnings has been
in the financial press a lot recently
For example, the cover story in Business Week
magazine on May 14 was titled “The Numbers Game”
The subtitle said the following:
Companies use every trick to pump earnings and fool
investors. The latest abuse: “Pro
forma” reporting.
And a major article in the New York Times in March
was headlined:
How Did They Value Stocks? Count the Absurd Ways.
I suspect that many of you don’t know exactly what
pro-forma reporting means
It’s really not hard to define – it means anything
you want it to!
In fact, the only constant is what it doesn’t
mean
Thus, pro-forma earnings are just about anything
other than the real net income of a company determined by GAAP
Actually, the term does have a more traditional
meaning
When a company has to prepare an SEC registration
statement in connection with a business combination, it may have to present
information as if the two companies had already been combined
That’s what most experienced accountants thought pro
forma information meant
That meaning has been obscured, however, in recent
usage
Companies now use the notion to describe some
variation on net income excluding one or more items – usually expenses
In fact, the SEC’s Chief Accountant has said that
companies now want to emphasize EBS instead of EPS
EBS means Earnings Before Bad Stuff
This notion of looking for useful alternatives to
net income started innocently enough several years ago
Some companies started reporting EBIDTA as a way
that you could arguably better compare companies that had purchased assets at
different times and had different capital structures
However, even those EBIDTA pioneers were principally companies that reported low earnings or even losses under GAAP and were looking for something more positive to say
More recently, some companies began reporting what
they called cash earnings
They added back depreciation expense and goodwill
amortization, in particular
The more creative practitioners of the pro-forma art
form add back those expenses and many others such as
Any stock options expense
Payroll taxes related to stock option exercises
Losses from equity method investments
Marketing costs
Costs to start up new businesses
Interest, etc., etc.
Some of these items don’t require additional cash
expenditures, but they are all real costs
One company that has been criticized quite a bit for
its pro-forma earnings is Amazon.com
Earlier this year it started clarifying its press
releases so that you can at least now see what adjustments the company made to
its GAAP net income
In the first quarter of 2001, Amazon’s pro-forma net
loss was $76 million while GAAP yielded a loss of $234 million
The company said that the pro-forma numbers
excluded:
Stock-based compensation costs
Amortization of goodwill and other intangibles
Impairment and restructuring costs
Equity in losses of investees
And non-cash gains and losses
Now it may sound as though I’m pretty negative about
this whole idea, but that’s not necessarily so
Let me give you a personal example of how the pro
forma idea can be used productively
Some of you may know that George Benson is an excellent
golfer
However, on a pro-forma basis, I can actually out
score George
For example, it’s appropriate to leave out the
scores for my first four holes
I’m still warming up then and those scores certainly
aren’t representative of my true ability
And my out of bounds shots shouldn’t count either –
I define them as unusual and non-recurring
Taking those adjustments and a little other score
keeping creativity into consideration, I figure my pro-forma average score is
about 68
And that beats the heck out of George’s generally
accepted golf principles average
More seriously, the pro-forma earnings amounts
aren’t necessarily as misleading as my golfing example would indicate
The problem I have with them is that there is no
common approach to them and investors simply don’t understand what they are
getting in most cases
The FEI and National Investor Relations Institute
recently issued some guidelines for earnings press releases that will help a
little
However, about all those voluntary guidelines
call for is for companies to show GAAP net income in the release and clearly
reconcile to the pro-forma numbers
The SEC has threatened to crack down on misleading
earnings releases
I heard the Chief Accountant of the SEC Enforcement
Division say recently that action will be taken in at least a couple of
egregious situations
Before leaving this topic, let me switch gears a
little and talk about some other performance indicators
During the dot.com frenzy of the recent past,
prominent financial analysts were saying that traditional GAAP measures were
useless, as I mentioned earlier
Those analysts asserted that there were more up to
date metrics that were a better indicator of a company’s future prospects and
its current value
For example, they suggested measuring and reporting
things like:
Customer share of mind
Page views
And engaged shoppers
I have the same problem with these measures as I do
with pro-forma earnings
First, are they being determined on a consistent
basis so what one company reports is truly comparable with another company?
And second, are they really a good way of helping
predict future cash flows and business success?
Let me go back to my earlier golf example to help
illustrate this point
I like to buy colorful golf shirts and have a pretty
large collection
But if I represented that I have a larger quantity
of golf shirts than Dean Benson, does that mean my score will be better than
his?
I wish it were that easy!
To summarize this point, I’m not arguing that
generally accepted accounting principles are perfect
If they were, the FASB could have been disbanded
after I left, or probably even before I got there
But the objective of reporting earnings under GAAP
is to help investors predict future cash flows and that’s clearly a valid
notion
And the whole premise of standard setting is to
create a reasonable amount of consistency so that investors can make rational
decisions when looking at alternative investment choices
Thus, I submit that accounting does matter
and it will be a long time before pro-forma earnings or related notions produce
similarly useful results
Now I’ll move to my second main topic – accounting
for business combinations
As you’ve probably read recently, the FASB has
completed its study of this matter and has agreed to issue new rules
The new accounting standards are now at the printer
and we should see them in final form in the next week or so
This project was added to the agenda during my last
year at the FASB, just about five years ago
Five years may seem like a long time to develop a
new accounting pronouncement
But it’s actually a reasonably short time given the
difficult issues involved and the political controversy that ensued
I assume that most of you are not accountants so I won’t
bore you with the many technical details of the new rules
Let me give you a very brief summary, however
Effective July 1, there is only one method of
accounting for mergers and acquisitions
That’s the so-called purchase method, which involves
recording all of the assets and liabilities acquired at their fair values
In most cases, acquirers pay more for companies than
the values of the specific assets and liabilities acquired
The excess amount is called goodwill – I’ll talk
more about it in a minute
Up until now there has been a second way of
accounting for business combinations, the pooling of interests method
Under that method, the amounts in the acquired
company’s financial statements were simply combined with the acquirer’s – as if
they had been together forever
The FASB concluded that it didn’t make sense to have
two different methods for economically equivalent transactions
In addition to doing away with poolings, the other
big change in the new rules is that goodwill will no longer be amortized to
expense
For most companies the change to not amortize
goodwill will not begin until next January 1
This means that in the common situation of paying
more than the net assets acquired, companies won’t have to penalize future
income statements by expensing that excess over time
For example, AOL-Time Warner will be able to take
about $6 billion of goodwill amortization expense out of future income
statements
That will cause what’s now about a $3 billion loss
to become about a $3 billion profit
Presumably, AOL-Time Warner will no longer need to
refer to EBIDTA or some other measure of operations
Instead of goodwill amortization, the FASB calls for
AOL-Time Warner and all other companies to periodically evaluate whether the
value of goodwill has been maintained
If a company determines that goodwill is impaired,
it will have to write that asset down or off in the period the loss occurs
Requiring goodwill to be charged to expense over an
arbitrary future period had been one of the most criticized aspects of the
FASB’s earlier exposure draft on this project
Requiring regular impairment reviews rather than
amortization solved a political problem for the Board
That’s because Congress had held hearings and had
threatened legislation over what constituents had alleged would be adverse
economic consequences of the earlier proposal
Companies argued that the value of goodwill actually
appreciates in many cases, particularly when it relates to certain intangible
assets that aren’t recorded under current GAAP
Some companies said there would be fewer mergers
under the new rules and that that would stifle the new economy
While a few companies made these appeals to
Congress, most want the government to keep out of accounting standards
Most accountants would prefer not to have
Congressionally Required Accounting Principles
If nothing else, CRAP would be a lousy acronym
But the FASB changed its view not just because of
the political heat
It actually felt that the impairment review approach
made more sense
Net income will now be reduced for goodwill charges only
when something bad happens to make it less valuable economically
As an example, you may have seen Nortel’s recent
announcement that it is writing off well over $10 billion of overpayments for
acquisitions
In years in which no impairment is recorded,
companies will effectively be representing to investors that they’ve looked at
the goodwill and believe its value is as much or greater than recorded
The impairment review process that the FASB calls
for is likely to be a fairly subjective and costly exercise for many companies
But the financial information provided to
shareholders should be much better and worth the additional cost
What are the principal benefits of the new
accounting rules for business combinations?
First, investors won’t have to try to figure out how
to compare companies that have used dramatically different methods to account
for acquisitions
Second, companies won’t have to jump through the
accounting hoops they previously did in order to qualify for pooling treatment
For example, companies often couldn’t engage in
stock buyback programs or sell major operations because they would have
violated the pooling rules
You may have noticed that both First Union and SunTrust recently said they were buying back stock while still vying for Wachovia
Third, investors will be signaled about real
economic problems by goodwill impairment charges, such as Nortel’s gigantic
write-off
Fourth, companies will have the flexibility to
structure transactions to include cash and stock rather than all stock, as
required by the pooling rules
In my view, however, the greatest benefit
from requiring all acquisitions to be purchases will be in making companies
more accountable for how much they pay
The full value of the consideration, whether stock
or cash, will be recognized
One of my colleagues, Ben Ayers, published a study
indicating that companies often have overpaid in stock deals in order to
achieve the more favorable pooling treatment
There should be less of this in the future
To summarize this topic, perhaps accounting mattered
too much in the case of business combinations
Ideally, financial reporting should reflect
the economic results of business activities – and not cause them
Clearly, accounting does matter a great deal in
connection with mergers and acquisitions and it will continue to do so
But I think we now have things back in balance and
the accounting will matter without being a driving force
To wrap up, accounting continues to be the language
of business and the scorecard by which managers are judged
It isn’t perfect, but it also isn’t boring
In my office I have a paperweight given to me by a
friend who is managing partner of an accounting firm that deals exclusively with
troubled businesses
It says, “If the cash lasts, luck will follow”
I think those are good words for managers and
investors to consider
We’d all like to have information that best helps us
predict whether the cash will last
And one other quote to end with is from Larry
Summers, former Treasury Secretary and new President of Harvard University
He said -----
If one were writing a history of the American
capital market, it is a fair bet that the single most important innovation
shaping that market was the idea of generally accepted accounting principles
I agree so I’m not inclined to give up accounting in
favor of poop scooping!