What to Look for in Sizing Up Earnings

Much of the controversy over accounting sleight-of-hand stems from companies’ awareness that analysts and investors focus most intently on the bottom line--quarterly net income.

That’s why firms would rather take big one-time charges than be forced to take deductions that reduce net income every quarter for years on end.

But the Financial Accounting Standards Board, which regulates accounting practice, has grown more adamant that some costs should be dealt with on an ongoing basis, not as one-time write-offs.

Hence the FASB’s recent vote to end “pooling of interests” mergers, in which companies avoid incurring “goodwill”--the premium an acquiring company pays above the value of its target company’s hard assets. Goodwill normally must be written off against net income over time. What’s more, the FASB voted last week to cut to 20 years from 40 the time period for expensing goodwill.

The net result of these rulings will be depressed bottom-line earnings, as companies first will be unable to avoid incurring goodwill and, second, will have to deduct twice as much per quarter during the shortened write-down period.

*

Will lower reported earnings really affect investors’ attitudes toward companies and their stocks? Maybe not, if more firms can persuade investors to watch “cash flow” instead.

Cash flow is broadly defined as a company’s cash receipts minus cash payments, or cash coming in minus cash going out. It thus disregards such noncash charges as depreciation of assets, amortization of goodwill and changes in reserve accounts.

In capital-intensive industries with large depreciation charges--cable TV, for instance--investors’ focus has long been on cash flow rather than net income as a gauge of corporate health.

Some observers believe that as stiffer accounting rules depress net profits, more companies will try to divert investors’ attention to cash flow.

And that’s not necessarily a bad thing, provided investors also know how to look critically at cash flow, said David W. Tice, manager of the Prudent Bear Fund in Dallas.

For example, though depreciation is a noncash charge, it shouldn’t be ignored, Tice said--because companies still must spend real money to maintain factories, equipment and other hard assets.

Similarly, investors should realize that some of the intangible things a company buys when it makes an acquisition--goodwill items such as customer lists and the know-how and connections of a savvy executive--have a limited useful life.

The acquiring firm is paying real dollars (or shares) for those things, so it’s logical to require periodic goodwill write-downs to reflect that real loss of value, Tice said.

*

Japonica Partners, a Providence, R.I.-based investment firm that specializes in rehabilitating distressed companies, uses its Internet site (https://www.japonica.com) to sound off on accounting issues.

One of its targets has been Sunbeam Corp., which Japonica controlled in the early 1990s, years before the appliance maker became embroiled in the accounting scandal that has devastated its stock.

According to Japonica, here are some of the more obvious signs of trouble investors can look for in watching cash flow and other income statement and balance sheet changes:

* Rising net income while cash flow is falling. Normally, cash flow and net profit should be moving in the same direction. A discrepancy is cause for further investigation.

* Rising accounts receivable (money owed to the company) or inventories. These can be a tip-off to overly aggressive sales tactics that may come back to haunt the company.

* Decreasing reserves. Some firms try to boost current earnings by dipping into funds set aside for future expenses. A popular method is to mark down liabilities for future pension payments.

Japonica said more subtle warning signs--requiring investigation that may go beyond the printed financial statements--include changes in sales terms to retailers, such as offering rebates or more liberal return policies.

Investors should also scrutinize the composition of a company’s audit committee (a subgroup of the board of directors). Members should be independent directors--i.e., free of business affiliations with the firm--and ideally should have accounting experience.