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'Clean' earnings reports should help clean
up mess
Heydon Traub, Boston Business
Journal, August 23, 2002
The two hot items in the financial
news these days are, one, accounting scandals and related regulation, and
two, reporting of earnings and option expenses.
The former came to a boil last week with the bulk of companies having
reached their Aug. 14 deadline to have CFOs and CEOs certify their financial
statements. Technically, there are 945 companies required to certify their
financial results to the SEC. CEOs of companies that have fiscal years that
are the same as the calendar year needed to file by Aug. 14. That represents
about 75 percent of the companies, however, so not all companies have had to
file yet. Some have as late as Dec. 27 due to the timing of their normal
quarterly reports.
In any case, we have seen that the majority of companies have been reporting
their financials by the rules and that a very small number are now having to
restate. When all the reports are in by year-end, we will have two
interesting factors in play. First, whatever accounting games companies were
playing before are mostly behind us. I say "mostly" because accounting
always involves some form of interpretation, and many companies previously
were taking the most aggressive approach.
The new "regime" does not mean companies can't interpret the rules loosely
to maximize profits. In addition, there is no guarantee that the
certifications are true. If CEOs were cheating up until now, there is a
chance they may continue. However, the likelihood of jail time for not
confessing to previous sins is very high and is a strong deterrent.
Companies are taking more conservative approaches and making their
financials more transparent, recognizing that their stock price will
actually be rewarded for such clean accounting. So with the accounting games
behind us, this should be a positive for the stock market.
This "clean" reporting leads to the second factor to consider: All of the
conservative accounting will lead to lower reported earnings. However, to
use analyst lingo, these will be high-quality earnings, whereas many
companies were criticized before (Enron and WorldCom were two) for
low-quality earnings — and at times their stock price suffered for it.
The billion-dollar question is, How much of this change is already priced
into the market? It seems clear that investors are already expecting some
lowering of earnings but are not necessarily selling, since investors should
place a higher multiple (higher price-earnings ratio) on these
higher-quality earnings.
Probably the largest component of earnings impact from the changes under way
relates to expensing options. Until recently, almost no companies recorded
an expense when they granted employees options. With stock prices going
through the roof, some companies were able to pay a large percentage of
compensation via options. In effect, you could hand out big raises via
options without reducing earnings. All of this was completely legal and
well-known.
Part of the complication here is that it is not simple to place a value on
the options — thus making it difficult to show an options value as an
expense. However, companies have begun to adopt the idea of expensing
options. There have been many estimates made regarding the impact for the
overall market, leading to a reduction in earnings ranging from 10 percent
to 20 percent. However, even that range may be off.
There are several bits of positive news around all this uncertainty. First,
you should know that companies have two sets of books. One set is the
financial statements discussed above, and the second is the tax books. Two
of the more notable differences on these are options expenses (shown on tax
books only) and pension fund income (shown on financial statements only).
According to a report in Fortune, profit growth shown on these two reports
diverged greatly in 1999-2000, but has since moved closer. Since 1960, they
have both grown at about the same annualized rate (7 percent). Since there
are fewer questions about the tax reports and the two have been moving
closer together over the long run, this should be a sign that there are not
many more shenanigans going on with financial statements than have already
reported. In addition, the first-quarter profits on tax statements are on a
record pace for the full year.
So with the quality of earnings substantially improved over the last few
years, what about the earnings picture overall? Well, the numbers there are
generally good. Earnings are likely to grow at a low double-digit rate this
year and next. About 60 percent of companies who have reported have beaten
earnings for Q2, while less than one-quarter have come in below
expectations. The only cloud on this front is that we have been seeing an
increase in negative pre-announcements (companies warning that their
earnings will come in worse than analysts are currently expecting) for Q3.
As usual, the picture is not fully clear. However, it seems that most of the
recent downturn has been because of reduced confidence in the earnings
numbers and a weakening economy.
There is already an improvement on earnings quality, and as time goes by,
concerns over the scandals will dissipate, gradually leading to a higher
stock market. In addition, earnings (no matter which accounting method you
use) are likely to grow fairly well, which also will lead to a rising stock
market.
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