Creative financial engineers fill potholes with illusion

Today, we live in a world of managed earnings. While it is corporate executives who do the managing, they do so with at least the tacit approval of corporate directors and auditors, and with the enthusiastic endorsement of institutional investors with short-term time horizons rather than in response to the demands of long-term investors.

Like it or not, corporate strategy and financial accounting alike focus on meeting the earnings expectations of the Street quarter after quarter. The desideratum is steady earnings growth — manage it to at least the 12% level if you can — and at all costs avoid falling short of the earnings expectations at which the corporation has hinted, or whispered, or “ballparked” before the year began.

If all else fails, obscure the results by taking a big one-time write-off. All of this creative engineering apparently serves to inflate stock prices, to enrich managers, and to deliver to institutional investors what they want.

But if the stock market is to be the arbiter of value, it will do its job best if it sets its valuations based on punctiliously accurate corporate financial reporting and a focus on the long-term prospects of the corporations it values.

The market’s direction seems quite the opposite, however. For while America’s accounting practices may well be the envy of the world, our nation’s financial environment is permeated with the concept of managed earnings.

set the score, then play the game

The accepted idea is to smooth reported earnings, often by aiding security analysts to establish earnings expectations for the year, and then, each quarter, reporting earnings that “meet expectations,” or, better yet, “exceed expectations.” Failure to meet expectations may be preceded by lower “whisper earnings,” which must, in turn, be met. It is an illusory world that ignores the normal ups and downs of business revenues and expenses, a world in which “negative earnings surprises” are to be avoided at all costs.

Managed earnings are reflected in the values of America’s most respected companies. Microsoft Corp., for all its rapid growth and essentially conservative practices that tend to understate earnings, focuses on producing quarter-after-quarter gains, even as it prominently discloses “below the line” the huge dilution of earnings resulting from its use of stock options to reward employees.

The odd failure of accounting principles to include stock option costs as compensation, of course, can result in a large overstatement of bottom-line income (prompting Warren Buffett’s questions: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go in the calculation of earnings, where in the world should they go?”). Forget that nuance. The bottom line — ignoring option dilution — is the number that Wall Street accepts as reality.

General Electric Co. Inc., surely one of America’s most successful companies, also produces regular double- digit quarterly earnings growth. While many of its businesses are cyclical, somehow analysts have been able to forecast its earnings within 2% of actual for the past 10 quarters in a row, an accuracy said to be a 1-in-50 billion chance. It is creative financial engineering that fosters this remarkable precision.

analysts like being managed

American Express Co. Inc., another blue-chip stock, also regularly meets the market’s growth expectations. The firm securitized a pool of credit card receivables [in 1999’s second quarter] in order to produce the expected earnings. When at a meeting with management one analyst raised doubts about the practice, the company’s chairman defended the smoothing of earnings, and then took a poll of the securities analysts in attendance. The vote: 10-1 in favor of avoiding the decline in reported earnings. A landslide! Wall Street clearly endorses the managed earnings that corporate America targets.

I share SEC Chairman Arthur Levitt’s concern that earnings management has gone too far. He cites abuses in huge restructuring changes, creative acquisition accounting, “cookie jar” reserves, excessive “immaterial” items, and premature recognition of revenue. And I surely agree with the chairman that “almost everyone in the financial community shares responsibility [with corporate management] for fostering this climate.”

It is, in a perverse sense, a happy conspiracy. But I believe that no corporation can manage its earnings forever, and that managed earnings misrepresent the inherently cyclical nature of business. Even as we begin to take for granted that earnings are steady and ever-growing, we ought to recognize that, somewhere down the road, there lies a day of reckoning that will not be pleasant.

Mr. Bogle, founder of the Vanguard Group in Malvern, Pa., is a frequent contributor to InvestmentNews. This article was excerpted from his address late last year to the New York Society of Securities Analysts.