What happens, however, when the grades are inflated?
Just ask shareholders in Enron whose holdings were virtually wiped out this fall as the company collapsed into bankruptcy. For years, it turns out, the company's public statements overstated profits and concealed debts.
That is an extreme case that has grabbed the attention of regulators and shareholders' lawyers. But while looking at Enron, the Securities and Exchange Commission is also concerned with a much more widespread corporate habit--the growing practice of issuing "pro forma" earnings reports that tend to paint a rosy picture of company results.
Pro forma, which means "as if", has in recent years evolved into "a sophisticated term for lying about your results," says Wharton accounting professor emeritus Peter H. Knutson. He compares companies that abuse pro forma statements to the husband who stumbles home in the middle of the night and tells his wife, "Don't look at the lipstick on my collar. That doesn't count. The fact that I'm home is what counts."
By law, quarterly and annual reports filed with the SEC must follow generally accepted accounting principles, or GAAP, which dictate what must be included in calculations of sales, earnings and other information. But there is no standard for pro forma reports.
Companies have long been required to file pro forma statements when they are involved in major transactions such as mergers, Knutson said. This is intended to show how the resulting entity is expected to look after the deal is complete--to give a more accurate view. "They have now deteriorated," he said. "A pro forma is what it would be if it were something other than what it is?It includes everything except the bad stuff."
With no strict rules, companies use pro forma statements to describe what their earnings and other results would be if certain facts were removed from the GAAP calculations. That can mean, for example, taking out "one-time" expenses such as benefits for laid-off workers, or the cost of settling a major lawsuit or funding the golden parachute for a dismissed executive.
Horsham, Pa.-based e-commerce company VerticalNet last spring issued a press release stating it had lost 30 cents per share in the first quarter. That was the pro forma figure. But in its filing with the SEC, the company reported the loss was more than three times as big--99 cents a share. The difference involved a $44.3 million charge for several acquisitions. Removing this figure from the pro forma earnings calculation gave analysts and investors a deceptively positive view of the company's performance, Knutson said. VerticalNet explained at the time that it would be too confusing to provide both calculations in the press release.
Networking giant Cisco recently issued a press release putting fiscal 2001 pro forma earnings at $3.1 billion. But under GAAP the company had lost $1 billion.
Amazon.com, the giant online retailer, has been heavily criticized for emphasizing pro forma results. Its Oct. 24 press release on the quarter ended Sept. 30 focused on a pro forma loss of $58 million, while conceding that the loss was $170 million under GAAP. The difference came in accounting--or not accounting--for expenses such as the cost of "stock-based compensation, amortization of goodwill and other intangibles" as well as restructuring expenses, the company explained.
The use of misleading pro forma reports has become more widespread in recent years because of "the whole idea that you have to make the numbers or the market is going to crush the stock," Knutson said.
Today, analysts issue earnings estimates, and then survey companies such as First Call disseminate "consensus" estimates that investors quickly absorb from the Internet and CNBC. "If you're not going to make your numbers, then you better come up with a different number that you can make," Knutson said. "There are a lot of companies that are not profitable and want to look profitable. If you can get rid of certain expenses, then you can look profitable."
As the Amazon, Cisco and VerticalNet examples suggest, pro forma reports are especially popular with Internet and other high-tech companies that want to put the best face on relentless losses. Generally, companies argue that they are providing what Wall Street really wants: a picture of the core business that's uncluttered by one-time events. But for many of these companies, acquisitions, stock-option costs and similar expenses occur so frequently as to, in fact, be part of the core business.
And if companies' intentions were to illuminate, rather than to dazzle, pro forma results would be accompanied by detailed comparisons with GAAP results. Yet many press releases trumpet pro forma figures and either fail to note GAAP figures, dismiss them as unrepresentative or skimp on explanations. "It's clearly an example of self-serving disclosure," Wharton accounting professor Robert E. Verrecchia says. "Firms are operating in an environment where there aren't any rules, and it is very much caveat emptor."
Alarmed by the growing practice, the SEC warned early this month that it would use anti-fraud statutes to sue companies that use pro forma results to mislead investors. The commission said it is considering new rules to restrict the practice. The SEC also issued a list of tips for investors, suggesting, for example, that they scour corporate statements for information about accounting practices, judge what's missing and compare pro forma results with GAAP figures.
Knutson argues that companies should be required to file their press releases with the SEC, along with explanations for any differences between figures in the releases and those in quarterly and annual statements that companies already must file.
Verrecchia also sees the solution in disclosure. There are benefits, he notes, to allowing a company's managers to explain the story behind the numbers as they see it, so long as they are not withholding crucial information or attempting to mislead.
Since public companies do have to file quarterly and annual reports under GAAP rules, a careful investor can separate puffery from fact, Verrecchia says. The person most likely to be hurt by a pro forma statement is the one who won't go to that trouble. "They look at these numbers and think they are real numbers, and they are not," he said. "It's hard to know to what extent the government should protect foolish people from foolish actions."
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