Denny Beresford's Terry Breakfast Lecture
Subtitle:  Does Accounting Still Matter in the "New Economy?"


Note from Bob Jensen
Before reading this speech, readers may also want to note the following:

"I love accounting!" I start each semester's first session of my MBA and Masters of Accountancy (MAcc) classes that way to let the students know that I'm still very enthusiastic about the career I chose 40 years ago and continue to pursue. (I also tell them that if they exhibit at least a reasonable amount of enthusiasm in return it will make the class much more enjoyable for me and for them too!)
Dennis Beresford, "If I could do it over again," CPA Journal of the New York State Society, July 2001 --- http://www.nysscpa.org/ 

Message from Professor Beresford on July 22, 200`

July 22, 2001 
Bob,

Thanks for the kind comments. Feel free to post my Terry Breakfast presentation at your web site if you want. I made the presentation last Thursday so it won't be possible to video tape it.

Denny


In 2017 my Website was migrated to the clouds and reduced in size.
Hence some links below are broken.
Contact me at rjensen@trinity.edu if you really need to file that is missing

 

Outline for Terry Breakfast Meeting
Note that these are rough outline notes for a lecture were not re-written for publication in text format.

July 19, 2001

Dennis Beresford
Terry College of Business Administration
University of Georgia
Athens, GA 30602
email  Dennis Beresford [dberesfo@terry.uga.edu

Introduction

Overview of Presentation

Pro-Forma Earnings

Business Combinations

Summary

 

 

 

Introduction

Perhaps you saw this story in the Atlanta newspaper last fall.

It describes a young lady who has started her own business as a professional "pooper scooper"

The article praises her entrepreneurial spirit.

But it also observes that in the final analysis picking up after dogs isn't the greatest job in the world.

However, it's not the worst job in the world, she's quoted as saying

"I used to be an accountant"

The news about accountants isn't all this negative, however.

For example, earlier this month New Line Cinema announced that it has bought a script with the title of "Ballad of Paul Finley, Accountant"

The story revolves around a meek CPA serving prison time for a botched robbery.

In prison he hooks up with a female pen pal drawn to the outlaw life.

She eventually helps him escape and they embark on a Bonnie and Clyde style escapade

New Line Cinema said they paid "low six figures" for the script - I suspect that means $1,000.01

Of course accountants have been used to Rodney Dangerfield, no respect, type situations for some time.

As one of my MBA students said a couple of years ago, "Don't worry Professor B, accounting isn't supposed to be interesting."

Well, I think we probably can agree that accounting is not everybody's cup of tea

But at least a few parties have recently challenged whether financial reporting is all that important these days

 

So let's get to today's topic - Does Accounting Still Matter in the "New Economy?"

My answer is yes - are there any questions now?

 

Overview of Presentation

Now I was advised to keep my presentation relatively short.

But that may be just a little too succinct, so let me elaborate somewhat.

I think it's clear that accounting does matter, perhaps even more in the so-called new economy

Saying it a different way, the ultimate success or failure of a business still rests on its ability to produce positive cash flows.

And financial reports still seem to be an excellent tool to help predict future cash flows.

It's hard to believe that only a year ago a prominent analyst for Goldman Sachs wrote a report that argued -

The cash burned by dot.com companies was, as he put it, "primarily an investor sentiment issue" and not a long-term risk for the sector.

It turned out that he was right - cash burn was not a long-term risk because there wasn't a long-term for a large number of those companies.

As I said a couple of minutes ago I believe that traditional accounting measures still do a pretty good job of helping forecast future cash flows.

I'll try to make my case this morning by talking primarily about two matters

The first is the practice of many companies trying to convince investors that alternative measures are superior to normal accounting results.

The other is an important new accounting standard that deals with a subject where poor economic decisions have sometimes been made to achieve accounting objectives.

As you may have guessed already, the first topic is the so-called pro-forma earnings phenomenon.

And the second is the FASB's new rules on accounting for business combinations.

 

Pro-Forma Earnings

The general subject of pro-forma earnings has been in the financial press a lot recently.

For example, the cover story in Business Week magazine on May 14 was titled "The Numbers Game"

The subtitle said the following:

Companies use every trick to pump earnings and fool investors. The latest abuse: "Pro forma" reporting.

And a major article in the New York Times in March was headlined:

How Did They Value Stocks? Count the Absurd Ways.

I suspect that many of you don't know exactly what pro-forma reporting means.

It's really not hard to define - it means anything you want it to!

In fact, the only constant is what it doesn't mean.

Thus, pro-forma earnings are just about anything other than the real net income of a company determined by GAAP.

Actually, the term does have a more traditional meaning.

When a company has to prepare an SEC registration statement in connection with a business combination, it may have to present information as if the two companies had already been combined.

That's what most experienced accountants thought pro forma information meant.

That meaning has been obscured, however, in recent usage.

Companies now use the notion to describe some variation on net income excluding one or more items - usually expenses

In fact, the SEC's Chief Accountant has said that companies now want to emphasize EBS instead of EPS.

EBS means Earnings Before Bad Stuff

This notion of looking for useful alternatives to net income started innocently enough several years ago.

Some companies started reporting EBIDTA as a way that you could arguably better compare companies that had purchased assets at different times and had different capital structures.

However, even those EBIDTA pioneers were principally companies that reported low earnings or even losses under GAAP and were looking for something more positive to say.

More recently, some companies began reporting what they called cash earnings They added back depreciation expense and goodwill amortization, in particular

The more creative practitioners of the pro-forma art form add back those expenses and many others such as any stock options expense.

Payroll taxes related to stock option exercises.

Losses from equity method investments.

Marketing costs

Costs to start up new businesses

Interest, etc., etc.

Some of these items don't require additional cash expenditures, but they are all real costs.

One company that has been criticized quite a bit for its pro-forma earnings is Amazon.com

Earlier this year it started clarifying its press releases so that you can at least now see what adjustments the company made to its GAAP net income.

In the first quarter of 2001, Amazon's pro-forma net loss was $76 million while GAAP yielded a loss of $234 million

The company said that the pro-forma numbers excluded:

Stock-based compensation costs

Amortization of goodwill and other intangibles

Impairment and restructuring costs

Equity in losses of investees

And non-cash gains and losses

Now it may sound as though I'm pretty negative about this whole idea, but that's not necessarily so.

Let me give you a personal example of how the pro forma idea can be used productively

Some of you may know that George Benson is an excellent golfer.

However, on a pro-forma basis, I can actually out score George

For example, it's appropriate to leave out the scores for my first four holes.

I'm still warming up then and those scores certainly aren't representative of my true ability.

And my out of bounds shots shouldn't count either - I define them as unusual and non-recurring.

Taking those adjustments and a little other score keeping creativity into consideration, I figure my pro-forma average score is about 68

And that beats the heck out of George's generally accepted golf principles average.

More seriously, the pro-forma earnings amounts aren't necessarily as misleading as my golfing example would indicate.

The problem I have with them is that there is no common approach to them and investors simply don't understand what they are getting in most cases.

The FEI and National Investor Relations Institute recently issued some guidelines for earnings press releases that will help a little

However, about all those voluntary guidelines call for is for companies to show GAAP net income in the release and clearly reconcile to the pro-forma numbers.

The SEC has threatened to crack down on misleading earnings releases

I heard the Chief Accountant of the SEC Enforcement Division say recently that action will be taken in at least a couple of egregious situations.

Before leaving this topic, let me switch gears a little and talk about some other performance indicators.

During the dot.com frenzy of the recent past, prominent financial analysts were saying that traditional GAAP measures were useless, as I mentioned earlier.

Those analysts asserted that there were more up to date metrics that were a better indicator of a company's future prospects and its current value.

For example, they suggested measuring and reporting things like:

Customer share of mind

Page views

Engaged shoppers

I have the same problem with these measures as I do with pro-forma earnings.

First, are they being determined on a consistent basis so what one company reports is truly comparable with another company?

And second, are they really a good way of helping predict future cash flows and business success?

Let me go back to my earlier golf example to help illustrate this point.  I like to buy colorful golf shirts and have a pretty large collection But if I represented that I have a larger quantity of golf shirts than Dean Benson, does that mean my score will be better than his?

I wish it were that easy!

To summarize this point, I'm not arguing that generally accepted accounting principles are perfect.

If they were, the FASB could have been disbanded after I left, or probably even before I got there.

But the objective of reporting earnings under GAAP is to help investors predict future cash flows and that's clearly a valid notion.

And the whole premise of standard setting is to create a reasonable amount of consistency so that investors can make rational decisions when looking at alternative investment choices

Thus, I submit that accounting does matter and it will be a long time before pro-forma earnings or related notions produce similarly useful results.

 

Business Combinations

Now I'll move to my second main topic - accounting for business combinations.

As you've probably read recently, the FASB has completed its study of this matter and has agreed to issue new rules.

The new accounting standards are now at the printer and we should see them in final form in the next week or so.

This project was added to the agenda during my last year at the FASB, just about five years ago.

Five years may seem like a long time to develop a new accounting pronouncement.

But it's actually a reasonably short time given the difficult issues involved and the political controversy that ensued.

I assume that most of you are not accountants so I won't bore you with the many technical details of the new rules.

Let me give you a very brief summary, however.

Effective July 1, there is only one method of accounting for mergers and acquisitions.

That's the so-called purchase method, which involves recording all of the assets and liabilities acquired at their fair values.

In most cases, acquirers pay more for companies than the values of the specific assets and liabilities acquired

The excess amount is called goodwill - I'll talk more about it in a minute.

Up until now there has been a second way of accounting for business combinations, the pooling of interests method Under that method, the amounts in the acquired company's financial statements were simply combined with the acquirer's - as if they had been together forever.

The FASB concluded that it didn't make sense to have two different methods for economically equivalent transactions.

In addition to doing away with poolings, the other big change in the new rules is that goodwill will no longer be amortized to expense

For most companies the change to not amortize goodwill will not begin until next January 1.

This means that in the common situation of paying more than the net assets acquired, companies won't have to penalize future income statements by expensing that excess over time.

For example, AOL-Time Warner will be able to take about $6 billion of goodwill amortization expense out of future income statements.

That will cause what's now about a $3 billion loss to become about a $3 billion profit

Presumably, AOL-Time Warner will no longer need to refer to EBIDTA or some other measure of operations.

Instead of goodwill amortization, the FASB calls for AOL-Time Warner and all other companies to periodically evaluate whether the value of goodwill has been maintained

If a company determines that goodwill is impaired, it will have to write that asset down or off in the period the loss occurs.

Requiring goodwill to be charged to expense over an arbitrary future period had been one of the most criticized aspects of the FASB's earlier exposure draft on this project.

Requiring regular impairment reviews rather than amortization solved a political problem for the Board

That's because Congress had held hearings and had threatened legislation over what constituents had alleged would be adverse economic consequences of the earlier proposal.

Companies argued that the value of goodwill actually appreciates in many cases, particularly when it relates to certain intangible assets that aren't recorded under current GAAP.

Some companies said there would be fewer mergers under the new rules and that that would stifle the new economy.

While a few companies made these appeals to Congress, most want the government to keep out of accounting standards.

Most accountants would prefer not to have Congressionally Required Accounting Principles.  If nothing else, CRAP would be a lousy acronym.

But the FASB changed its view not just because of the political heat.  It actually felt that the impairment review approach made more sense

Net income will now be reduced for goodwill charges only when something bad happens to make it less valuable economically.

As an example, you may have seen Nortel's recent announcement that it is writing off well over $10 billion of overpayments for acquisitionsIn years in which no impairment is recorded, companies will effectively be representing to investors that they've looked at the goodwill and believe its value is as much or greater than recorded.

The impairment review process that the FASB calls for is likely to be a fairly subjective and costly exercise for many companies.  But the financial information provided to shareholders should be much better and worth the additional cost.

What are the principal benefits of the new accounting rules for business combinations?

First, investors won't have to try to figure out how to compare companies that have used dramatically different methods to account for acquisitions.

Second, companies won't have to jump through the accounting hoops they previously did in order to qualify for pooling treatmentFor example, companies often couldn't engage in stock buyback programs or sell major operations because they would have violated the pooling rules.  You may have noticed that both First Union and SunTrust recently said they were buying back stock while still vying for Wachovia

Third, investors will be signaled about real economic problems by goodwill impairment charges, such as Nortel's gigantic write-off.

Fourth, companies will have the flexibility to structure transactions to include cash and stock rather than all stock, as required by the pooling rules.

In my view, however, the greatest benefit from requiring all acquisitions to be purchases will be in making companies more accountable for how much they pay

The full value of the consideration, whether stock or cash, will be recognized.

One of my colleagues, Ben Ayers, published a study indicating that companies often have overpaid in stock deals in order to achieve the more favorable pooling treatment.  There should be less of this in the future

To summarize this topic, perhaps accounting mattered too much in the case of business combinations.  Ideally, financial reporting should reflect the economic results of business activities - and not cause themClearly, accounting does matter a great deal in connection with mergers and acquisitions and it will continue to do so.  But I think we now have things back in balance and the accounting will matter without being a driving force

 

Summary

To wrap up, accounting continues to be the language of business and the scorecard by which managers are judged.

It isn't perfect, but it also isn't boring.

In my office I have a paperweight given to me by a friend who is managing partner of an accounting firm that deals exclusively with troubled businesses It says, "If the cash lasts, luck will follow."

I think those are good words for managers and investors to consider.

We'd all like to have information that best helps us predict whether the cash will last

And one other quote to end with is from Larry Summers, former Treasury Secretary and new President of Harvard UniversityHe said -----

If one were writing a history of the American capital market, it is a fair bet that the single most important innovation shaping that market was the idea of generally accepted accounting principles

I agree so I'm not inclined to give up accounting in favor of poop scooping!

Dennis Beresford



It may be useful following the Terry article to reproduce two modules from the July 27, 2001 edition of Bob Jensen's New Bookmarks.

This recommendation should become international law.

Corporations whose press releases provide pro forma earnings should also include a reconciliation to GAAP results, according to best practices guidelines jointly issued by the Financial Executives International and the National Investor Relations Institute.  Pro forma earnings reports can be highly misleading and manipulated by management to mislead investors. 
( www.niri.org/publications/alerts/ea042601.cfm  ).


Forwarded by Don Ramsey
Corporate America's New Math:  Investors Now Face Two Sets of Numbers In Figuring a Company's Bottom Line
By Justin Gillis
The Washington Post
Sunday, July 22, 2001; Page H01 
http://www.washingtonpost.com/wp-adv/archives/front.htm   

Cisco Systems Inc., a bellwether of the "new economy," prepared its books for the first three months of this year by slicing and dicing its financial results in the old ways mandated by the rules of Washington regulators and the accounting profession.

Result: a quarterly loss of $2.7 billion.

Cisco did more, though. It sliced and diced the same underlying numbers in ways preferred by Cisco, offering an alternative interpretation of its results to the investing public.

Result: a quarterly profit of $230 million.

That's an unusually large swing in a company's bottom line, but there's nothing unusual these days about the strategy Cisco employed. Across corporate America, companies are emphasizing something called "pro forma" earnings statements. Because there are no rules for how to prepare such statements, businesses have wide latitude to ignore various expenses in their pro forma results that have to be included under traditional accounting rules.

Most of the time, the new numbers make companies look better than they would under standard accounting, and some evidence suggests investors are using the massaged numbers more and more to decide what value to attach to stocks. The pro forma results are often strongly emphasized in news releases announcing a corporation's earnings; sometimes the results computed under traditional accounting techniques are not disclosed until weeks later, when the companies file the official results with the Securities and Exchange Commission, as required by law.

Cisco includes its results under both the pro forma and the traditional accounting methods in its news releases. People skeptical of the practice of using pro forma results worry that investors are being deceived. Karen Nelson, assistant professor of accounting at Stanford University, said some companies were "verging on fraudulent behavior" in their presentation of financial results.

Companies that use these techniques say they are trying to help investors by giving them numbers that more accurately reflect the core operations of their businesses, in part because they exclude unusual expenses. Cisco's technique "gives readers of financial statements a clearer picture of the results of Cisco's normal business activities," the company said in a statement issued in response to questions about its accounting.

Until recently, pro forma results had a well-understood and limited use. Most companies used pro forma accounting only to adjust previously reported financial statements so they could be directly compared with current results. This most frequently happened after a merger, when a company would adjust past results to reflect what they would have been had the merger been in effect earlier. Pro forma, Latin for "matter of form," refers to statements "where certain amounts are hypothetical," according to Barron's Dictionary of Finance and Investment Terms.

What's changed in recent years is that many companies now using the technique also apply it to the current quarter. They include some of the leading names of the Internet age, including Amazon.com Inc., Yahoo Inc. and JDS Uniphase Corp. These companies have received enthusiastic support from many Wall Street analysts for their use of pro forma results. The companies' arguments have also been bolstered by a broader attack on standard accounting launched by some academic researchers and accountants. They believe the nation's financial reporting system, rooted in the securities law reforms of the New Deal, is inadequate to modern needs. In testimony before Congress last year, Michael R. Young, a securities lawyer, called it a "creaky, sputtering, 1930s-vintage financial reporting system."

The dispute over earnings statements has grown in intensity during the recent economic slide. To skeptics, more and more companies appear to be coping with bad news on their financial statements by redefining the concept of earnings. SEC staffers are worried about the trend and are weighing a crackdown.

"People are using the pro forma earnings to present a tilted, biased picture to investors that I don't believe necessarily reflects the reality of what's going on with the business," said Lynn Turner, the SEC's chief accountant.

For the rest of the article (and it is a long article), go to 
http://www.washingtonpost.com/wp-adv/archives/front.htm 
The full article is salted with quotes from accounting professors and Bob Elliott (KMPG and Chairman of the AICPA)


For related reading, see the following:

BARUCH LEV'S NEW BOOK Brookings Institution Press has just issued Baruch's new book, Intangibles: Management, Measurement and Reporting. Regardless of the "dot com" collapse, this subject continues to be high on the corporate executive's agenda. Baruch foresees increasing attention being paid to intangibles by both managers and investors. He feels there is an urgent need to improve both the management reporting and external disclosure about intellectual capital. He proposes that we seriously consider revamping our accounting model and significantly broaden the recognition of intangible assets on the balance sheet. The book can be ordered at https://www.brookings.edu/press/books/intangibles_book.htm 

Professor Lev's free documents on this topic can be downloaded from  http://www.stern.nyu.edu/~blev/newnew.html 

Related documents of interest include the following:

FASB REPORT - BUSINESS AND FINANCIAL REPORTING, CHALLENGES FROM THE NEW ECONOMY NO. 219-A April 2001 Author: Wayne S. Upton, Jr. Source: Financial Accounting Standards Board --- http://accounting.rutgers.edu/raw/fasb/new_economy.html 
Upton's book challenges Lev's contention that the existing standards are enormously inadequate for the "New Economy."

The Garten SEC Report: A press release and an executive summary are available at http://www.mba.yale.edu  
The Garten SEC Report supports Lev's contention that the existing standards are enormously inadequate for the "New Economy."
(You can request a copy of the full report using an email address provided at the above URL)


Bob Jensen's homepage is at http://faculty.trinity.edu/rjensen/

Bob Jensen's Introduction to Accounting Theory --- http://faculty.trinity.edu/rjensen/acct5341/theory.htm