I received so much feedback on my column (Stupid Accounting Tricks) that I thought I would respond en masse today and elaborate a bit on the subjects of pro forma accounting and managing earnings.
First, the title of my column “Stupid Accounting Tricks” offended some. I don’t know why. But honestly, it was just a play on Letterman’s “Stupid Pet Tricks”, nothing more. I originally considered using “Who’s Zoomin’ Who?” as the title. I actually liked it a lot more, but I thought both the meaning and the source of the title would be a bit too obscure. And more importantly, I would be showing my age, as the song was from 1985. (For the record, I am 28 years old, have been now for 22 years, and hope to be for 30 more. So there.)
Secondly, I wasn’t trying to trash Extreme or praise Foundry per se. My main objective was to use two stocks that I follow — two competitors in fact — to point out the perils of pro forma accounting. I believe that the markets would have probably reacted quite differently to these two earnings reports if both companies used the same accounting rules. And I personally favor accounting practices that don’t require long, explanatory footnotes on the quarterly earnings report. Such notes are a red flag that the company is manipulating the numbers. I hoped that by pointing out the perils of pro forma accounting, I could help investors do a better job of evaluating earnings statements and balance sheets so that they could make better investment decisions. I intend to publish more about this in the future, offering specific tips on how to look for telltales signs that things are not what they appear to be.
Extreme Networks is by no means alone in the practice that is commonly referred to as managing earnings. Sometimes, a company manages earnings to make things look better than they really are (as I believe Extreme did), and sometimes a company manages earnings to make things look worse than they really are.
It’s fairly obvious why a company would want to make things look better, but why would a company want to make things look worse? To set the stage to make things look much, much better in the future. Sometimes a company has such a great quarter that it wants to defer some earnings to the following quarter. And sometimes, if a company is having a lousy quarter, they may make it look even worse than it really is to set the stage for a miraculous rebound in future quarters.
For example, it is not unusual for a company to clean up their balance sheets by taking a huge charge in one quarter to make things look better the following quarters. Another common practice is cookie jar reserves. This is the practice of overestimating liabilities in one period to create a reserve that can be used to bolster profits in future periods.
The phantom inventory write-off is another popular technique for improving profits in future quarters. If a company knows it is going to have a lousy quarter anyway, they make take a huge charge for inventory write-offs, claiming that the inventory is obsolete and can no longer be sold. That doesn’t mean they necessarily physically get rid of the inventory. It just gets the inventory off the books. Guess what happens when business picks up? The inventory is sold, and it is 100% profit. All of the sudden, earnings per share and gross margins go through the roof.
All companies manage earnings to some extent. Some very well known companies — Cisco and GE for example — are very skillful at managing earnings. When it is done within certain limits, managing earnings is not the worst crime in the world.
But there’s a fine line between managing and manipulation, and the line too often gets obliterated. And manipulation is not limited to creative accounting.
Back in the old days, I sold enterprise application software for Management Science America. One day, I was sitting in the back of the room while another consultant was performing a demonstration to a prospect at a corporate visit. I watched a consultant use smoke and mirrors to make it appear that the product could do something it couldn’t do — something that was very important to the prospect. The consultant didn’t tell an outright lie, but his presentation was clearly designed to cause the prospect to incorrectly infer that the product met their needs. Observing this, I muttered the word “sneaky” under my breath. An executive Vice President, who was sitting next to me and shall remain nameless, overheard me and whispered in my ear, “That’s not sneaky. That’s showing the product in the best possible light.”
Well that’s similar to what pro forma accounting often does — it shows the numbers in the best possible light. It’s not illegal unless a company really does something stupid. It’s not an outright lie. In some cases, it can even give the investor a clearer picture of results from ongoing operations by eliminating meaningless charges like goodwill. But it can be manipulative and it can lead to bad investment decisions when it is used to eliminate everything but the kitchen sink from consideration in calculating earnings.
Oh, by the way, Management Science America, or MSA as it was known, has been defunct for years. MSA spent too much time and effort showing their products in the best possible light and not enough time developing the best possible products, but that’s a story for another day if anyone is interested. Last I heard, the executive VP was a car salesman. Creative marketing, like creative accounting, can only obscure problems and salvage careers for so long.
Some Final Thoughts
It’s my contention that analysts and reporters are often no better at understanding earnings statements and balance sheets than the average investor. Now here’s a thought for you to ponder. In today’s world, where companies stretch the practice of pro forma accounting to its limits and beyond, I think that accountants make the best analysts. That wasn’t true in the old days before regulation FD. Back then, the best “analyst” was the schmoozer — the guy who had the relationships to get the inside scoop before anybody else. But now, everybody has access to the same information at the same time, and analysts can only add value by <gasp> performing analysis, and many so-called analysts are just not up to the task. So we see knee jerk upgrades and downgrades based what earnings press releases, instead of real analysis. Hence, the knee jerk downgrades of Foundry by two analysts yesterday. (Some would argue that the knee jerk upgrades and downgrades are themselves attempts by analysts to manipulate the stock, but I won’t go there — at least not today. No need to confuse things further.)
As an informed investor, you can take advantage of these knee jerk reactions. If you know from your analysis that the company’s results were really worse than they appeared to be, you can sell on the knee jerk upgrade. Conversely, if you know from your analysis that the company’s results were really better than they appeared to be, you can buy on the knee jerk downgrade.
Oh, and thanks for reading and thanks for writing. Keep those letters coming.