Last year Enron was found to have manipulated its financial position with the help of its auditor, Arthur Anderson who are now essentially out of business because of the scandal. Subsequently WorldCom announced it had overstated a key measure of earnings by more than $3.8 billion over five quarters dating back to January 2001. It had called operating expenses capital expenses with the result that its profits looked very much better than they really were. Worldcom had also used Arthur Anderson for auditing paying the firm USD$4.4m each year - to fail in its duties. The problems are more widespread than that. Xerox has restated $6.4 billion in revenues dating back to 1997. Merrill Lynch has been in the news, El Paso Gas is under investigation for sham energy trades, the former Chairman of Christies has been convicted and investigations are underway into actions of senior executives at Global Crossing, ImClone, Tyco and Adelphia.
Accounting Methods
Much of the problem stems from the rule-based accounting methods of the US. Make a rule and someone’s bound to find a way around it.
Here in New Zealand, we have a principles-based system where the intent of the reporting is the essential element.
“Reported Earnings” is the term used in the US to describe earnings calculated in accordance with the criteria established by their Financial Accounting Standards Board. “Operating Earnings”, on the other hand, refers to the after expenses / net ongoing revenue of a company after adjusting for “extraordinary” items.
Operating Earnings are a substantial determinant of a company’s value. The trouble is that there are no established standards for this calculation, the term “extraordinary” not having been defined and therefore open to manipulation.
Jeremy Siegal, a respected market commentator and Professor at Wharton University, notes that from 1970 – 1990, operating earnings closely tracked reported earnings with operating earnings exceeding reported earnings by only about 2%. The 1990 – 1991 recession was a turning point with operating earnings averaging 14% higher. The discrepancies reached a staggering 50% in 2001. A new standard has been proposed known as “Core” earnings which requires firms to treat employee stock options as expenses, to exclude gains and losses from pension plans and to exclude gains and losses from the sale of assets, unless the assets are part of the firm’s core business. A recent Barron’s article highlighted how significantly different a firm’s profitability looks when Core Earnings are compared with Reported Earnings.
Out of all of this negativity, it is surely encouraging to, for a start, see the scams being exposed, see the people responsible being brought to justice and, most importantly, seeing measures put in place to deal with the issues on a long term basis. Articles in US newspapers are a good indication of the extent of the wrath of that nation’s investors right now. They are angry and distrustful, feeling duped and let down by their own.
CORE REPORTED
FIRM EARNINGS EARNINGS DIFFERENCE PERCENTAGE
(MILLIONS) (MILLIONS) (MILLIONS)
DuPont -$49 $ 4,318 -$4,367 101%
IBM $4,854 $7,713 -$2,859 37%
Microsoft $5,459 $7,721 -$2,262 29%
GE $11,896 $14,128 -$2,232 16%
Motorola -$5,549 -$3,397 -$1,556 46%
Cisco -$2,517 -$1,014 -$1,503 148%
AOL -$6,197 -$4,921 -$1,193 24%
AT&T -$6,056 -$4,863 -$1,193 25%
Yahoo -$980 -$93 -$887 954%
When you consider that most US investors would have very little of their money positioned outside the US, you begin to understand the pain they are going through.
We should not underestimate this factor when trying to make sense of where the sharemarket is going. Think back, if you can, to 1987 in New Zealand. Many people can vividly recall their experiences at this time and have avoided shares ever since because of what happened then. Those same people have missed out on any benefits they might have gained by investing in shares but their fear of loss has been overwhelming. Time is clearly needed now for US investors to regain confidence in their market. If and when they do, we will all be the beneficiaries.
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