Expect Surprises Long after August 14

What deadline? Companies won't be able to give their books a thorough scrubbing until next spring

The bulls have high hopes for Aug. 14--the Securities & Exchange Commission's deadline for the top executives of nearly 1,000 publicly traded companies to start swearing that their financial reports are on the level and accurate. Between now and then, the optimists are betting, the nasty stuff festering in company books will have to come to a head. And that could spark a stock market rally, based on company numbers investors can trust, in the fall.

Dream on. Aug. 14 is just the start of months of accounting revelations that are likely to feel more like extended root-canal work than a quick extraction. Experts estimate that companies in the Standard & Poor's 500-stock index overstated their earnings by upwards of 10% to 15% in most recent years, largely because they didn't count the cost of employee stock options and made over-optimistic assumptions about their pension plans. Once other sources of puffed-up earnings--as well as outright fraud--come out, the reduction in earnings could be much worse, especially in the technology, cable, and telecom industries, which stretched their accounting the furthest.

Why will it take so long to drain this abscess? First, Aug. 14 isn't the big day for everyone. The SEC's directive actually says that chief executives and financial officers must sign the affidavits when their companies file their next financial statement or report a significant event from that day on. Some CEOs won't have anything to file until weeks later.

In fact, since the new rules were announced on June 27, even honest executives haven't had time to find toxic numbers and purge them from their books. Companies won't be able to give their accounts a thorough scrubbing until they prepare their next audited annual reports in the spring. Meantime, most execs will do their best, gulp hard, and sign. Says accounting analyst Trevor Harris of Morgan Stanley: "If you've only got a few weeks to evaluate your past 10Ks and 10Qs, you don't have time to investigate everything."

Right now, there's no telling how many more debacles still lurk. The SEC won't decide whether all major corporate filings are up to snuff for months after Aug. 14. Besides, there's a big debate among businesses and accountants about the proper accounting treatment for pension plans and stock options. The delays will likely cast a cloud on earnings--and the stock market--for months. For example, overly optimistic pension plan assumptions have boosted earnings at many companies over the past two years. But under current rules, most companies won't revise them before December.

As for options, analysts at S&P say they would reduce S&P 500 earnings by 17% this year if they were expensed. But that estimate is based on the values companies have put on options grants in their annual reports. Accounting regulators say they know of no one who has checked the assumptions behind the calculations.

Sadly, for all the uproar, there's a sure sign that execs haven't fully bought into the clean-numbers movement: the way in which they present their market-moving earnings press releases. Many tech companies still emphasize figures that make them look better than results that conform to generally accepted accounting principles, GAAP. They headline dressed-up numbers such as pro forma earnings, which exclude any expense they choose. Media and cable-TV companies favor earnings before interest, taxes, depreciation, and amortization (EBITDA), another non-GAAP profit measure that glosses over capital spending. "There has been a little bit of progress [toward GAAP], but basically companies don't get it," says Chuck Hill, director of research at earnings estimate tracker First Call. "As much as we would like to think companies are bending over backwards to do the right thing, it is not happening."

Brokerage-house analysts aren't much help, either. They tend to do what companies want. For example, only 6 of the 21 analysts that have given First Call their estimates for AOL Time Warner Inc.'s 2003 earnings actually provided GAAP figures. The rest just follow company guidance. The difference: 62 cents per share with GAAP vs. $1.05 using AOL's custom-made measure of choice, cash earnings per share, which understates taxes.

Even true believers in the Aug. 14 effect admit they are making a leap of faith. "If we can get all this behind us by the end of August, then we could be set up to rally in September and through the end of the year," says Ed Yardeni, chief investment strategist at Prudential Securities Inc. Yet he concedes that there will remain "a lot of questions about the right way to account for earnings."

Realistically, the best investors can hope for is some relief from the nagging feeling that they have been suckered. They invested in companies only to realize they have no idea what those businesses are really earning. It will be a while before they believe they know enough.

By David Henry in New York, with Amy Borrus in Washington

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