When numbers aren't numbers

Many trading days on Wall Street lately have spawned some unpleasant surprises. Last week these unpleasant surprises came from mainstays of the American business sector and the NYSE, first IBM and then General Electric, followed by AT&T, if that company can still be considered a real blue-chip company. Merrill Lynch was also in the spotlight for its actions, not its financial performance.

The cases of IBM and GE are particularly harsh because they highlight problem plaguing U.S. stock markets (and to a lesser degree European markets). This is not a passing drop in profitability, which would be natural in a weak economy as the profitability of companies ¿ even the largest ones ¿ goes down.

The problem is the continuing erosion of the investors' faith in the trading system and public companies. For many years these two giant companies earned the market¿s trust through quality management and their ability to achieve impressive and steady growth in profitability.

That is how GE became the biggest and most profitable company ever over a period of 20 years. Former CEO Jack Walsh, who set the company on this path, became a business icon. IBM's CEO, Louis Gerstner, spent almost a decade revolutionizing the company from an existential crisis to a strong, solid and profitable company.

Now questions have cropped up regarding more than the current results of the last quarter or the last year at both companies. The questions concern the past several years and go beyond an analysis of the order backlog or the revenues of one of the divisions.

There is a fundamental curiosity as to how many of the lauded achievements of the past few years reflect real performance and how many were created by fancy accounting reports.

Some of this accounting display has already become the norm, especially in the high-tech sector ¿ the cost of options to executives and employees is not recorded as a current expense. Since the options became an integral part of wages, and sometimes even the lion¿s share thereof, there is no logical reason not to include their cost as a payroll expense. However, accounting rules do not demand this, so it was not done.

Had the financial results been corrected accordingly, the growth of many companies¿ profits in recent years would have been considerably lower. The options issue, which carries a lot of weight at small technology companies, is a fundamental issue at giant companies too. Even so, some of them had many other ways to improve their reported performance.

Here lies the crux of the matter. After the Enron affair and in light of recent revelations ensuing from it, the business sector¿s whole reporting method is coming under scrutiny. The findings are not encouraging.

The question being asked by investors ¿ the institutional and individual ¿ is quite simple: Can we trust the numbers the companies are reporting in their quarterly and annual results? Investors are worried that the numbers being reported are not the true figures, but rather a comfortable and complimentary version cooked up by the management via flexible accounting rules used by flexible accountants. This pottage is being passed off on another group of professionals, called analysts, who swallow the delicacies served to them and then go home to write recommendations on the restaurants they visited and the ingenious chefs who work there.

Another flashy name that suffered a heavy blow last week is Merrill Lynch. It turns out that this investment bank will have to pay a heavy price ¿ with its prestige, if not in cash ¿ for the work of its analysts during the height of the bull market.

It is important to note, however, that even in this case, as in the cases of IBM and GE, there is nothing unique about Merrill Lynch. It is just the biggest and most prominent, so it attracts more attention.

There is therefore no specific problem that will explain why the shares of these companies dropped sharply on one day or another. There is a severe problem throughout the system, and it cropped up one day at IBM and another day at GE. This problem has harmed many companies in the months since the Enron crisis erupted, ant it will continue to strike one company after another, large and small alike.

This also holds true for the scandals regarding the analysts at the investment banks, including the relationships between them, the plans they made and the hot IPOs. Yesterday Merrill Lynch was exposed, last week it was Credit Swiss First Boston and tomorrow it will be the turn of some other respected company.

The plague is spreading, gradually and inexorably, because that is the nature of such plagues. They infect anyone who is vulnerable, and almost everyone is vulnerable to these financial and accounting ills. A few, like Warren Buffet, "The Oracle of Omaha," immunized himself against the bug, but the way things look today, most of the leading figures who cropped up in the business sector¿s good years operated like witch doctors, spreading enticing theories that proved false.

The future of the markets depends on the response of the authorities

If that is the real state of affairs, what does the future hold for the markets? This depends to a great extent on the reactions of the authorities, particularly in the U.S. If they make some real changes, such as reforms in the law, the enforcement mechanisms and the agendas of the financial systems with all their institutions, past experience has shown that the public's lost faith can be restored in a long and gradual process.

If the necessary reforms are not undertaken, on the other hand, the erosion in faith will deepen and the willingness to invest in financial markets will ebb.

It is still too early to tell where the system is going. New revelations and exposures will continue to dog the bourses for the foreseeable future and will spur the formulation and implementation of reforms. There are already a few signs that changes are on the way, including in the activities of the analysts.

The litmus test will be treatment of the financial reports of publicly traded companies. If they don't show what they're supposed to ¿ the real figures ¿ there will be many more days like the ones we experienced last week on Wall Street.