Beware of "Fake" Earnings

On January 1, a new accounting standard for goodwill related to acquisitions and other intangible assets went into effect. What does the new rule do? For one thing, it will add $6 billion in "fake" earnings to AOL's 2002 numbers, and an additional $0.11 per share to GE's first- quarter earnings. Investors will need to read every last footnote in earnings releases.

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By Jeff Fischer (TMF Jeff)
January 3, 2002

Ideally, business would become easier to understand as the years rolled by. Improvements in accounting practices would come to light annually. Information would be disclosed to investors in an ever more timely and understandable fashion. New checks and balances would fall into place, making it impossible for management to delude employees and investors with phoney or doctored numbers.

Ideally. Ideally this and so much more. But the business world is far from ideal. Where the end objective is money (which isn't much different from power), men and women alike have been known to turn wraith-like, hop astride a tall black horse (maybe in the form of a sleek expensive car) and ride like demons in search of power, stomping over truth in the pursuit. If only honest hobbits ran the world of business.

Hobbits notwithstanding, America depends on government and financial regulation to keep its business-play clean. The result is the best stock market and market economy in the world. But it isn't perfect, and at the stroke of January 1, 2002, big business just became more confusing. That's because on June 29 of last year, the Financial Accounting Standards Board (FASB) passed "Statement 142, Goodwill and other Tangible Assets," and for most companies, the law went into effect on January 1.

Statement 142 and goodwill
Remember when JDS Uniphase (Nasdaq: JDSU) announced that it "lost" about $51 billion due to goodwill writedowns? Goodwill is money that a company pays above the actual value of assets received in an acquisition. So, if Company A bought Company B for $100 million and Company B had assets only worth $60 million, Company A would need to writedown the extra $40 million that it "lost" in the acquisition. Companies amortize such a loss (recording it on a regular schedule) over a period not to exceed 40 years. At least, that's how it worked in the past.

Under the new FASB 142 ruling, goodwill is still recognized as an asset, but automatic amortization of goodwill is no longer allowed. Rather than simply amortizing goodwill after an acquisition, companies must now perform an annual test to determine "impairment of value" for its acquisitions. In other words, a company must annually value all of its acquisitions (as separate business units) to determine whether or not their value has fallen or risen in relation to the price paid. This doesn't only affect acquisitions made after January 1, 2002, it also applies to any unamortized goodwill from past acquisitions that companies carry into 2002.

As you can imagine, thousands of companies carry goodwill balances.

What does this mean to companies?
Already, many companies have struggled with the new accounting standard. While we might praise the new practice because it will try to place a current fair value on an acquired asset rather than just assume that the asset's value need be written down for years, valuing such assets -- whole business units separately -- is proving tricky. Companies have had to hire consultants, accountants and lawyers in attempts to value sometimes dozens of business units that were acquired and have since grown, shrunk and, typically, been absorbed into the rest of the company. How do you break such a unit back out to value it?

But companies aren't complaining very much because FASB 142 will cause merger and acquisition costs to decline radically -- at least on paper. AOL Time Warner (NYSE: AOL) recently reported that its net income could surge by as much as $6 billion this year due to the new accounting practice. The giant company previously had a great deal of goodwill to automatically writedown, and now it doesn't.

Another example: General Electric (NYSE: GE) expects the new goodwill accounting standard to add $0.11 per share to first-quarter 2002 earnings. Hundreds of other companies will likewise benefit when they report earnings, but hundreds of others will be forced to admit that they greatly overpaid for assets in past years when they determine the current fair value of acquired units. At that point, they will need to writedown their goodwill.

What does this mean to investors?
Higher net income sounds great, but the problem is this isn't real money. It's a legal form of accounting magic. Dollars are not flowing to the bottom line, but because goodwill won't be written off as it used to be, the net result will often be higher reported earnings. Will companies clearly state where these increased earnings are coming from? Probably not clearly enough, because already companies are bent on reporting results as positively as possible. That won't change.

Additionally, the fact that 2001 was a difficult year for earnings makes 2002 comparisons much easier, and when a company adds the benefit of the new goodwill accounting rule, some year-over-year "growth" numbers will be highly deceiving.

What can you do?
You must read earnings reports thoroughly. When company SEC documents are released, read those as well. Don't rely on headlines from companies to make your investing decisions. Read down to the last footnote in each earnings press release. Determine the company's real income -- in real dollars. When the cash flow statement is available, determine how much free cash flow (which is cash from operations minus capital expenditures) was generated. Free cash flow is the lifeblood of a company. Accounting magic is tomfoolery and eventually comes home to roost.

Additionally, in some cases you'll want to avoid companies that are relying on an acquisition strategy to grow, because these companies will have more confusing financials. Be especially cautious with young, unprofitable companies that are acquiring like wildfire, buying unprofitable competitors. On the flipside, giants with decades of proven acquisition acumen -- such as GE and Johnson & Johnson (NYSE: JNJ) -- should not be abandoned, but their numbers should be as scrutinized as well as any other company.

Finally, if owning individual stocks proves too nerve-wracking for you (heck, even the companies themselves are confused by new accounting practices), invest in the S&P 500 index fund and rest easier.

Jeff Fischer would like to see Africa -- he's enjoying Survivor Africa for the scenery (and he likes the remaining five survivors, too). Of companies mentioned, he owns Johnson & Johnson. You can see all the stocks he owns in his profile, thanks to the Fool's disclosure policy.