Beyond Quarterly Earnings



Beyond Quarterly Earnings

How to Improve Financial Reporting

By ALFRED RAPPAPORT

Special to THE WALL STREET JOURNAL

March 8, 2004

Recent corporate-governance reforms, including the Sarbanes-Oxley Act, fail to address the root cause of accounting scandals: a widespread obsession with earnings that drives companies to push accounting standards to the limit and, in extreme cases, to engage in outright fraud.

Analysts fixate on quarterly earnings at the expense of fundamental research. Corporate executives point to the investment community's behavior to rationalize their own preoccupation with earnings. To meet Wall Street expectations, managers make decisions to increase short-term earnings -- even at the expense of long-term shareholder value -- and may employ accounting gimmicks. The resulting misallocation of resources shortchanges everyone -- investors, employees, and consumers alike.

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|SHAREHOLDER SCOREBOARD | |

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|Dig into full lists of the rankings for the 1,000 | |

|companies and download the data in Excel. | |

|• Best Performers (1, 3, 5, 10-Year) | |

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|• Worst Performers (1, 3, 5, 10-Year)      | |

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|• Dow 30 Companies | |

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|• The 100 Biggest Companies | |

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|• Honor Roll | |

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|• Laggard List | |

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|• Most Improved | |

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|• Biggest Reversals of Fortune | |

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|• Companies vs. Industry Peers | |

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|• How Industry Groups Fared | |

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|• Alphabetical List of 1,000 Companies | |

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|• How the Rankings Were Compiled | |

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There is another way to track a company's progress that offers advantages to investors, company management, board members, auditors and accounting standard-setters: a Corporate Performance Statement, which would present a more straightforward picture of a company's results -- and would deal directly with uncertainty about the future.

Unless a company can generate cash to fund growth and pay dividends, its shares are essentially worthless. Neither last year's earnings nor next year's estimated earnings provide much help in gauging the magnitude, timing and uncertainty of future cash flows. To anticipate shifts in a company's prospects, no single-period performance measure, including cash flow, can substitute for a detailed analysis of the industry's attractiveness and the company's chosen strategies. Earnings are an amalgam of facts (realized cash flows) and subjective assumptions about the future (accruals). By combining yesterday's accomplishments and tomorrow's uncertainties, accountants produce a bottom line that doesn't tell investors what they need to know.

Estimating Revenue and Expenses

Two basic accounting principles govern the calculation of earnings -- revenue recognition and expense matching. Companies recognize revenue when they deliver products or services, can establish the amount due from customers and are reasonably assured that they will collect. But estimating the contribution of this period's costs to future revenue can be capricious speculation. How much revenue, for example, will a company generate (and when will it materialize?) from current-period expenditures for research and development, employee training, brand building, or additions to production capacity?

Accountants typically cope with this uncertainty by arbitrarily expensing the entire cost of intangible investments such as research and development. Just as arbitrarily, they allocate the cost of tangible investments such as plant and equipment over their estimated useful life using straight-line depreciation or one of a variety of accelerated depreciation methods.

Matching costs with revenue is a subjective exercise that invites companies to push the limits of accounting. Nonetheless, companies report earnings per share with to-the-penny precision. In the name of better corporate governance, the Sarbanes-Oxley Act requires that chief executives and chief financial officers certify the "accuracy" of their financial statements.

In the present unforgiving climate for accounting shenanigans, companies have an unprecedented opportunity to meaningfully improve their financial statements. A Corporate Performance Statement would:

• Separate cash flows and accruals.

 

• Classify accruals by levels of uncertainty.

 

• Provide a range as well as the most likely estimate for each accrual.

 

• Exclude arbitrary, value-irrelevant accruals.

 

• Detail assumptions and risks for each line item.

 

Separating actual cash flows from accruals -- those speculative assumptions about the future -- provides a baseline for estimating future cash flows and allows investors to evaluate whether accrual estimates are reasonable. Making accruals transparent also discourages companies from producing unrealistic estimates or engaging in outright fraud. Most important, separating cash flows and accruals helps restore confidence in the integrity of financial reporting.

The Corporate Performance Statement classifies accruals into categories that reflect different levels of uncertainty. Accruals embedded in reported revenue for future collection of receivables and in cost of sales for payment of suppliers ordinarily have relatively low levels of uncertainty. At the other end of the spectrum, estimating the cost of employee stock options requires speculative long-term assumptions for such things as the life of the options, stock-price volatility and interest rates.

The traditional income statement ignores the variability of possible outcomes. The Corporate Performance Statement presents optimistic and pessimistic estimates in addition to the most likely figure for each accrual. Accruals like depreciation and amortization that provide no insight into future cash flows are excluded from the statement. Finally, the statement would be accompanied by a "management discussion and analysis" section in which management presents the critical assumptions supporting each accrual estimate and its business model along with performance indicators, such as customer-retention rates, time to market for new products and quality improvements that drive value.

Breaking It Down

The Corporate Performance Statement begins by calculating free cash flow as revenue minus operating expenses and all investments, including working capital changes. Revenue reflects cash received from customers plus receivables for products and services delivered during the period. (Unrealized noncash gains and losses from long-term sales contracts are reported as medium- or high-uncertainty accruals rather than revenue.) Operating expenses comprise current-period payments to suppliers and employees, plus amounts payable next period for products and services received in the current period. Noncash charges, such as depreciation, amortization, deferred taxes, and asset and liability revaluations, are excluded.

Revenue and operating-expense accruals -- think of them as "check is in the mail" accruals -- are relatively low-risk because a company expects to convert the corresponding receivables and payables into cash over the next accounting period. Subtracting operating expenses from revenue yields "cash" operating profit after taxes.

Next, the statement adds or subtracts working capital changes (predominately accounts receivable, inventory, accounts payable and accrued liabilities) to arrive at cash flow from operations before new investments. Cash flow from operations is not affected if a company improperly or prematurely records revenue because the overbooked revenue is offset by an identical increase in receivables. All investment outlays are then subtracted to determine free cash flow. Investments include those that appear on the balance sheet, like production facilities, equipment, patents, and trademarks, as well as expenditures companies ordinarily expense for such things as research and development, software development, and branding activities. Whether a company records an expenditure as an operating expense or an investment does not affect free cash flow since the expenditure is subtracted in both cases.

The Corporate Performance Statement moves from what happened (realized cash flows) to what might happen (accruals). Accruals can provide clues about future cash flows when they are based on credible and clearly disclosed management assumptions. But to gauge whether cash flow can be sustained and grow, particularly for young companies, investors must focus on issues like market growth potential, probable behavior of competitors, technology changes and quality of management.

Degrees of Uncertainty

"Check is in the mail" accruals carry a relatively low level of uncertainty about expected near-term cash flows. Medium and high-uncertainty accruals, on the other hand, reflect estimated changes in the present value of cash flows arising from multiyear agreements between the company and its customers (warranty obligations, uncollectible receivables, unrealized gains or losses on long-term contracts), employees (defined-benefit pensions and other postretirement benefits, as well as stock options) and the government (deferred income taxes, environmental obligations). These accruals have longer cash-conversion cycles and wider ranges of plausible outcomes.

Among medium-uncertainty accruals, allowances for uncollectible receivables and warranty obligations are typically developed from historical experience, modified for changes in current conditions. Restructuring charges reflect estimates of future-period outlays for such things as severance pay, canceled leases, and litigation. Deferred-tax accruals result from temporary timing differences between pretax book income and taxable income for items such as depreciation expense. Estimated unrealized gains (or losses) from incomplete long-term construction, energy, and R&D contracts usually depend on assumptions about future prices, costs, and a host of other factors.

The costs of defined-benefit pension and employee stock-option plans are examples of high-uncertainty accruals. Pension expense, for example, should reflect the change in the present value of the company's obligations minus the change in the present value of expected returns on pension-fund assets. The computation requires a panoply of assumptions, including projected employee turnover, future pay increases, estimated retirement dates, future market discount rates and expected return on plan assets.

Faced with the unknowable magnitude and timing of future cash flows that capitalized assets will generate, accountants use arbitrary depreciation methods to assign expenses over their expected useful lives. This is clearly a case of accounting ritual trumping relevance. We therefore exclude depreciation and amortization charges from the Corporate Performance Statement.

Companies are required to record an impairment charge if the value of acquired goodwill, other intangible assets or long-lived fixed assets have shrunk below their balance-sheet amounts, typically estimating asset values based on speculative assumptions about future sales and costs. Even if a company can reasonably establish values for individual assets, intangibles such as customer goodwill, employee training, software development and R&D ordinarily can't be sold separately from the company itself. Investors are interested in the going-concern value of a company's various businesses and its consolidated value, not the value of individual assets. Asset impairment charges are therefore also excluded from the Corporate Performance Statement.

Nonrecurring gains and losses, charges from discontinued operations and the effect of accounting changes are disclosed in the management discussion and analysis section but excluded from the Corporate Performance Statement because they offer no meaningful help in forecasting the sustainability and growth potential of a company's cash flows. The Corporate Performance Statement presents no bottom line because no single number can reasonably encapsulate a company's performance.

Companies that significantly improve their financial reporting reduce market uncertainty, thereby encouraging more favorable pricing of their shares. More important, management can pursue long-term shareholder value unconstrained by short-term earnings distractions.

The information in the Corporate Performance Statement should already be available for internal purposes or there should be legitimate concerns about senior management's grasp of the business and the board's exercise of its oversight responsibility. Board members, particularly members of the audit and compensation committees, should know how much of the company's reported performance comes from realized cash flows and how much from accrual estimates, as well as the likelihood that accruals will prove to be materially overstated or understated.

Rewarding Long-Term Gains

Companies commonly use short-term financial measures such as operating earnings and return on invested capital to measure operating-unit performance and to determine incentive pay for senior executives. The Corporate Performance Statement makes it easier for boards to champion executive-compensation plans that reward management for creating long-term value rather than achieving short-term earnings results.

Auditors are vulnerable to bias. While they owe their first loyalty to shareholders, they are also eager to please clients. To report better earnings, companies look to accelerate revenue and delay expenses. This is the subject of most negotiations between auditors and their client companies and the source of virtually all the recent accounting scandals.

The Corporate Performance Statement eliminates the need for such negotiations. Auditors verify reported free cash flow by reviewing the company's internal controls and conducting substantive testing. For accruals, the Corporate Performance Statement shifts the auditor's task from judging whether single-point estimates are reasonable to evaluating management's three-level (optimistic, pessimistic and most likely) estimates.

The corporate performance approach shields accounting standard-setters from intense corporate lobbying and government intervention. For example, the argument that companies should not deduct the cost of employee stock options from earnings because options are too difficult to value disappears. There are no reported earnings and the wide variability of possible outcomes is explicitly recognized in the Corporate Performance Statement.

The Financial Accounting Standards Board and the International Accounting Standards Board can then focus on developing the most informative means of estimating accruals and reporting their potential variability, criteria for the line items companies include in the Corporate Performance Statement, and disclosure guidelines for the management discussion and analysis section.

The 'Forgetting' Curve

The learning curve for implementing the new corporate-performance approach will be relatively gentle. The forgetting curve, the time it takes to shed old habits and ways of thinking, will be more challenging. Investors, financial analysts, professional money managers, corporate management, auditors and accounting standard-setters are heavily invested in the existing earnings model, which serves as an important source of their professional reputations and personal income.

To induce the corporate and investment communities to conduct their business differently, there will have to be substantially more informative disclosure than that provided by traditional corporate financial reporting. CEOs and directors can seize the moment to reduce investor uncertainty and restore confidence in corporate reporting.

-- Mr. Rappaport is the Leonard Spacek Professor Emeritus at Northwestern University's J.L. Kellogg Graduate School of Management. He directs shareholder value research for L.E.K. Consulting and is co-author of "Expectations Investing: Reading Stock Prices for Better Returns" (Harvard Business School Press, 2001).

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