December 13, 2005

Excerpts: The Battle For The Soul of Capitalism - Part XXII

By: 800-CEO-READ @ 8:14 PM – Filed under: Management & Workplace Culture

Managed Earnings

Hand in hand with the excesses of CEO compensation came “managed earnings” as a major contributor to the stock market boom. Sleight-of-hand financial engineering produced quarterly profits that were viewed by investors as predictable and recurring. The result: handsome rewards to those projecting unprecedented levels of future earnings growth, and then, with the skill of the alchemist, delivering the results they had forecast.

During the 1990s, the idea of corporations providing quarterly earnings guidance took hold and quickly was followed by earnings management. “Exceeded expectations,” or “met expectations” (or, heaven forbid, “failed to meet expectations”) became the jargon of corporate America’s financial reporting. Market participants anxiously awaited each company’s quarterly announcement, quickly comparing it with the earlier “guidance.” What was ultimately revealed, however, is what we always knew to be true: relying on the accrual accounting that is the basis for corporate financial statements is an act of faith, no more, no less. As the eminent economist Peter Bernstein has written: “The financial statement records as revenues money not yet received. It excludes from expenses money actually paid out if spent on assets expected to produce revenues in the future.” And when earnings guidance is given, there seem to have been few limits on the earliest possible recognition of revenues and the latest possible recognition of expenses. On some occasions, fraud was involved.

A 2004 study by Thomson Financial found that since 1998 companies have missed their analysts’ expectations only 16 percent of the time. The remaining 84 percent of the time they at least met expectations—23 percent exactly, another 22 percent by an additional one penny per share, and 39 percent by more than one penny—remarkable predictability, during good times and bad times alike, in complicated businesses with many lines of endeavor. It was, of course, “too good to be true.”

For such performance defies common sense. Thoughtful investors know that while business growth may follow rough trend lines, quarterly surprises are inevitable. Accounting results that show otherwise are nonsense. Although it seems absurd that a company that misses its guidance by a mere penny can see its market capitalization promptly plummet by several billions of dollars, in a certain way the logic is unexceptionable: if, with all that financial pushing and pulling and stretching, the company nonetheless falls short of its guidance, it is only a matter of time before the chickens come home to roost in the form of a major negative surprise.

Such surprises, it turns out, can be measured. At least some overaggressive accounting is often uncovered later by federal and state regulators, requiring the kinds of earnings restatements catalogued in Box 1.3. In total, some 1,570 public companies restated their earnings from 2000 to 2004, seven times the 218 companies that restated their earnings from 1990 to 1994. While many corporate executives have already been paid huge bonuses based on those engineered earnings, I have not heard of a single instance in which their bonuses have been recalculated and the overpayments returned to the stockholders.

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