Accounting Concerns Add Up to Stock Woes

Investors’ sudden obsession with accounting irregularities is likely to weigh on the stock market throughout 2002, raising the specter of a third consecutive down year on Wall Street for the first time since World War II.

At the very least, market watchers say, accounting concerns fueled by the collapse of Enron Corp. could put a damper on any rally that might otherwise accompany an economic rebound.

“It’s a dangerous time for the stock market,” said Robert Shiller, Yale economics professor and author of the 2000 book “Irrational Exuberance.” He noted that the uproar over corporate accounting comes at a time when investors already are faced with a pricey stock market and a U.S. economy that is struggling to emerge from recession.

Enron fallout “is likely to have a major impact on the market over the next year or so,” said Chuck Hill, research director at earnings tracker Thomson Financial/First Call in Boston.

Major U.S. stock indexes fell for a fourth straight session Wednesday, in part because of continuing worries that many companies may have used accounting gimmicks to dress up their financial reports in recent years. The benchmark Standard & Poor’s 500 index is down 5.6% year to date after sliding 9% in 2000 and 12% in 2001.

Paul J. Zak, associate professor of economics at Claremont Graduate University, said investors are girding for “the probability that more companies will have to restate profits and that future accounting standards will be tighter and future profits slimmer.”

Much of the recent attention has been focused on conglomerate Tyco International Ltd., whose shares lost half their value over the last two weeks as concerns grew over the reliability of its earnings statements--including the disclosure this week that the firm spent $8 billion on 700 acquisitions over the last three years without making them public.

The latest victim of investor concern was software maker VeriSign Inc., which slid almost 10% Wednesday on worries that its revenue might be inflated by sales to affiliated companies.

Besides Tyco and VeriSign, stocks under the accounting microscope include Reliant Resources Inc., the power trading arm of Reliant Energy Inc.; Irish drug giant Elan Corp.; and computer networking company Enterasys Networks Inc. The stocks have sunk 40% to 70% year to date.

“There’s no question there will be more blowups coming, more mini-Enrons,” Hill said, calling the trend a cyclical phenomenon. “At the peak stages of a business cycle, pressure builds on companies to push the envelope. When the downturn inevitably comes, the dirty laundry gets aired and we make corrections to the process.”

The accounting fears pose a two-pronged problem for the market, Hill said.

First, wary investors may be reluctant to pay high prices for stocks when the corporate earnings they use to value the shares could be unreliable.

Second, earnings reported in the coming months may be reduced as nervous auditors clamp down on any accounting strategy that might be deemed aggressive. Auditors don’t want to be tagged as “another Andersen,” he said, any more than companies want to called “the next Enron.” Accounting giant Andersen is under fire for its role in the Enron fiasco.

If corporate earnings and the value investors place on those earnings fall, so do stock prices.

Zak said the risk to the market is a continuing series of earnings restatements chipping away at confidence--or a bombshell involving a blue-chip stalwart like General Electric Co., General Motors Corp. or IBM Corp. that provides another jolt on the scale of Enron.

“Trust has a huge impact on the economy,” he said. “If another big shoe drops and this gets to the point where investors start pulling money out of stock mutual funds, bankers tighten their reins and companies can’t raise capital through the debt or equity markets for expansion, that wouldn’t bode well for growth.”

Despite the accounting controversy, market analysts hope the economy will rebound strongly enough to overcome doubts about corporate earnings and give investors a reason to buy stocks.

As Hill put it, accounting jitters are a depressant. The market won’t rise as much as it might have otherwise, but any gains would be welcome.

“I still believe there will be an economic and earnings recovery, but it will be muted,” he said.

A reassuring sign for the market, Zak said, is that mutual fund investors have held tight: New cash invested has slightly outpaced redemptions this year. Despite the accounting concerns, the U.S. remains “the cleanest stock market on the planet,” he said. He also noted that baby boomers have few attractive alternatives for their retirement savings.

In the long run, regulatory fallout from the Enron debacle is expected to have a positive impact on U.S. markets.

“In the short run this could hurt, but in the long run more diligent accounting and auditing is going to be a healthy thing,” Shiller said.

Hill said the controversy will result in tighter rules adopted by the accounting industry and tougher regulatory enforcement on companies reporting misleading earnings.

He called the Securities and Exchange Commission’s recent cautious advice on so-called pro forma earnings “a big step forward.” In an alert posted at its Web site (www.sec.gov), the agency urges shareholders and prospective investors to view any earnings report highlighting pro forma numbers with “appropriate and healthy skepticism.”

Pro forma numbers often do not conform to generally accepted accounting rules. They are hypothetical, based on company assumptions that may or may not be valid or helpful to investors, the SEC said.

Already, Hill said, he has been heartened to see firms such as AOL Time Warner Inc. and computer chip maker Xilinx Inc. move away from pro forma earnings.

But Hill warned that investors and Wall Street analysts will have to remain diligent.

“Five years from now if the economy is booming, companies may not pull another Enron exactly but they will get bold again one way or another,” he said. “That’s the way it works.”