Bad For CFOs, Good For Investors
It has been a tough year for Perot Systems (PER ) Corp. In April, the Plano (Tex.) tech-services company said it was taking a $29 million charge and lowering its 2003 earnings targets. The reason: The Financial Accounting Standards Board had a new rule in the works that would rein in a common corporate practice of booking expected revenue from some long-term contracts years before the bill has been sent.
Three months later, the company's auditors, PricewaterhouseCoopers, got a look at the rule's final wording, and it was bad news. They told Perot to restate its results for the first and second quarters and to take another charge, this one for $14 million. The timing -- right after the company's second-quarter earnings presentation -- was terrible. After that, its shares went nowhere before finally picking up this month. For Chief Financial Officer Russell Freeman, the rule change has been a "tremendous headache."
In fact, in industries ranging from media to telecom, CFOs are reaching for the aspirin. The rule will make earnings and share prices more volatile for businesses that depend on contracts with more than one type of revenue -- such as the one-time payments that Perot collects when it finishes building a corporate computer system and the continuing fees it gets for running it. In these cases, companies can no longer book revenues long before they arrive in order to offset high up-front costs of fulfilling a contract, such as hiring workers or getting equipment and supplies.
For investors, though, there's a big upside. That's because the smoothing of earnings sometimes obscured real losses when things didn't pan out as expected. Electronic Data Systems Corp. (EDS ), for instance, was able to load up on long-term computer outsourcing contracts that kept sales and earnings growing. As a result, it could book the revenues years before they were collected. But then political infighting and technical glitches delayed the already-booked payments on a $9 billion contract with the U.S. Navy, reducing EDS' cash flow by $2 billion since 2001. The new rule forced EDS to restate its results for the first and second quarters, take a $2.2 billion charge for the third quarter on Oct. 27, and wait to book the Navy revenues until they arrive. EDS declined to comment. "This rule is a healthy change," says Rod M. Bourgeois, who follows the IT services industry for research boutique Sanford C. Bernstein & Co. "It adds a level of accountability."
Investors hope greater transparency will translate into greater financial discipline. With companies forced to account for big contracts more conservatively, they may be less likely to lure customers with expensive freebies and discounts. And executives may slow down their growth, knowing that taking on too many costly projects all at once will crimp their earnings -- and share price.
But without any revenue smoothing, the turbulence that many companies experience from quarter to quarter will become more obvious. For example, Walt Disney Co. (DIS ) used to take some of the fees it collects from local cable systems that carry its ESPN station and book them during the football season. That way, it could match the fees with its production costs as they arose. No longer. In July, Disney took a $71 million charge and warned investors that its Media Networks segment, which accounts for more than 40% of its total revenue, would see "significantly reduced revenue and profitability" during its first fiscal quarter, ending Dec. 31, because of the accounting change. The revenue and profit reduction is expected to be reversed in the next two quarters, but the new accounting gives investors a better idea of the volatility in the business.
Even the smallest companies can't escape the rule's impact. Align Technology Inc., a Santa Clara (Calif.) maker of orthodontic equipment, had to overhaul how it accounted for revenue from a key product, requiring "excruciating" analysis, says CFO Eldon M. Bullington. Yet the rule also forced Align to simplify its contracts with customers, something they were clamoring for. "It solves what was always a loose end," Bullington says. And just like a trip to the dentist, investors' gain has been worth the pain.
By Andrew Park in Dallas