On Oct. 16, TranSwitch Corp. (TXCC ) reported impressive numbers for its third quarter. With net income of $2.6 million on sales of $5.7 million, the Shelton (Conn.) semiconductor maker's net profit margin was nearly 50%. In its earnings release, CEO Santanu Das noted TranSwitch's increasing design wins and said its strategy was "resonating with our customers."
What Das didn't say was that 23% of TranSwitch's net income had come from a credit that had little to do with ongoing operations. The company reaped about $600,000 in pure profit from selling inventory it had written down to zero in previous quarters. While TranSwitch says it told shareholders about the reversal in a conference call later that day, investors who just read the earnings release may have gotten a much rosier picture of the company's business. TranSwitch denies any attempt to mislead. In fact, the company says that when it detailed the benefit from the inventory sale in a filing with the Securities & Exchange Commission three weeks later, it went beyond what is mandatory under current accounting rules. "My understanding is that it is not required to be disclosed," says Chief Financial Officer Peter J. Tallian. "However, it is good practice to give this information to investors."
REASON TO BE SKITTISH
TranSwitch is one of scores of companies using a little-known accounting technique that can make financial statements look healthier than they otherwise would. The practice entails reversing big charges that companies took in the past for inventory write-downs or other issues. It is especially prevalent among technology companies that got hit the hardest in the past few years. A BusinessWeek investigation of 255 tech companies that took special charges in recent years reveals that at least 42 have gained some benefit from reversals. Of those 42 companies, 28, or two-thirds, did not disclose the benefit in their earnings releases. Besides selling written-off inventory, companies profited from reversing lease terminations, tax liabilities, severance costs, litigation charges, equipment-cancellation fees, and other restructuring fees. "The biggest accounting trick people are not even aware of is unwinding special charges," says Howard Schilit, an accounting expert and director of the Center for Financial Research & Analysis.
The increasing use of reversals comes at a sensitive time for Corporate America. Investors' faith in equities was shaken by the tech bust and accounting fraud at Enron (ENRNQ ), WorldCom (MCWEQ ), and others. Stocks have rallied of late, but the growing mutual-fund industry scandal has investors on edge again. What's more, overseas investors seem increasingly skittish about U.S. equities. Foreigners poured $16.6 billion into the U.S. stock market in the first nine months of 2003, down from $36.9 billion in the same year-ago period, according to the U.S. Treasury.
What makes reversals troubling to some experts is that the accounting rules governing them leave room for interpretation. Kevin McBride, a fellow at Financial Accounting Standards Board (FASB), says companies are not required to report such gains in earnings releases and that they need to be disclosed in SEC filings only if they are "material." Asked if a 20% boost to net income from reversals qualified, he said the call "will be based on management's judgment of materiality." The SEC says that under Regulation S-K, companies are required to disclose and quantify any reversals that are material in financial statements filed with the SEC, though not in their releases. However, Lynn E. Turner, former chief accountant at the SEC, says companies should include the information in their earnings releases. "If that reverse has a material impact on the companies' reported gross margin or net income, then not to disclose that would be misleading to investors," says Turner.
Several companies are erring on the side of full disclosure. Telecom-equipment maker Lucent Technologies (LU ), which suffered through its own accounting scandal three years ago, discloses the benefits of reversals in both its earnings releases and SEC filings. In the quarter ending Mar. 31, for instance, it reported a gain of $131 million from unwinding several charges. Imation (IMN ) Corp., an Oakdale (Minn.) maker of storage devices, also notifies investors in its releases as well as its SEC filings. "From a transparency standpoint, we believe readers should have the ability to understand the composition of our net income," says Controller Paul R. Zeller.
Even some companies that think the SEC rules are so vague that they are not obligated to disclose gains to investors do it anyway. For example, chipmaker Altera (ALTR ) Corp. spells out the gains from selling written-off inventory in both its SEC filings and its earnings releases. "It creates more of a trust factor," says CEO John P. Daane.
How many other companies are benefiting from reversals without disclosing it to investors? There are plenty of possibilities. Besides the 255 tech companies, 1,348 nontech companies have reported special charges in the past four years, according to a review of financial records conducted by Standard & Poor's (MHP ).
THE RIGHT THING TO DO
Even when companies do disclose reversals, it's sometimes hard to assess their impact. That's because some companies, including Intel (INTC ) Corp., do not quantify the reversal's size. In its SEC filing for the first quarter of 2003, Intel says the $111 million increase in its operating income was due in part to "unusually high levels of sales of microprocessor and chipset inventory that had been previously reserved." But it did not specify how much reserved inventory was sold. "We didn't think that identifying the specific dollar amount for an individual factor was meaningful," says Intel spokesman Robert Manetta.
Another example comes from semiconductor company Vishay Intertechnology, led by Chairman and CEO Felix Zandman (VSH ). In its most recent SEC filing, Vishay disclosed that selling written-down materials improved its gross margins. But the Malvern (Pa.) company said the impact "cannot be quantified in any specific reporting period, however, because of the large number of affected products and the impracticality of tracking raw material inventory usage on a product-by-product basis." In an interview, Vishay Controller William M. Clancy says that the inventory "gets spread to so many different parts that it's really hard to track when it is utilized."
Certainly, some reversals are necessary. Companies downsize or shelve unprofitable businesses during tough times. When they do, they are required to compose restructuring plans. Sometimes, the expenses turn out to be higher or lower than expected, and adjustments must be made. In its SEC filing for the quarter ended Aug. 2, chipmaker Analog Devices (ADI ) Inc. said that $2.9 million of its $4.4 million reversal was due to lower-than-expected severance costs. Analog initially estimated that 509 employees would receive pink slips, but only 439 workers were ultimately laid off. Although the reversal amount accounted for 5.5% of net income, Analog says it did not disclose the gain in its press release because it was not required to by law. "We are trying to focus on new information," says spokeswoman Maria Tagliaferro.
After the recent outbreak of accounting scandals in Corporate America, companies and regulators pledged that financial transparency would become a top priority. Clearly and completely disclosing the reversals that are now boosting profits would be a good place to start.
By Spencer E. Ante in New York