Under The Microscope

(2 of 3)

The SEC warned Xerox three weeks ago about booking sales of copiers that, technically, are leased, not sold. Revenue from a lease is generally reported over the life of the lease, not up front. Xerox has said it will contest the SEC on this issue.

Some telecom companies are getting a second look, partly because more than a few use Arthur Andersen, Enron's auditor, but also because many achieved their once spectacular growth partly by immediately recognizing revenue from long-term contracts, analysts say. Qwest has received the most attention because its merger with US West opened the door to other accounting issues. Qwest has denied that it did anything wrong. "Think about a bottle of wine," former sec chairman Arthur Levitt said in a speech two years ago. "You wouldn't pop the cork on that wine before it was ready. But some companies are doing this with their revenue, recognizing it before a sale is complete, before the product is delivered to a customer or at a time when the customer still has options to terminate, void or delay the sale."

MANAGED EARNINGS Critics of Tyco, which has bought hundreds of companies over the years, charge that it inflates write-downs for the costs of its acquisitions, in effect creating stored earnings it can summon at will to pump up quarterly results in a way that makes earnings growth appear to be the result of expanding sales or higher margins. These allegations are "totally inaccurate," Kozlowski says. But those denials aren't persuasive to David Tice, who runs the Prudent Bear Fund and practices short selling, a technique that bets on a stock to fall. He has sold Tyco stock short and asserts that Tyco's core growth rate is just 7% or so a year--not the 15% to 20% that the company reports.

While investors sort that one out, they can also look at GE, famous for its steadily rising earnings and steadily rising stock price. GE is an acquisitive conglomerate known for reporting one-time gains and one-time losses in striking balance, keeping growth on a calm and steady course. The company has also benefited from earnings that flow from its overfunded pension plan. Last year, with the broad stock market down 13%, GE reported a whopping $1.7 billion of income from pension-plan investments. How could that be? Here's one possibility cited by stock analysts: by raising the estimated rate of return on the money set aside to fund employee pensions in the future, a company can immediately cut the amount of money it sets aside and let that flow to the bottom line. But if the higher returns never materialize, there will be an earnings hit later on. GE denies that it manages its earnings. "I don't want to be painted with that brush," CEO Jeffrey Immelt told analysts last week.

Stock analysts also question the pension accounting of IBM, which two years ago assumed a 9.5% rate of return on pension investments and has upped that expected return to 10%. IBM has said the increase was based on its experience in managing the fund.

Insurance companies routinely set aside reserves for future claims. Because insurer AIG has posted steadily rising profits for years, some analysts believe the company may over-reserve in good times and use the stored earnings to pump up results in bad times. AIG has said its policy for setting aside reserves is appropriate and fully disclosed in regulatory filings.

Cisco has come under the lens, as have a slew of other tech companies, for its use of so-called pro forma earnings, which may leave out recurring expenses and are often referred to as "earnings before all the bad stuff." Last year Cisco asked investors to ignore a $2.2 billion charge for inventory loss, which most accountants consider to be a normal business expense rather than something extraordinary.

HIDING DEBT This is where Enron got into trouble. Yet hundreds of companies shift liabilities off their books without breaking any laws or accounting rules. Many, like Enron, use special-purpose entities (SPE) that, as long as the entities receive at least 3% of capital from outsiders, can be left off the consolidated books of a parent company.

There are other ways to hide debt. In the 1980s Coke divested most of its bottling operations and saddled them with most of the parent company's long-term debt. Coke kept stakes of just under 50% in the bottlers, giving it the leverage to force price increases for syrup even when the bottlers couldn't pass on those costs. Coke's large ownership interest means that it is on the hook for much of the bottling companies' liabilities, yet the bottlers' debts do not show up on Coke's balance sheet. For that reason, some analysts consolidate the bottlers with Coke in looking at the company's financial picture.