The Daily Interview: Figuring Out the Bottom Line in Earnings Reports

With the torrent of corporate earnings reports in the last few weeks, investors have been hearing a lot about accounting terms such as goodwill amortization and pro forma earnings. But what do these terms really tell us about a company's business?

Bob Willens Accounting and Tax Analyst Lehman Brothers

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To get some perspective on this topic, Daily Interview caught up with Bob Willens, an accounting and tax analyst and managing director at Lehman Brothers. Among other positions he's held are chairman of the committee on revision of the corporate tax laws, a part of the American Institute of Certified Public Accountants.

While net income according to Generally Accepted Accounting Principles, or GAAP, measures company's profits after all expenses have been deducted from total sales, companies are increasingly reporting pro forma results, which make certain assumptions about what should and should not be included in financial results.

Willens sees pro forma accounting as a maligned yet still helpful measure of earnings, and tells us some of the key information investors should focus on in a company's earnings statement. Willens also discusses the significance of new rule changes made recently by the Financial Accounting Standards Board, or FASB, regarding amortization of goodwill.

TSC: What's your opinion of using pro forma rather than actual earnings?

Willens: [In the case of mergers], purchase accounting gives rise to goodwill and to amortization. This method penalizes net income on a GAAP basis. So in order to eliminate this problem and present a more accurate picture of earnings, some companies use pro forma or cash earnings in lieu of net income.

I believe that there's a basis for doing this: A lot of people, including those at FASB, felt that amortization of goodwill was not a legitimate expense. Why? Because goodwill is not really a wasting asset. It may be increasing in value. So amortization is not quite accurate and unduly penalizes income. That's the theoretical underpinnings of pro forma income. So pro forma excludes goodwill amortization. I've felt comfortable with pro forma as long as there's transparency in what's being excluded.

The concern involving pro forma is that there is no uniform code of practice for it. It's become quite eclectic and it would include whatever the company wants to include such as interest expense and compensation costs to the point that it resembles revenue!

TSC: Any comment on companies who have attracted attention because of their use of pro forma earnings, such as Amazon or Computer Associates?

Willens: I think that there needs to be a bridge between the GAAP definition of net income and the pro forma method. This is a disclosure issue. Also, if we decide that pro forma earnings is the right way to measure the earnings-per-share number for Amazon, then what are we doing with net income? Can we say then that GAAP's definition of net income is outmoded and should be looked at again? Maybe it's a GAAP problem and not so much the pro forma problem

TSC: That's an interesting perspective.

Willens: Amazon has even repriced options and excluded that from their pro forma. No one does that [what Amazon did for] fear of the huge expenses incurred. Amazon doesn't care because it doesn't include that [in its results]. Amazon has been very good at selling pro forma. Computer Associates' approach to booking software revenue on the pro forma basis is conservative, I would say. I am sure there are other reasons for concern [about the company] like proxy fights. But as far as their accounting of software licenses are concerned, I think their approach of spreading their fees over the life of the software product is actually preferable to booking revenue all up-front.

TSC: We've been seeing companies with both very aggressive and very conservative accounting practices. Vigilance aside, what could investors watch out for in earnings releases?

Willens: You could look at some old-fashioned ratios to measure a company's performance as a starting point. First, inventory turnover, especially if you want to predict inventory writedowns a la Cisco. Inventory turnover ratio is costs of goods sold to average inventory. [For more on inventory turnover ratio, see this recent TSC article ]. A high ratio tells you that the company has a pretty efficient inventory in place. A low ratio indicates that the inventory is overstated and becoming obsolete or unsalable, so writedowns may be imminent. Also you need to compare these ratio numbers with the company's past ratios and industry average numbers.

Receivables turnover ratio is dividing sales by average net receivables. Once again, a high ratio indicates a good credit policy. A low ratio in comparison with industry standards may tell you that the receivables are not being collected. Or the company may be recording fictitious credit sales. You hope and pray that it's bad collection, but it might signal more trouble in store.

Ratio of debt reserve to total receivables is a good thing to study. If the ratio is trending lower, then the company is probably understating their provision for bad debts, and that will tell you that a write-off of receivables may be imminent. This has become an issue for some tech companies who were involved in vendor financing for their customers who couldn't pay back their debts.

TSC: When investors hear about write-offs in a company's financial results, what questions should they be asking?

Willens: What you'll likely hear is that it doesn't really matter, because it is a non-cash charge, and that it is a stock market phenomenon. When JDS Uniphase acquired SDL, JDS' stock was around $111, and now it's around $9. So the write-off is reflecting the decline in the market.

However, to me as an accountant, when someone writes off goodwill to zero, it's significant, because goodwill signifies the ability of the acquired business to generate excess returns and the expectancy of continued customer patronage. So a write-off of goodwill tells me at least theoretically that the acquired business is...

TSC: Worthless...

Willens: Yes, or close to it, or that it is not going to produce what the company expected when the acquisition was made. There is a connection between goodwill and the company's capacity for earnings. [In JDSU's case], this is obviously not a liquidation crisis or anything like that. JDS Uniphase is still around and has a lot of cash. Still, you ought to be concerned.

TSC: What triggers a write-off?

Willens: The primary indicator is when the company's book value is greatly in excess of its market value, which is precisely the case with JDS.

TSC: That covers many tech and telecom stocks these days. . .

Willens: Yes. We're going to see in 2002 a number of write-downs that you are not going to believe, unless the market comes back strong. In the aggregate, we'll see hundreds of billions of write-downs in the first and second quarters of 2002.

TSC: So we're not out of the woods yet.

Willens: No, right now, this is just the tip of the iceberg as far as write-downs go.

TSC: Could you tell us about the recent rule changes regarding mergers that the Financial Accounting Standards Board announced? How do they help or hurt companies?

Willens: FASB has made substantial changes in the way one accounts for a merger. The FASB's principal objective here is to eliminate pooling-of-interest accounting method, which it has found to be not properly reflective of a merger. Companies have preferred pooling because by combining assets item by item, it didn't give rise to goodwill [since] when you amortize goodwill or your intangible assets, you always penalize your earnings.

Also because of the politics involved in taking such a drastic step, it was compelled to make the purchase accounting method more appealing, since this is really the only alternative left for merging firms. Beginning in 2002, goodwill won't have to be amortized, including goodwill from deals completed in the past. Other intangibles with finite lived assets, however, will have to be amortized.

TSC: How do you define finite lived assets?

Willens: Finite lived assets refer to assets that will produce income for only a limited period of time for competitive reasons or legislative reasons

TSC: Such as patents?

Willens: Yes, exactly. Copyright as a lesser example. Even customer lists or trademarks would be considered by the FASB as finite lived assets. There are a host of finite lived intangibles that arise in an acquisition or a merger, which will have to amortized as before. Some people are under misapprehension that there will never be amortization again. That is simply not true.

Furthermore, companies will also have to remeasure their prior acquisitions under the new rule. It's not so much about restating anything, but it's about attributing a portion of the premium that you've paid in an acquisition to other intangibles.

TSC: It sounds like a nightmare.

Willens: It's an absolute bookkeeping calamity. But what's worse than that is that you paid $1 billion for goodwill, but now on a second look, it might not be all goodwill. Say, it was $100 million for the customer list, $400 million of trademarks, and $100 million for a noncompete covenant... All of this will have to be amortized, which is what the FASB wants to see going forward.

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