More Earnings Shenanigans

Earnings manipulations have reached crisis proportions, says Whitney Tilson, who in this article explains two of the leading tricks of the trade: big bath accounting and the manipulation of earnings using gains in the value of pension funds. Investors should pore over their companies' SEC filings to arm themselves against potentially misleading information.

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By Whitney Tilson
November 20, 2001

I've already written several columns about various ways in which companies manipulate their financials to present as rosy a picture as possible to investors, but I feel compelled to return to the topic. It seems as if every time I open a business-oriented newspaper or magazine, I learn of more ways companies are engaging in such shenanigans. Earnings manipulations have reached crisis proportions, in my opinion, and must stop before investors lose confidence in our financial system.

Today, I'd like to discuss two ways this confidence is being undermined: big bath accounting and accounting for the impact of pension and other retirement benefits.

Big bath accounting
During the bull market of the 1990s, companies typically pulled out all the stops to report earnings that were as high as possible. Common tricks included paying employees with stock options -- which don't appear as a cost on the income statement -- extending credit to uncreditworthy customers and then booking the revenues (see Lucent, among many others), reporting pro forma earnings that excluded legitimate costs (also known as EBBS, or "earnings before the bad stuff"), and declaring certain expenses as "one-time" or "unusual," which reminds me of my golf game: I consistently shoot an 80 if you don't count the 28 bad shots.

Investors today must be wary of precisely the opposite game: Because the weak economy and the Sept. 11 tragedy will cause many companies to miss their numbers, some are going out of their way to take every charge they can and thus report earnings even worse than they would otherwise be.

The management of one company I spoke with recently admitted they would have reported a small profit in the third quarter but was told by their accountants that if they had any discretionary charges to record, now would be a good time to take them since other companies were going to report bad earnings and investor expectations would be low. Consequently, the company took a variety of charges and reported a substantial loss. This was all legal and complied with Generally Accepted Accounting Principles (GAAP), which gives you some idea how much discretion management has in the numbers it reports.

Research from Morgan Stanley presented in the cover story of the latest Business Week shows the magnitude of the problem. A chart going back to 1988 shows the total amount of corporate charge-offs by year: In 10 of the 14 years, the amount ranged between roughly $10 billion and $20 billion, and only exceeded $50 billion in two years. Care to guess which years? The only two in which the economy was in a recession, 1992 and 2001, during which write-offs estimated at $110 billion and $125 billion, respectively, were recorded.

While deliberately understating earnings may not seem as bad as overstating them, it can be if it misleads investors in future periods about the true nature of a company's business and year-over-year comparisons.

Impact of pension and other retirement benefits
An article last week in The Wall Street Journal, "Declining Pension-Fund Values May Trim Companies' Earnings," caught my attention, so I tracked down a copy of the Bear Stearns reports cited in the article. After reading through 158 pages, I must confess that the topic is so mind-numbingly complex that I don't think I could ever fully understand it.

The message, however, was clear: The long-running bull market inflated the value of the funds many companies had set aside to pay future pension obligations, such that the plans became overfunded. This, in turn, allowed many companies to apply such gains toward reducing product or operating costs, thereby inflating earnings -- artificially, in my opinion -- in a way that is virtually invisible to investors.

I could have subtitled this section "Revenge of the Old Economy" because, generally speaking, only Old Economy companies have traditional defined-benefit pension plans, which make possible the type of gaming noted above. "New Economy" companies typically only offer defined-contribution plans such as 401(k)s. (Of course, they have other ways to puff up their earnings, such as compensating employees by issuing a blizzard of stock options.) According to a Credit Suisse First Boston report, 356 companies in the S&P 500 had defined-benefit plans, while only 11 of the companies in the Nasdaq 100 did.

According to Bear Sterns, "aggregate 2000 operating income for the S&P 500 is approximately 3% lower when adjusted for retirement benefit income." But the impact on earnings is much larger for some companies. IBM (NYSE: IBM), for example, would have had operating income in 2000 that was nearly $2 billion (or 17%) lower than it reported had there been an adjustment for service cost (the present value of the retirement benefits earned by the employees working during the current year) and income from its pension fund and other retirement benefits.

The decline is greater than 10% for 40 other companies in the S&P 500. Here are a few notable examples:

Company                             Impact
------------------------------------------ General Electric (NYSE: GE) -12% FedEx (NYSE: FDX) -15% Qwest (NYSE: Q) -18% Verizon (NYSE: VZ) -18% Boeing (NYSE: BA) -19% Raytheon (NYSE: RTN) -26% Lucent (NYSE: LU) -29% Allegheny Technologies (NYSE: ATI) -50% Lockheed Martin (NYSE: LMT) -52% NCR (NYSE: NCR) -70% Northrop Grumman (NYSE: NOC) -89% USX (NYSE: X) -390% McDermott International (NYSE: MDR) -417%

Inflating earnings in the manner discussed here is entirely legal, of course, and GAAP doesn't require that such adjustments be reported separately in the income statement (though there is discussion along these lines), but I believe companies should do so anyway.  It's hard to think of anything that more obviously belongs in the "Other Adjustments" category, below the operating income line. I'm not holding my breath, however: Can you imagine IBM choosing to report 17% lower operating income?

Perhaps more important is the impact on future earnings -- and the news isn't good. While various smoothing mechanisms built into accounting rules allow a company to continue pumping pension gains into earnings even after the portfolio's value has begun to decline, the impact of a declining or stagnant market will eventually be felt.

IBM, for example, booked a $1.3 billion gain from its pension plan alone in 2000, but Bear Sterns projects that this amount will fall to only $417 million in 2003. At DuPont (NYSE: DD), a $465 million gain in 2000 will turn into a $136 million expense in 2003. In total, the changes in pension cost/income impact 2002 earnings estimates by at least 5% for 49 companies in the S&P 500. Have analysts and investors factored such material changes into their earnings projections, upon which today's stock prices are largely based? I suspect not.

Tips for investors
Adjusting for big bath accounting is highly subjective, but at least the information is readily available in the financial statements. As a general rule, I suggest focusing on the cash flow statement, in which actual costs are tracked. This will tell you how much free cash flow a business is generating, which is the key determinant of value.

It's harder to adjust for income and expenses related to pension and other retirement benefits, as the information is complex and only published once a year in a company's 10-K statement. I've long urged investors to read the fine print in companies' 10-Qs and 10-Ks, and this is another reason to do so.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of any company mentioned in this article at press time. Mr. Tilson appreciates your feedback at To read his previous columns for The Motley Fool and other writings, visit