Researchers expect more accounting 'blowups'
By Adam Levy
Bloomberg News Service
NEW YORK — When U.S. companies release second-quarter results this month, their accounting practices may get more attention than the numbers they produce.
Investors and analysts are bracing for more revisions to financial reports since the recent multibillion-dollar restatements at WorldCom Inc. and Xerox Corp. and earlier ones at companies such as Enron Corp. and Kmart Corp.
"There will be a continuing stream of these blowups," said Howard Schilit, president of the Center for Financial Research and Analysis Inc., an independent research firm in Rockville, Md. They represent the flip side of the 1990s bull market for stocks, "where the most egregious behavior was rewarded," he said.
Schilit, who doesn't invest in stocks, said the most likely candidates for accounting revisions are companies such as Cisco Systems Inc. that grew with the help of acquisitions. AOL Time Warner Inc., once faulted for accounting similar to WorldCom's, and 3M Co., which has taken charges for seven quarters in a row, also deserve scrutiny, he said.
IBM Corp. tops the list of Bill Fleckenstein, president of Fleckenstein Capital Inc., who has bet against the company by selling borrowed shares. Other candidates, he said, might include Mirant Corp., Omnicom Group Inc., Oracle Corp. and Qwest Communications International Inc.
U.S. companies are filing financial restatements to correct false or faulty accounting at a record pace this year, according to a study by New York University's Stern School of Business. The record is 158, set last year. Restatements almost tripled from 1997 to 2001.
This is more than a bookkeeping issue. Investors have lost $150 billion in the past year alone on WorldCom, which inflated profits by improperly accounting for some expenses; Enron, which hid debt through the use of partnerships; and Tyco International Ltd., whose accounting for acquisitions has drawn the attention of the Securities and Exchange Commission.
Tyco, WorldCom and Xerox all contributed to the Standard & Poor's 500 Index's first-half decline of 14 percent, the steepest since 1970. The Dow Jones industrial average dropped 7.8 percent, partly because of IBM's 40 percent loss in the period. The Nasdaq composite index, including WorldCom and Oracle, sank 25 percent.
For the second quarter, charges for items such as accounting errors may top $5 billion, said Robert Willens, managing director of Lehman Brothers Holdings Inc.
These charges might impede an earnings rebound, said Chuck Hill, director of research for Thomson First Call. After five straight quarters of falling earnings, U.S. companies are expected to post increases of 3 percent for the second quarter, 17 percent for the third and 29 percent for the fourth, he said.
"Estimates for the second half of the year are unrealistic," Hill said.
Until recently, Waste Management Inc. had the record for the largest restatement at a U.S. company. The trash hauler, in February 1998, erased $2.9 billion of earnings all the way back to 1992 because it had exaggerated the value of assets such as trucks and landfills.
Now the record belongs to WorldCom, which disclosed that about $3.9 billion of expenses belonging on its income statement were booked as capital expenditures. The accounting maneuver, found during an internal audit, enabled the second-largest U.S. long-distance telephone company to conceal losses for more than a year.
The discovery may force the Clinton, Miss.-based company to file for bankruptcy, investors said. Such a filing would surpass Enron's, made last December, as the largest in U.S. history because of WorldCom's $92 billion of assets as of March.
"This is yet one more shoe in a closet full that the U.S. financial community seems to have," said Robert Christian, the chief investment officer at Wilmington Trust Co., which manages $27 billion.
Accounting has also become an issue at telephone companies such as Global Crossing Ltd., which sought bankruptcy protection in January. The SEC, the U.S. attorney's office, a congressional panel and the Bermuda-based company's board are examining whether the fiber-optic network operator inflated earnings and misled investors by overstating sales of capacity on its network.
"We got into this pickle because there was a certain amoral climate that existed in the late 1990s, when the market was going great guns," said Charles Elson, director of the University of Delaware's Corporate Governance Center. "There was the feeling that the results mattered more than what you did to get there."
Many investors are wondering which company will be next. Some have singled out Cisco, the world's largest producer of computer-networking equipment, as Schilit did.
"Cisco has gotten a lot of scrutiny because they had a market (value) that grew very rapidly and people said it was too good to be true," said Walter Casey, an analyst at Banc One Investment Advisors Inc., which owned about 19.2 million shares at the end of March.
Since 1998, Cisco has taken billions of dollars in charges to write off research projects at 45 acquired companies. The San Jose, Calif.-based company also used synthetic leases, a way for companies to take debt off their books and keep tax benefits. In May, chief financial officer Larry Carter said the company would buy $1.9 billion in property to end the leases.
"Cisco believes and practices conservative accounting procedures," spokeswoman Abby Smith said. "We are always striving for ways we can improve."
AOL Time Warner's America Online unit, the largest Internet service provider, restated results for fiscal 1995, 1996 and 1997 because it had classified $385 million in marketing costs as an asset. The revision took place in May 2000, before its merger with Time Warner Inc.
Richard Parsons, AOL Time Warner's chief executive officer, said about his company back in January: "This ain't no Enron." A spokesman for the New York-based company declined to comment last week about its accounting.
3M separates restructuring items for the convenience of analysts, said a spokesman, John Cornwell. "A couple of years ago, some were criticizing us for being too conservative with our accounting," he said. "You just can't win."
IBM, Fleckenstein's top candidate, gave investors more details about its results after The New York Times reported in February that it didn't properly account for the sale of a unit to JDS Uniphase Corp. The world's largest computer-services and hardware company also shifted some items in its income statement.
Fleckenstein also focuses on former Arthur Andersen clients who paid the firm relatively large fees for consulting as well as to audit work.
Along with Enron and Global Crossing, they include Mirant, the biggest U.S. natural-gas trader; Omnicom, the world's No. 3 advertising company; Oracle, the third-largest software maker; and Qwest, the No. 4 U.S. local-phone company.
Mirant doesn't plan to restate results, spokesman James Peters said. Omnicom said in mid-June that its accounting was appropriate; a Qwest spokesman, Tyler Gronbach, said much the same thing about his company recently. At Oracle, spokesman Jim Finn said his company complies with U.S. accounting standards.
Lehman's Willens said companies are likely to be more diligent in explaining financial results in an effort to restore confidence. He expects companies to explain how estimates are calculated and what might happen if they aren't correct.
"More disclosure is necessary to claw their way back to respectability," he said. "It's going to be a long road."
