Commentary: Still Spooked by the Market

By David Henry

Enron Corp.'s meltdown touched off a wave of paranoia about Corporate America's accounting. Months after the scandal first broke, it is still casting a dismal shadow across just about every other public company with an aggressive growth strategy.

Market players can't seem to shake that creepy feeling, despite the strengthening economy. Stocks of big companies with intricate accounting--notably those with lots of mergers and acquisitions--are particularly hard hit. An index of 20 such companies constructed by Bridgewater Associates Inc., a Westport (Conn.) money manager, is down 19% since the start of the year. Worse, the stocks are selling at an average discount of 15% from the Standard & Poor's 500-stock index.

Brace yourself for a long wait. Given the complexity of the problem, the malady will linger for 12 months, if not longer. Convulsions in shares of General Electric Co. (GE ) and IBM (IBM ) in early April--over questions about earnings counted from pension plans, acquisitions, and divestitures--are but recent flareups.

Experts say they're still seeing hints of exaggerated earnings that the market has yet to catch. Among the red flags: schemes that may inflate sales, earnings that rely on overoptimistic assumptions of pension plan returns, and off-balance-sheet activities. Examples of the kinds of issues likely to come up: AOL Time Warner Inc.'s previously unconsolidated losses in joint-ventures in Europe and Latin America and Qwest Communications International Inc.'s (Q ) revenue from reselling equipment to local carriers to whom it also owes money. "This is not going away anytime soon," warns accounting specialist Trevor S. Harris of Morgan Stanley Dean Witter & Co. "There is still plenty of stuff going on."

The reality is that accounting practices are too complex to change overnight. Players embracing the new religion of straightforward numbers find it's not as easy as scheduling a conference call with analysts or pouring more information into an annual report as GE did. Even professional money managers are scared that they don't know enough accounting. "Investors are just starting to come to grips with this," says David Dreman of Dreman Value Management LLC. Indeed, more than 400 institutional investors recently packed a Manhattan ballroom to hear a dense four-hour lecture on accounting from Harris.

Assuming the pressure stays on and the S&P 500 companies clean up their numbers, their earnings will be lower than they would otherwise have been. And that could be a big drag on the market, preventing it from coming back as strongly as the economy. In this market, stock valuations don't provide much of a cushion for lower earnings. The S&P 500 is still trading at 22 times estimated '02 earnings. The only force capable of stopping the problems without more pain, Harris says, would be a boom that might cover companies as they switched to more conservative financial reporting.

A hoary Wall Street axiom says that any topic that attracts a crowd is old news and already priced into the market. But accounting problems are different. They're too complex to be cured simply by the realization that they are important. Harris says his crash course was but a start. One class is no substitute for the years of experience that many on Wall Street still lack in digging through financial reports. The skill rusted during the '90s stock bubble. Then prices climbed so fast that many investors didn't believe they could afford to wait and read reports filed with the Securities & Exchange Commission. Now, many wish they knew how.

Companies will take time to change, too. True, the SEC has ordered more disclosure, but chief executives and directors are still trying to figure out exactly what they must reveal and how to let it out. Their caution is understandable: Many spent the last decade learning to fudge their numbers to keep their stock prices up and their cost of capital down. Now, if they dare to tell more than their competitors, they worry they'll risk hurting their stocks and finding the credit window slammed in their faces. "We're not yet to the point where corporations are sure honesty is the best policy," says Gene D'Avolio, co-author of a Harvard University paper in September on the market and corporate accounting games.

Auditors, though motivated by the death throes of Arthur Andersen, are at a loss. They need to retrain staff so they not only make sure clients' transactions comply with generally accepted accounting principles but also ensure that those transactions make economic sense. And the Financial Accounting Standards Board, the private body which oversees GAAP, is trying to do in six months what it failed to do in 20 years: tighten up the rules on consolidated financial reporting to stop Enron-like off-balance-sheet maneuvers. FASB's new rules are yet more changes for the market to absorb. "It is at least 18 months before things settle down," says Harris.

Meantime, the market will get whacked as news of accounting problems hits individual stocks. Some will turn out to be overblown, allowing smart investors to pick up bargains. Others will kill off failing companies. Either way, the volatility will weigh on the market.

The great tragedy, of course, would be if accounting flu lingers so long that it turns investors' interest away from viable companies and the stock market. But it's an unavoidable risk: The market will not recover durably until the illness is purged.

Henry covers corporate finance.

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