A Good Idea about Earnings

There was a time when the American accounting system was the envy of the world. Its transparency, uniformity, and credibility allowed investors to make intelligent comparisons among U.S. corporate earnings statements. It encouraged millions of average people to invest, thus transforming America into the world's first mass equity culture. But Enron and other accounting scandals, customized and managed pro forma earnings, and growing doubts about Wall Street's veracity have combined to deeply undermine people's belief in the basic honesty of the financial system.

Fortunately, help may be on its way. While the Financial Accounting Standards Board dithers, ratings agency Standard & Poor's is putting forth a tough new measure of corporate earnings that goes a long way toward improving U.S. financial reporting. FASB, the Securities & Exchange Commission, the New York Stock Exchange, Nasdaq, chief executives, and--most important--Wall Street investment houses, would do well to take the S&P proposal seriously. It offers them a road map to restoring investor confidence. Shortcomings in the proposal need to be discussed, but it should not be ignored.

Standard & Poor's (owned, along with BusinessWeek, by The McGraw-Hill Companies) is proposing a new measure of core earnings that would, among other things, eliminate three popular financial strategies that companies use to bolster their numbers. Core earnings would expense stock options as regular compensation (which could hit high-tech companies pretty hard); exclude pension gains (which could hit large industrial companies with big pension funds); and include restructuring charges from ongoing operations while excluding gains and losses from asset sales (which could hurt big companies trying to smooth out earnings gains over time).

This is dramatic stuff. Under the Standard & Poor's core earnings measure, Cisco Systems Inc., for example, would have had a bottom-line loss of 35 cents a share in fiscal 2001 instead of its reported 14 cents loss. Expensing of option grants would lower Cisco's EPS by 21 cents. Earnings at General Electric Co. drop to $1.11 in 2001, from $1.41, mainly by eliminating big gains from pension income. Both companies quickly criticized the S&P proposal--too quickly.

There are almost as many measures of earnings today as there are companies. Pro forma has destroyed any serious means of measuring performance across industries and the broad economy. It has allowed analysts, investment bankers, and CEOs to join in gaming the system to push profits higher, contributing to the scandals of recent months.

The biggest effect of the new Standard & Poor's core earnings measure may be on valuation, rather than earnings itself. Under core earnings, the EPS multiple for the S&P 500-stock index would surely rise from 22. The worry is that if investors believe a higher multiple makes the market overvalued, they would sell. But they just might not. Stripping away pension gains and other fake earnings flows would increase the overall quality of earnings, making them more valuable and perhaps worthy of a higher multiple. At the end of the day, the level of earnings may decline, but valuations could easily rise. Of course, core earnings may be more volatile, but they would also be more genuine.

Boosting the integrity and standards of the financial markets is a critical imperative. Standard & Poor's has taken a bold step in suggesting a methodology that makes great strides toward restoring uniformity, clarity, and reliability to Corporate America's financial statements. It will follow up by incorporating its core earnings measure into the S&P 500 index and its analysts' company ratings. Regulators, analysts, and CEOs would do well to embrace it or something much like it.

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