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Rules group targets tech earnings ploy

The board that sets accounting standards is now targeting pro forma earnings, the benchmark that most tech companies use to gauge their results.

Reporting pro forma earnings, a practice favored by many technology companies, has come under the gun recently, attacked by investors, the media and the U.S. Congress.

And now the makers of accounting rules may join the fray.

The Financial Accounting Standards Board, a private entity that sets the rules for accounting professionals, is debating whether to set up guidelines for various aspects of pro forma accounting.

If FASB, which recently changed rules governing the recognition of goodwill, sets a standard for pro forma earnings, the impact on technology companies could be significant. It's now quite common, particularly in the tech sector, to see companies tout special "operational earnings" or "cash earnings" that exclude a range of items. While the case can be made for some items such as goodwill amortization or investment losses, other exclusions raise a few eyebrows.

Critics have made a lot of noise about so-called pro forma earnings, which often exclude many expenses, but FASB could have the biggest impact because it develops the Generally Accepted Accounting Principles (GAAP) used to define accounting practices. Now it's considering extending them to cover how companies present their data to investors.

FASB has given interested parties until Sept. 19 to comment on its proposal, and it could take months after that to make a decision. The scope of the project is still under debate as well, but key questions up for discussion include these: Which financial measures do investors, creditors and others need? Is it possible to distinguish between operating activities and noncore activities? Should existing standards be changed to require the presentation of new metrics?

Pro forma reporting is usually a hypothetical presentation of accounts. It has been used to help companies report their financial picture after a major change, such as a merger. In that case, companies would provide current financial results and pro forma year-ago results, showing what the merged company would have earned had the merger taken place a year earlier.

In that case, the reason for pro forma reporting is clear: It gives investors a better way to gauge the company's performance by excluding one-time events. But the reasoning behind some of the newer uses is murkier, and the results more perplexing.

• Intuit, for instance, excluded losses on investments, amortization costs and acquisition-related expenses in reporting its fourth-quarter results. The exclusions allowed it to turn a loss of $61.3 million in a loss of $17.1 million.

• Telecom-equipment maker Ciena excluded deferred stock compensation charges, payroll taxes on stock options, a benefit from receivables that were previously written off, amortization of intangibles and goodwill to come up with a third-quarter pro forma profit of $58 million, or 17 cents per share. Including the one-time items, the company posted a profit of $5.65 million, or 2 cents per share.

• Amazon.com gives investors multiple pro forma numbers to look at. For its second quarter, it reported a "pro forma operating loss" of $28 million excluding stock-based compensation costs, amortization of goodwill and other intangibles, and restructuring-related and other costs.

It also reported a "pro forma net loss" of $58 million, excluding stock-based compensation costs, amortization of goodwill and other intangibles, restructuring-related and other costs, other gains, investment losses, and the cumulative effect of change in accounting principles. Add in all those exclusions, and you get the company's actual net loss of $168 million.

Going too far?
"A lot of these companies are under tremendous pressure to attain profitability," said Mark Bradshaw, assistant professor at Harvard Business School. "And a lot of these companies, as part of their growth, were acquiring companies, building a bunch of goodwill, which is amortized. I can see (in) the (desire) to say, 'Let's look at (something else),' they made up this word 'cash earnings.' As this trend increased, it spread to all firms."

The differences between GAAP results and pro forma results can add up to quite a lot. For instance, Standard & Poor's said recently that second-quarter earnings figures for the S&P 500 index slipped 32.9 percent compared with a year ago. But according to the research service First Call, second-quarter results for the S&P 500 fell 17 percent.

The discrepancy derives from how many of the pro forma exclusions S&P and First Call allowed when computing the results. Standard & Poor's adheres more closely to GAAP, while First Call follows the pro forma results that companies and Wall Street analysts use. (Both will continue to revise their figures as companies finish reporting earnings.)

Of course, the fact that Wall Street analysts are able to use the pro forma numbers suggests that they have some utility. But some are concerned that "everyday" investors may not be able to see through the hype as readily.

Several studies have compared the reactions of institutional investors and retail investors, Bradshaw said. While the evidence is not conclusive yet, he said, "it seems to be that if you have a lot of retail investors, they'll react to 'non-information.'"

Accounting professionals say that though there's nothing wrong with companies pulling out certain unusual line items to put them in context, the exclusions may have gotten out of hand.

"We've always had different financial statement items broken out anyway. And there's plenty of room to discuss different items. There's room in the conference call to say 'we'd like to point this stuff out,'" said Greg Miller, assistant professor at the Harvard Business School. "But the idea of flipping it and making it the primary number just confuses things."

Changing the game
Setting up definitions of types of charges could be extremely helpful, said Chuck Hill, director of research for First Call.

"Restructuring charges can be categorized as all types of items. You see some charges that really could be categorized as operating items," and should therefore not be excluded from results, Hill said.

"Now, all you have to do is say, 'Hey, we're laying people off,' and it's called a restructuring charge, and the poor competitor down the street (has) been laying them off all week and taking a hit to operating earnings," he said.

While the FASB rules would not necessarily prevent companies from playing games in their press releases, those businesses could come under scrutiny from other arenas.

In April, Financial Executives International, backed by the National Investor Relations Institute, issued a set of "best practices" that calls for companies to report both pro forma and GAAP results in their press releases.

And if companies are not willing to make the changes on their own, the government could get involved. The Securities and Exchange Commission had no formal comment on the FASB proposal, but a spokesperson pointed out that commission officials have commented several times about pro forma shenanigans.

Former SEC chief accountant Lynn Turner said in several speeches earlier this year that he was concerned about "the abuses of pro forma earnings announcements, which distract investors from the real GAAP earnings." And in June he disclosed that the Commission was investigating several companies for possible deception in their use of pro forma earnings.

"There is the broad regulation that (press releases) can't be misleading, but you could drive a truck through that," Hill said. "Companies should be free to report earnings on a basis they think you should value them on, but there has to be a clear trail from (GAAP) to the basis they're espousing."