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The Earnings Game

By Phil Weiss (pweiss@homemail.com)

Towaco, NJ (Feb. 4, 1999) -- With the large number of high-flying stocks that can be found in today's market, many companies are under significant pressure to manage earnings and make sure that they fall in line with or exceed expectations.

Many companies today appear to be going out of their way to segregate as many items as they can from operating income as companies that fail to meet earnings estimates often see their stock price suffer severely from such shortfalls. It's up to us as investors to look at these special items and decide for ourselves whether or not we agree with the way the companies have presented them. This is what I did when I looked at Pfizer's recent earnings in last night's report.

A couple of weeks ago, Rob wrote a report in which he questioned some of the numbers that are presented in Microsoft's (Nasdaq: MSFT) financial statements as well. Personally, I don't have a lot of difficulty with what the pieces referenced in Rob's report accuse Microsoft of, but then again, when it comes to our software King, there have been times when your portfolio managers have had some disagreements. I say this, though, because I believe that Microsoft's accounting is on the conservative side as it defers a portion of its revenues from software sales until the support agreement sold with the software has been exhausted. As a Rule Maker investor, I don't like big surprises like the ones we've seen from Cendant (NYSE: CD) and Oxford Health (Nasdaq: OXHP) over the last couple of years. I prefer conservative accounting any day.

For more on Microsoft's conservative accounting you can check this link

In October 1998, the SEC's Chief Accountant wrote a letter to the American Institute of Certified Public Accountants (AICPA) on "Auditing and Financial Reporting Concerns" stating some of the SEC's concerns about how certain items are being treated in financial statements. I've also read three articles on this subject in The Wall Street Journal over the last two weeks.

Among the chief issues discussed in the SEC letter were the tendency of companies to do the following:

  • Write off in-process research and development (IPR&D) costs acquired as part of a purchased business;
  • Write off assets that are to be disposed of on a discretionary basis;
  • Inappropriate revenue recognition practices; and
  • Improper accruals and liability estimates/Excessive loss accruals (this is where Rob found fault with Microsoft).

I'll add pooling mergers and adjusting pension contributions to this list as well.

Let's talk a little more about what these things I've mentioned above are and how they can influence reported earnings.

IPR&D

When a company acquires a business or group of assets, the allocation of the purchase price can affect both current and future operations. This is because portions of the purchase price may be written off, allocated to purchased assets or create goodwill (the excess of the non-allocable purchase price over the amount paid for the assets). Companies prefer to avoid creating goodwill on their balance sheets because goodwill is deducted over a number of years, which means that it will result in lower earnings until the goodwill has been fully written off.

What's happening is that companies are stretching the limits of what qualifies as IPR&D by lumping certain other acquired assets together with what traditionally would qualify as IPR&D. For example, companies may attempt to classify other intangible assets such as patents, copyrights, brand names, and customer lists together with what is legitimately IPR&D. This results in a write-off of the entire amount (viewed as a one-time charge) rather than a combination of a write-off and an amortizable assets.

ASSET WRITE-OFFS

In order to write off assets that are no longer to be used, a company must adopt a formal plan to dispose of such assets (whether by sale or abandonment). When such a plan is adopted, the asset is no longer depreciated/amortized on the company's financial statements -- its value is just written off the books. It's also treated as an unusual item. If a company prematurely classifies an asset as abandoned, it may distort operating results and confuse investors. On the other hand, if an asset should be written down (due to a decline in value) and it is not, then operating results may in fact be overstated.

REVENUE RECOGNITION

Revenue can be recognized prematurely when a company pushes a lot of product into the sales channel without making adequate provisions for returns. It could also recognize revenue prior to delivery of the product to a customer's site or prior to completion of the terms of the sales arrangement. It may even be that a company recognizes revenue from a sale when the customer still has the ability to terminate the sale unilaterally. One way to look for this practice is to look for growth in accounts receivable turnover or receivables growing faster than sales.

IMPROPER ACCRUALS AND LIABILITY ESTIMATES

This can occur when a company charges costs of future periods in the current period prior to the development of a detailed plan. Or it could be the result of a company accruing too much for a specific liability. An article that I read some time ago said that many companies benefited from just such a practice when they accrued their liability due to a change in accounting for Post-retirement Employment Benefits. The article said that for several years after the change companies were slowly reversing the overaccruals back into income without openly stating this fact to investors. Many financial companies have been smoothing their earnings by manipulating reserves that have been set aside for future loan losses or sales returns. They do this by stockpiling huge reserves in good times, which can be used to protect earnings in lean times. In addition, companies can be guilty of this practice when they set up restructuring reserves. The reserve is set up and treated as a one-time item. Then the actual cost is less than the accrual. The recapture of the overaccrual is treated as part of ordinary income.

POOLING MERGERS

When companies acquire other companies with stock, they can choose to account for the transaction as a pooling of the assets of the two companies at stated book value. This enables the companies to avoid the creation of goodwill and, as discussed in the section on IPR&D above, results in higher earnings as well.

ADJUSTING PENSION CONTRIBUTIONS

How much money a company has to contribute to its pension funds each year depends on several factors. Included among these factors are employee demographics and the rate of return expected from existing assets. With the rise of the stock market, some companies may be tempted to raise their projected rates of return enabling them to lower their current contributions and save money. This was something that Lucent Technologies (NYSE: LU) recently did. Although the cumulative effect of the change of $1.3 billion was separately stated on this quarter's earnings release, the effect of the change in assumptions could last for years.

So, how do we discover that a company may be guilty of some of the practices that I've discussed above? Well, as Rule Maker investors we know that a lot can be learned by looking at the financial statements in the 10-K and the related footnotes. Start by taking a look at the balance sheet. Keep an eye on inventories and accounts receivable. If inventories are growing too quickly, perhaps some are outdated or obsolete. If accounts receivable are growing faster than sales, there might be a problem. Then take a look at liabilities -- both long and short-term debt. Have they increased? If so, why? How about accounts payable? Finally, read management's comments. They should address any unusual numbers or patterns.

If you have any questions about any of the material that's been covered tonight, we can continue the discussion on our Companies Message Board.

One important note: Last night until 9:00 pm ET our performance numbers were in error due to gremlins that appeared when we added our biannual $2,000 to the portfolio. The numbers have been corrected now, and our new $2,000 in savings has officially been added to the portfolio. Cha-ching! (Remember: we began with $20,000 last February and we add $2,000 in new savings, which we will very soon invest, every six months.) This $2,000 will be invested within the next week or so. We'll announce the company that we're investing it in soon!

Finally, did you ever watch Walter Payton play football? If you did, you might want to say a prayer for him as he awaits a liver transplant.

Have a Foolish evening.

Phil Weiss, Fool

02/04/99 Close
Stock  Change    Bid
AXP   -  1/4   100.25
CHV   +  15/16 76.94
CSCO  -5 7/8   105.25
KO    -  7/8   63.63
GPS   -2 7/8   64.06
EK    +2 1/8   68.88
XON   -  9/16  69.81
GM    -2 3/8   87.06
INTC  -8 9/16  130.13
MSFT  -7 3/4   159.06
PFE   -2 1/8   131.63
SGP   +  9/16  54.56
TROW  +  1/2   34.00

                   Day   Month    Year  History
        R-MAKER  -2.28%   0.34%   5.50%  33.50%
        S&P:     -1.85%  -2.43%   1.89%  26.10%
        NASDAQ:  -3.34%  -3.82%   9.91%  45.81%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    159.06   103.23%
    5/1/98   55 Gap Inc.      34.37     64.06    86.39%
   6/23/98   34 Cisco Syst    58.41    105.25    80.19%
    2/3/98   22 Pfizer        82.30    131.63    59.93%
   2/13/98   22 Intel         84.67    130.13    53.68%
   8/21/98   44 Schering-P    47.99     54.56    13.69%
    2/6/98   56 T. Rowe Pr    33.67     34.00     0.97%
   5/26/98   18 AmExpress    104.07    100.25    -3.67%
   2/27/98   27 Coca-Cola     69.11     63.63    -7.93%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     87.06    20.24%
   3/12/98   20 Eastman Ko    63.15     68.88     9.07%
   3/12/98   20 Exxon         64.34     69.81     8.51%
   3/12/98   15 Chevron       83.34     76.94    -7.69%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   3817.50  $1939.05
    5/1/98   55 Gap Inc.    1890.33   3523.44  $1633.11
   6/23/98   34 Cisco Syst  1985.95   3578.50  $1592.55
    2/3/98   22 Pfizer      1810.58   2895.75  $1085.17
   2/13/98   22 Intel       1862.83   2862.75   $999.92
   8/21/98   44 Schering-P   2111.7   2400.75   $289.05
    2/6/98   56 T. Rowe Pr  1885.70   1904.00    $18.30
   5/26/98   18 AmExpress   1873.20   1804.50   -$68.70
   2/27/98   27 Coca-Cola   1865.89   1717.88  -$148.02

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1480.06   $249.17
   3/12/98   20 Eastman Ko  1262.95   1377.50   $114.55
   3/12/98   20 Exxon       1286.70   1396.25   $109.55
   3/12/98   15 Chevron     1250.14   1154.06   -$96.08

                              CASH   $2205.98
                             TOTAL  $32118.92

  
Note: On 8/4/98 $2,000 cash was added to the
portfolio. $2,000 will be added every six months.


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