Ouch! Real Numbers

New accounting rules will deflate earnings hype and, perhaps, stocks

Another hit to corporate earnings is coming. No, it's not the war. Nor the economy. Tougher accounting rules are taking effect that will slash the headline earnings companies like to trumpet -- and Wall Street uses to value stocks. David Bianco, an accounting analyst at UBS Warburg, figures companies will have to cut them by at least 10%. "The new rules will unmask a lower level of normal earnings," he says.

The next phase of the corporate cleanup is here. Washington is confronting Corporate America head-on and putting new curbs on the notorious practice of companies counting all sorts of routine expenses as "special, one-time" costs, then omitting them from their headline earnings. Once, "extraordinary charges" were just that: a rarity. But lately they've become the norm. Indeed, 16 of the companies in the Standard & Poor's 500-stock index have omitted special charges -- for layoffs, inventory writedowns, acquisitions, and the like -- in every quarter in the last three years. International Paper Co. (IP ), for one, has excluded "special items" in 11 of the last 12 quarters. Without these adjustments, its earnings according to generally accepted accounting principles, or GAAP, were 46% lower than what it highlighted in its press releases.

The trend, building for some time, has exploded recently. Over the past 12 years, the actual earnings of S&P 500 companies according to GAAP, have been 17% less than the numbers promoted by the companies -- and accepted by Wall Street analysts. But in the last two years, the divide widened to a more-than-40% chasm as companies wrote down assets hit by the sluggish economy and the stock market plunged.

Pressure to puncture earnings hype comes from multiple sources. The Securities & Exchange Commission is demanding that companies provide full explanations whenever they deviate from GAAP as well as chastising them about a lack of information in their annual reports. The Financial Accounting Standards Board, the guardian of GAAP, has put strict limits on how companies account for restructuring costs. And now it's gearing up to require companies to expense the stock options that they hand out to executives. Independent research service Thomson Baseline has started grading companies for "earnings purity," while ratings agency S&P tallies "core earnings," which are stricter than GAAP.

Now, peer pressure is building as some companies say they will go beyond the new rules in forgoing some of their past adjustments to GAAP. Among them: P&G (PG ), Citigroup (C ), Clorox (CLX ), 3Com (COMS ), McKesson (MCK ), and Intel (INTC ). P&G has excluded an average of $825 million a year in restructuring charges since 1999. Last year, the tactic added 50 cents a share, or 14%, to its core earnings. P&G will still spend money on restructuring, but starting in July, it will count the costs as normal operating expenses.

Of course, there's a risk that pulling down the earnings fa&cceadil;ade might also pull down stocks. But in the long term, it promises to provide investors with clearer and more accurate numbers -- and a firmer foundation for share prices. Analyst William Steele of Banc of America Securities applauds the change. "This is what the investment community is asking for," he says. "It's the wave of the future."

For finance execs prepping for the changes, Mar. 28 is the big day. From then on, under new SEC rules mandated by last year's Sarbanes-Oxley Act, companies supplying numbers that aren't based on GAAP must explain fully and prominently how and why they differ, even in press releases and Webcast conferences. The new explanations, along with required side-by-side comparisons of GAAP and pro forma earnings, will flash like yellow caution signals to skeptical investors, the SEC believes. "Companies are going to be thinking longer and harder before putting out non-GAAP numbers," says Martin P. Dunn, deputy director of the SEC's Corporation Finance Div., which drafted the rules. "They know they are going to have to justify and reconcile."

Another set of new SEC rules taking effect the same day will zero in on restructuring charges. In their 10-K and 10-Q reports, companies won't be allowed to exclude costs that are similar in nature to those they've had in the previous two years or expect to have in the next two. "We are concerned when a company takes a restructuring charge year after year and keeps trying to eliminate it from earnings by telling investors it is special or irrelevant," says Carol Stacey, the division's chief accountant.

Already, FASB has made it harder for companies to use restructuring costs to squirrel away cash to help boost earnings later. Regulators were worried about the wide latitude the old rules gave to companies. Consider Sara Lee Corp. (SLE ), the baker and Wonderbra maker. It reported $378 million of charges over the last two fiscal years for restructuring it described as its "Reshaping" program. It called the charges "unusual," and Wall Street analysts didn't count them against earnings. But Sara Lee has spent only $263 million of the money to get trim so far. In the six months through December, it took back $30 million of the charges, adding 2 cents a share to earnings. It still has $85 million of the original charges on its books. Will Sara Lee reverse those charges as well? No, says spokeswoman Julie Ketay, the estimates are sound.

The clampdown is not all bad news for companies forced to fess up about what they really earn. In fact, there are new opportunities for hyperbole. Look at this headline from Sara Lee's announcement on Jan. 23: "Earnings momentum continues as Sara Lee reports 110% increase in EPS [earnings per share]." The math is true to GAAP: 42 cents, vs. 20 cents a year ago when GAAP results were hit by big restructuring charges. But a year ago Sara Lee portrayed the 20 cents quarter differently. Then, the company announced earnings of 37 cents after excluding the charges as "unusual." Sara Lee makes no apology for the new spin. "It is according to GAAP," says Ketay.

In the effort to bring more truth into earnings, the new rules will sweep away a loophole that many companies have exploited in the past -- of counting the savings from a restructuring toward their headline numbers, but not its costs. P&G is one such case. It showed $1 billion a year in annual savings from restructuring in its last 10-K after excluding $3.3 billion in costs.

Such seemingly cost-free gains from hundreds of companies distort the picture of earnings that underpins the stock market. The trouble is, correcting it might hurt the market. The rule changes and other actions "will be a significant drag on the potential of companies to grow their [announced] earnings from current levels," says UBS Warburg's Bianco.

Just how much this will weigh on stock prices is the subject of hot debate. Some analysts argue that investors already see through the earnings hype and have priced stocks accordingly. Others think the bear market has investors running scared -- so they're more likely to heed the caveats that companies are adding to reports. Either way, when markets get going again, investors will have an easier time sorting out earnings fact from fiction.

By David Henry in New York, with Robert Berner in Chicago

— With assistance by Robert Berner

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