To most individuals who examine a company's income statement, the document is less important for what it tells about the past than for what it implies about future years.2 Last year's earnings, for example, have no direct impact on a company's stock price, which represents a discounting of a future stream of earnings (see Chapter 14). An equity investor is therefore interested in a company's income statement from the preceding year primarily as a basis for forecasting future earnings. Similarly, a company's creditors already know whether they were paid the interest that came due in the previous year before the income statement arrives. Their motivation for studying the document is to form an opinion about the likelihood of payment in the current year and in years to come.
In addition to recognizing that readers of its income statement will view the document primarily as an indicator of the future, a company knows that creating more favorable expectations about the future can raise its stock price and lower its borrowing cost. It is therefore in the company's interest to persuade readers that a major development that hurt earnings last year will not adversely affect earnings in future years. One way of achieving this is to suggest that any large loss suffered by the company was somehow outside the normal course of business, anomalous and, by implication, unlikely to recur.
To create the desired impression that a loss was alien to the company's normal pattern of behavior, the loss can be shown on a separate line on the income statement and labeled an "extraordinary item." Note that an extraordinary item is reported on an aftertax basis, below the line of income (or loss) from continuing operations. This presentation creates the strongest possible impression that the loss was outside the ordinary course of business. It maximizes the probability that analysts of the income statement will give it little weight in forecasting future performance.
Because the effect created by a "below-the-line" treatment is so strong, the accounting rules carefully limit its use. To qualify as extraordinary under the relevant Accounting Principles Board opinion, events must be "distinguished by their unusual nature and by the infrequency of their oc-currence."3 These criteria are not easily satisfied. According to the opinion, unusual nature means that "the underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates." Lest the extraordinary label be employed indiscriminately, the opinion prohibits its use for several types of events considered unusual in nature under the strict standard being applied. Among these are:
■ Write-offs of receivables and inventories.
■ Gains or losses on foreign currency translation (even when they result from major devaluations or revaluations).
■ Gains or losses on disposal of a segment of a business or the sale or abandonment of property, plant, or equipment.
Not even the September 11, 2001, terrorist attacks on the Pentagon and World Trade Center qualified as an extraordinary event under FASB's stringent criteria. After tentatively deciding that companies could break out costs arising from the disaster as below-the-line items, the task force on the subject voted not to allow the practice. The chairman of the task force, FASB research director Timothy S. Lucas, noted that even the airlines, which were plainly hurt by the events, would have difficulty separating the impact of the attacks from other revenue and earnings pressures during the period.4
Considering the exacting tests that an item must meet to be considered extraordinary, analysts may consider themselves on solid ground if they largely disregard any such item in forecasting future earnings. The APB opinion, after all, adds that "infrequency of occurrence" means that the event or transaction in question must be "of a type not reasonably expected to recur in the foreseeable future." Occasionally, one would suppose, an event meeting this strict standard might be followed just a few years later by an event at the same company, radically different in nature but also qualifying for classification as extraordinary and below-the-line reporting. On even rarer occasions, an extraordinary event might be followed the very next year by a qualifying event of a similar nature, even though such a recurrence was "not reasonably expected," to quote the accounting standard. Judging by the highly restrictive language of the APB opinion, however, it would be extremely surprising if any company ever booked an extraordinary item more than twice in a matter of several years.
Improbable though it might seem, however, a search of Standard & Poor's Compustat database identified 42 companies that recorded extraordinary gains or losses in at least four of the eight years ended 1998. Among the companies that repeatedly experienced events of an allegedly infrequent and unusual nature were such blue chips as Bell Atlantic, Fannie Mae, GTE, Maytag, Ralston Purina, Sears Roebuck, Sunoco, Time Warner, and U.S. West. BellSouth recorded seven extraordinary items during the period. Six were losses, including whacks of $1.6 billion in 1991 and $2.2 billion in 1994. In light of actual experience, analysts cannot simply project a company's future earnings as though an extraordinary event had never occurred, however fervently management might wish them to do precisely that.
Actually, companies lean on analysts to be even more accommodating when they evaluate past results to forecast future performance. Corporate officials not only encourage users of their financial statements to disregard losses that qualify for the label extraordinary, but also ask them to ignore certain hits to earnings simply because management pronounces them aberrant. To steer analysts toward the true (that is, higher trajectory) trend of earnings deemed official by management fiat, companies break out the supposed aberrations from their other operating earnings. The accounting rules prohibit them from displaying such carve-outs "above the line" (that is, on a pretax basis) and from using the label extraordinary. Accordingly they employ designations such as "nonrecurring" or "unusual." These terms have no official standing under GAAP, but they foster the impression that the highlighted items are exceptional in nature. Sometimes, losses that fail to meet the criteria of extraordinary items appear under the more neutral heading, "special charges." Even this terminology, however, leaves the impression that the company has put the problem behind itself. The semantics are so appealing to corporate managers that each year, more than a quarter of all companies filing with the Securities and Exchange Commission take a nonrecurring charge. As recently as 1970, only one percent of companies did so.5
In recent years, "restructuring" has become a catchall for charges that companies wish analysts to consider outside the normal course of business, but which do not qualify for below-the-line treatment. The term has a positive connotation, implying that the corporation has cast off its money-losing operations and positioned itself for significantly improved profitability. If abused, the segregation of restructuring charges can create too rosy a picture of past performance. It can entrap the unwary analyst by downplaying the significance of failed business initiatives, which have a bearing on management's judgment. Additionally, the losses associated with a restructuring may be blamed on the company's previous chief executive officer, provided they are booked early in the successor CEO's tenure. Within a year's time, the new kingpin may be able to take credit for a turnaround, based on an improvement in earnings relative to a large loss that can be conveniently attributed to the predecessor regime.
Even more insidiously, companies sometimes write off larger sums than warranted by their actual economic losses on a failed business. Corporate managers commonly perceive that the damage to their stock price will be no greater if they take (for sake of argument) a $1.5 billion write-off than if they write off $1.0 billion. The benefit of exaggerating the damage is that in subsequent years, the overcharges can be reversed in small amounts that do not generate any requirement for specific disclosure. Management can use these gains to supplement and smooth the corporation's bona fide operating earnings.
The most dangerous trap that users of financial statements must avoid, however, is inferring that the term restructuring connotes finality. Some corporations have a bad habit of remaking themselves year after year. For such companies, the analyst's baseline for forecasting future profitability should be earnings after, rather than before, restructuring charges.
Procter & Gamble is a case in point. As of April 2001, the consumer goods company had booked restructuring charges in seven consecutive quarters, aggregating to $1.3 billion. Moreover, management indicated that it planned to continue taking these ostensibly nonrecurring charges until mid-2004, ultimately charging off approximately $4 billion.
P&G defended its reporting by saying that Securities and Exchange Commission accounting rules precluded it from taking one huge charge at the outset of the restructuring program launched in June 1999. Instead, the company was required to record the charges in the periods in which it actually incurred them. Granting the point, the SEC did not compel Procter & Gamble to segregate the costs of closing factories and laying off workers from its other operating expenses. Indeed, the arguments were stronger for treating the chargeoffs as normal costs of operating in P&G's highly competitive consumer goods business, where countless products fail or become obsolete over time.
Abstract issues of accounting theory, however, had little impact on brokerage house securities analysts' treatment of P&G's earnings record. All 14 analysts who followed the company and submitted earnings per share forecasts to Thomson Financial/First Call excluded the restructuring charges from their calculations. P&G management was bound to like Wall Street's interpretation of the numbers. Including all of the ostensibly unusual gains and losses, operating income declined in all four quarters of 2000. Leaving out all the items deemed aberrant by management, net income rose in all quarters but the first. The latter interpretation surely gave investors a more optimistic view of P&G's prospects than the sourpuss GAAP numbers.6
Naturally, companies encourage analysts to include special items in their earnings calculations when they happen to be gains, rather than losses. They evidently reason that turnabout is fair play and judging by the results, many securities analysts apparently agree. The 14 Wall Street analysts mentioned earlier unanimously chose to include in their "core net earnings" figures the gains that Procter & Gamble classified as nonrecurring or extraordinary, even as they excluded the extraordinary and nonrecurring losses.
By characterizing the extraordinary as standard, Coca-Cola has steered analysts toward a net income surrogate that suggests steadier year-over-year increases than its business can deliver in reality. In particular, management has encouraged investors to treat gains on sales of interests in bottlers as part of its normal stream of earnings. These inherently temporary boosts to profits "are an integral part of the soft drink business," according to the company.7
The difference in perceptions is by no means negligible. Beverage analyst Marc Cohen of Goldman Sachs has estimated that excluding non-operating items, Coca-Cola's earnings increased by 11% in 1996. That would have been a highly respectable number for most long-established companies, but it was well below the 18% to 20% annual advance that management was promising investors. Including nonrecurring and extraordinary items earnings per share, as management preferred to present the numbers, EPS rose by 19%.
Coca-Cola's 1996 dependence on out-of-the-ordinary-course-of-events items was not an isolated event. In the first quarter of 1997, Coca-Cola maintained its targeted upper-teens growth rate, at least by its own reckoning, when $0.08 of total EPS of $0.40 represented a gain on the sale of Coca-Cola & Schweppes Bottlers. Oppenheimer analyst Roy Burry went so far as to say that with so many such discretionary items at its disposal, Coca-Cola's management had absolute control over the earnings it would report through the end of 1998, despite the vagaries of weather and competitors' initiatives.
Notwithstanding the creative methods employed by Procter & Gamble and Coca-Cola, the award for ingenuity rewriting history with the help of special items should probably go to Brooke Group. In 1990, the diversified company booked a special gain of $433 million. The gain arose from a reversal of a previously recognized loss generated by Brooke's 50.1% interest in New Valley Corporation (formerly Western Union). By reducing its voting interest in New Valley to less than a majority, Brooke contrived to de-consolidate the company and erase the red ink retroactively.
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