Corporate America

Corporate America's New Math: Investors Now Face Two Sets of Numbers In Figuring a Company's Bottom Line
By Justin Gillis
Washington Post Staff Writer
Sunday, July 22, 2001; Page H01
http://www.washingtonpost.com/wp-adv/archives/front.htm

Cisco Systems Inc., a bellwether of the "new economy," prepared its books for the first three months of this year by slicing and dicing its financial results in the old ways mandated by the rules of Washington regulators and the accounting profession.

Result: a quarterly loss of $2.7 billion.

Cisco did more, though. It sliced and diced the same underlying numbers in ways preferred by Cisco, offering an alternative interpretation of its results to the investing public.

Result: a quarterly profit of $230 million.

That's an unusually large swing in a company's bottom line, but there's nothing unusual these days about the strategy Cisco employed. Across corporate America, companies are emphasizing something called "pro forma" earnings statements. Because there are no rules for how to prepare such statements, businesses have wide latitude to ignore various expenses in their pro forma results that have to be included under traditional accounting rules.

Most of the time, the new numbers make companies look better than they would under standard accounting, and some evidence suggests investors are using the massaged numbers more and more to decide what value to attach to stocks. The pro forma results are often strongly emphasized in news releases announcing a corporation's earnings; sometimes the results computed under traditional accounting techniques are not disclosed until weeks later, when the companies file the official results with the Securities and Exchange Commission, as required by law.

Cisco includes its results under both the pro forma and the traditional accounting methods in its news releases. People skeptical of the practice of using pro forma results worry that investors are being deceived. Karen Nelson, assistant professor of accounting at Stanford University, said some companies were "verging on fraudulent behavior" in their presentation of financial results.

Companies that use these techniques say they are trying to help investors by giving them numbers that more accurately reflect the core operations of their businesses, in part because they exclude unusual expenses. Cisco's technique "gives readers of financial statements a clearer picture of the results of Cisco's normal business activities," the company said in a statement issued in response to questions about its accounting.

Until recently, pro forma results had a well-understood and limited use. Most companies used pro forma accounting only to adjust previously reported financial statements so they could be directly compared with current results. This most frequently happened after a merger, when a company would adjust past results to reflect what they would have been had the merger been in effect earlier. Pro forma, Latin for "matter of form," refers to statements "where certain amounts are hypothetical," according to Barron's Dictionary of Finance and Investment Terms.

What's changed in recent years is that many companies now using the technique also apply it to the current quarter. They include some of the leading names of the Internet age, including Amazon.com Inc., Yahoo Inc. and JDS Uniphase Corp. These companies have received enthusiastic support from many Wall Street analysts for their use of pro forma results. The companies' arguments have also been bolstered by a broader attack on standard accounting launched by some academic researchers and accountants. They believe the nation's financial reporting system, rooted in the securities law reforms of the New Deal, is inadequate to modern needs. In testimony before Congress last year, Michael R. Young, a securities lawyer, called it a "creaky, sputtering, 1930s-vintage financial reporting system."

The dispute over earnings statements has grown in intensity during the recent economic slide. To skeptics, more and more companies appear to be coping with bad news on their financial statements by redefining the concept of earnings. SEC staffers are worried about the trend and are weighing a crackdown.

"People are using the pro forma earnings to present a tilted, biased picture to investors that I don't believe necessarily reflects the reality of what's going on with the business," said Lynn Turner, the SEC's chief accountant.

Usage Spreading

The list of companies employing alternative methods of presenting their results to investors is large and growing. For instance, Amazon.com's

66-cents-a-share loss in the first quarter by standard accounting became a 21-cents-a-share loss under Amazon's own accounting technique. (Amazon is scheduled to announce its second-quarter earnings tomorrow.) Network Associates Inc., a computer company, sliced its second-quarter losses from 27 cents to 2 cents a share with similar massaging. Ditto PMC-Sierra Inc., a computer-equipment company. It turned a $1.39-a-share loss into an 8-cents-a-share loss for its second quarter. As in the Cisco case, losses can even become profits: Yahoo, the Internet portal, turned a 9-cents-a-share loss into a 1-cent-a-share profit in the second quarter.

Though many academic researchers have taken stands for or against pro forma financial results, others are on the fence, struggling to make sense of the change and its implications for the economy. One of these is Mark Bradshaw, an assistant professor of accounting at the Harvard Business School. His research suggests a growing reliance by investors on the massaged numbers, but the technique spread widely only in the 1990s, and he believes not enough time has passed to determine whether investors will be helped or hurt by the trend.

"There are two ways to interpret it," Bradshaw said. "One is that managers are fooling investors by creating their own scorecard, and people are believing it without paying attention. The other interpretation is that managers are being very helpful in trying to aid investors" by supplying more meaningful financial data.

Accounting Arcana people tend to think of accounting as a dry subject, but it is in fact riven by controversy and politics. Understanding the latest flap requires a brief trip into that world. Standard accounting rules are referred to in the United States as "generally accepted accounting principles," or GAAP. They have been worked out over decades by argument among regulators, accountants and standards-setting bodies. The rules impose stringent requirements on businesses as they prepare their books. Public companies have to follow these rules in filing financial documents with the SEC.

The past few years have seen repeated disputes about just how these rules should be applied. In particular, some experts believe that standard accounting offers no means of reflecting, on financial statements, some of the assets that matter most to companies in the modern economy: patents and other "intellectual property," a loyal and growing customer base, the value of a brand name, and so forth.

"Unfortunately, the current accounting model is somewhat out of date," Robert K. Elliott, chairman of the American Institute of Certified Public Accountants, said last year in testimony before the Senate Banking Committee. "It is very much based on the assumption that profitability depends on physical assets, like plant and machinery; on raw materials, like coal, iron ore, sheet metal, electrical wire and plastic; in other words, on the tangible inputs needed to produce tangible products. This is the accounting model of the Industrial Age. But we are no longer in the Industrial Age. We still have elements of it, of course, and we always will, but we have moved deeply into the Information Age."

Many people in this camp believe that standard accounting, while understating some of the primary assets and advantages of modern corporations, also forces them at times to book unreasonably large quarterly expenses that don't reflect the true dynamics of the business. An example would be depreciation, the slow decline in the value of machinery and equipment as it wears out. The money might have been spent to buy the equipment some time ago, but the equipment's gradual decline in value, reflected quarter-by-quarter as an expense item under standard accounting rules, lowers a company's reported earnings.

Charges like this are sometimes referred to as "phantom expenses." Another example would be the huge hits companies can take on their profit-and-loss statements after mergers, with the acquiring company forced to write down much of the value it paid for the acquired company over time.

The people who run the operations side of businesses -- can-do types whose focus is getting products out the door and money in the door -- have long chafed under accounting rules like this. But generations of them were taught in business school that there was no real alternative. Now, that view is collapsing. For many corporate executives who don't like the numbers yielded by standard accounting, an alternative is available.

Harvard's Bradshaw, working with Richard Sloan of the University of Michigan, found through a massive analysis of stock and accounting data that the change in attitudes about the benefits of pro forma accounting can be traced to the 1980s, when a boom in corporate buyouts produced turmoil in many companies' income statements. The popularity of including pro forma results has accelerated markedly in recent years. Bradshaw and Sloan's studies document a widening gulf between the numbers put out by companies and employed by Wall Street analysts and the numbers reported to the SEC under standard accounting rules.

To tackle this problem, the SEC has prodded industry groups to issue voluntary guidelines saying that companies should make clear how their pro forma numbers differ each quarter from standard accounting. Cisco does this, and so does Amazon. Amazon has become something of a model company on the issue, publishing a detailed breakdown of the differences as a chart.

But other companies have refused even to disclose full details of their standard accounting until they have to do so under the law. In January, Qwest Communications International Inc. of Denver reported in a news release a profit of $995 million for the prior year. The company made investors wait 51 days to learn from an SEC filing that it actually lost $81 million under standard accounting.

Qwest had been through a merger with USWest Inc. that made year-over-year comparisons virtually meaningless. And company executives contended they released enough information in a conference call with analysts that an enterprising investor could have calculated the $81 million loss.

Still, Robin Szeliga, the company's executive vice president and chief financial officer, said that "given the feedback we got from the investment community," Qwest has now adopted the same practice as companies such as Amazon and Cisco: It will publish a detailed breakdown comparing both sets of books.

"I think that's the right thing to do on a go-forward basis," Szeliga said. Cisco's Case No company has used pro forma statements more assiduously than Cisco Systems, the San Jose company that supplies much of the electronic plumbing for the Internet. Cisco has grown by acquiring dozens of other companies, so presenting a massaged version of past results has been a necessity.

But Cisco has for several years followed the practice of adjusting not just past results, but current ones as well. For example, in the three months that ended in April, the company improved its bottom line by deleting various charges associated with its acquisitions. It also excluded "restructuring costs and other special charges," which included a massive charge, prompted by weak business conditions, to reduce the value and record a loss on inventory that isn't selling.

By the time Cisco was done refiguring the books, the $2.7 billion quarterly loss it had to report under standard accounting rules had become a pro forma profit of $230 million, or 3 cents a share. That was still a drastic drop from the 13-cents-a-share profit the company reported in the same period a year earlier, but it looked better to investors and Wall Street analysts than a loss would have.

The method Cisco and other companies use to calculate an alternative set of books actually resembles techniques long used in securities analysis. For decades, followers of Columbia University professor Benjamin Graham and his classic 1934 work, "Securities Analysis," have parsed income statements to try to discern a company's sustainable earnings capacity -- an exercise that necessarily involves discarding one-time expenses. Cisco argues it is helping shareholders by presenting them with just such an analysis.

"The benefit to shareholders is that they can quickly see the results of normal day-to-day business activities," the company said in its statement.

"If Cisco did not report on a pro forma basis, shareholders would most likely have to make numerous adjustments to determine which results occurred from normal operations. This would make evaluating those results more difficult and time-consuming."

Not everyone accepts this argument. Jack Ciesielski, an accounting watchdog in Baltimore who publishes the Analyst's Accounting Observer newsletter, allows that there are problems with standard accounting. But he believes it's a mistake for investors or analysts to rely entirely on a company's massaged numbers; rather, they must dig into the standard accounting contained in official corporate filings, once those become available, to understand a company's finances.

"If those who shape opinions, like analysts, rely only on pre-chewed food once there's real sustenance out there, then you really have a problem," Ciesielski said.

A Truer Picture?

More and more, companies are using alternative versions of their books to measure vital corporate milestones such as reaching profitability. Amazon.com, though it has millions of loyal customers, has never turned a profit, and growth in its core business of selling books, music and videos has stalled in the economic downturn. Under heavy pressure from Wall Street to show better results, Amazon founder Jeff Bezos recently told investors that the company would reach "pro forma operating profitability" in the last three months of this year.

But that doesn't mean profitability as traditionally defined. For starters, it will be an "operating" profit -- meaning, among other things, that Amazon won't count as an expense the $34 million it spends every quarter making payments on its debt. More significantly, the pro forma results Bezos is talking about will exclude certain types of items that resulted in $168 million in charges on Amazon's last quarterly statement.

Bezos's promise is unquestionably significant -- if the company fulfills it, Amazon.com could well be generating more cash than it consumes by the fourth quarter, a change that might alleviate fears it will go out of business. But by conventional accounting, Amazon won't be profitable in the fourth quarter and probably not for years, many analysts project. Amazon.com argues that its pro forma statement gives investors a truer picture of its prospects.

"It's more reflective of our ongoing business operations," spokesman Bill Curry said. "It's basically how we look at and think about our business." He emphasized that the company's statements now include a "crystal clear" comparison between the two sets of numbers so investors can understand them better.

Staff members at the SEC have grown worried enough about what they perceive as slipping standards to go around the country giving speeches against the new trend in earnings reports. The agency is investigating a handful of companies and may make examples of some, charging them with fraudulent representations to investors. But for the moment the SEC is holding off on a broader crackdown, hoping the jawboning will result in clearer earnings statements later this month and in the fall.

If that doesn't work, new rules are possible. One of the simplest proposals, which has garnered much comment in financial circles, came from Ciesielski. He proposed that the SEC require companies to release their legally mandated financial filings on the same day they report earnings to the public, eliminating the typical window of 25 days to 30 days between the two. This would not only guarantee that investors have both sets of numbers at the same time, it would virtually force companies to explain the differences between the two earnings statements in detail.

Corporate America has opposed any such change, arguing that legal filings require far more work than news releases, and that tying the two together would slow down the dissemination of basic quarterly numbers to investors.

"I think it will delay the earnings release," Szeliga, of Qwest, said of theidea. "I don't think that particularly serves our investor base well."