The fourth quarter is when companies send their balance sheets out to the laundry.
This time of year, companies exclude all manner of "one-time" charges from earnings numbers in a tradition that will be exacerbated by the exceptionally poor state of this quarter's profits.
In some cases, writedowns and charges are a good thing, lowering a company's cost structure and boosting margins for future quarters. But hefty writedowns can be an indication of ineffective management, or inflation of previous quarters' numbers. They can also reduce a company's liquidity, or access to cash.
Some 60% of companies in the
report "pro forma" earnings, or earnings that do not comply with generally accepted accounting principles, according to Thomson Financial/First Call. As such, they exclude whatever charges or writedowns the company thinks it can get away with. While the
is threatening to crack down on the practice, it's unlikely to happen this quarter.
"They're just saber-rattling, jaw-boning a little bit," says Bob Willens, tax and accounting analyst at Lehman Brothers. "If it happens by the end of next year, it will almost be a surprise." Ultimately, rather than require standardized pro-forma reporting, the SEC will probably require better disclosure of the differences between pro forma earnings and GAAP net income, he says.
In the meantime, investors will have to sort it out for themselves. And this quarter may be a trial by fire. While accounting practices have become more flexible in the past decade, companies still do the majority of their bookkeeping in December.
Any assets that have fallen in value due to reduced production or downsizing, any receivables that are unlikely to be paid, any charges for severance pay to workers laid off, or venture-capital investments that have plummeted in value, will be written down now if they haven't been already.
The situation is more complicated than usual this year. In addition to the above, companies will also test a new accounting rule governing acquisitions that takes effect next year. Under the standard, companies will be able to stop taking regular charges on their quarterly earnings to amortize "goodwill," or the value of assets bought at prices above fair value. Only if a company determines that its underlying assets have fallen in value will it have to write down the difference.
The big or repeated charges are the ones to worry about most, experts say.
"We want management to take risks. Some are going to work, some aren't going to work, and you want to have that kind of environment," says Daniel J. Donoghue, a managing director and accounting specialist at U.S. Bancorp Piper Jaffray. "But if you see a track record that develops of consistent writedowns year after year, the conclusion is, this is a management team that is consistently making mistakes, or inflating interim results," he said.
Big inventory writedowns in the telecom and chip sectors could be particularly worrisome this quarter, considering a lot happened already earlier this year.
"In an area like telecom, which has been decimated, some of the leading players are beginning to look like they've bottomed, business-wise," says Jeff Brotman, adjunct professor of accounting at the University of Pennsylvania law school. "Further writedowns could be of great concern. It would make you wonder if recovery is really on the way. Makes you question the strength of the balance sheet."
kicked off a wave of writedowns in the sector in April of this year when it announced a big $2.5 billion charge for excess inventory.
later announced a staggering $12.3 billion charge related to acquisitions. And
set a hefty $5.1 billion charge to cover the cost of closing three factories and cutting 1,000 jobs, as well as to write down acquisitions.
Big charges can sometimes be a way of artificially boosting earnings in future quarters. "The skeptical view is that a company will always write off too much rather than too little to improve margins in the future," said Willen. "As a company you have a fairly free hand. You can't write off all equipment and continue to use it, but otherwise the company has almost total discretion."
Ultimately a company's debt-to-asset ratio and cash position are key factors, because a big writedown will reduce a company's asset base, which can make it harder to get loans. In particular, you want to look at what impact a write-off has on a company's debt-to-capitalization ratio. "If it goes from 50% to 30%, that's a red flag," says Donoghue.
Companies also need money to service debt, something a charge can impair. "You have to look at your coverages more than anything else. Look at cash flow coverage of interest expense. About three times is good," says Willen.
In some companies, high leverage ratios are normal. In others it's not dismissed so easily. "Particularly in cyclical businesses, where cash could evaporate at some point in the business cycle. Companies that generate regular predictable cash flow can take on more debt."