In September 1998, former Securities and Exchange Commission Chairman Arthur Levitt addressed the problem of managed earnings in a speech titled, “The Numbers Game.” In the speech, he railed against American managers consistently manipulating financial statements, and called for stricter regulations on earnings reports.

Levitt remained committed to honest financial reporting until his departure last summer, launching an all-out crusade against earnings management, and founding the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audits. Unfortunately, rather than a reduction in dubious reporting practices, companies have taken the speech as a “how to” seminar, and the problem has become an epidemic.

With the recent selection of Harvey Pitt as the new SEC Chairman, financial reporting vigilance is likely to continue. Pitt, a former Washington lawyer securities lawyer, is now Wall Street’s top regulator.

“During his testimony, Mr. Pitt gave investors a clear picture of his vision for the securities industry,” said Stuart Kaswell, Securities Industry Association senior vice president and general counsel, referring to Pitt’s appearance before the Senate Banking Committee last July. “He demonstrated true insight on the challenges facing the capital markets, and indicated a clear focus on investor protection.”

Tricks of the trade

Ideally, earnings statements reflect a firm’s profit from its core operations. However, as companies compete to impress investors by meeting or beating analysts’ projections, they post earnings statements that are often misleading.

During the last few quarters, companies have struggled to maintain a positive outlook for their investors as the once electric economy has slowed. The untouchable titans of the boom economy are feeling the strain. More importantly, they feel they have an image to maintain, and firms are finding earnings management more necessary than ever. Many companies report capital gains as earnings, and though the SEC claims that timing the collection of capital gains is an acceptable form of earnings management, most analysts find such reporting techniques to be misleading and deceptive.

Unfortunately, earnings management reaches beyond judicious collection on investments into the realm of fraud. A study of 200 publicly owned firms investigated for fraud over an 11-year period found that 50 percent were suspected of fraudulent revenue recognition. Revenue recognition was one of former Chairman Levitt’s top five managed earnings problem areas, accompanied by restructuring charges, acquisition accounting, “cookie-jar reserves” and over-capitalization.

With the SEC focused on earning statements, firms eager to impress investors are finding new ways to post questionable reports. Many firms report their earnings via press releases in “Pro Forma” format because media releases are not audited by the SEC. Unless the report lies outright about the state of the company, the SEC cannot contest the claims. The Pro Forma format was originally created for firms that wanted to anticipate future cash flow problems or that were going into a merger or acquisition.

Pro Forma reports do not necessarily adhere to Generally Accepted Accounting Principles, so managers can fudge the margins with relative impunity. In Pro Forma media statements, companies can exclude expenses such as interest, taxes, restructuring charges, spending on in-process research and development, or losses from intangibles like the amortization of goodwill, write-offs from impaired assets and failed Internet ventures.

Eyeing audits

Investors should also be suspicious of audited reports. Many companies that performed well in previous periods open excess revenue accounts known as “cookie-jar accounts.” In a period of lower than expected profits, firms close these reserve accounts to show an in-flux of cash. This practice allows firms to report consistent earnings and growth.

Employee pension plans are also manipulated to help improve earnings statements. Firms post profits in their earnings statements from pension plans that have grown exponentially over the last few years. This will positively affect the future earnings of those companies as they amortize the transitional gains arising from the 1999 windfall over a number of years. This means that earnings statements for years to come will be padded by pension plan gains, corrupting the quality of earnings. Of the sundry finesses in earnings statements, this and vague revenue recognition tread dangerously close to fraud.

Which indicators can investors trust?

Investors that feel dismayed by the apparent lack of honesty in corporate accounting can still find reliable measures in published statements. Many analysts consider revenue a good indicator of a firm’s health. By definition, revenue is generated by core business operations and is more difficult to manipulate in the books.

Another solid indicator of a company’s profitability is cash flow. Although the cash flow statement may be the least easily interpreted financial statement, it holds a wealth of information about the condition of a firm. Moreover, a report of cash on hand is hard to tweak and often more reliable. Most industries develop their own measures of profitability. Analysts often develop market indicators that are industry specific, or value certain statements over others for reasons unique to the industry.

Tech industry analysts and investors are paying special attention to cash flow, noting that a decline in technology investment may create an industry-wide cash scarcity.

In the standardized healthcare field, analysts skeptical of earnings statements from HMOs are looking at the medical loss ratio. The medical loss ratio shows the portion of every premium dollar used to pay for patients’ medical costs. This ratio gives analysts an idea of the efficiency of the HMOs operations, and also indicates the profit margin.

Chances are that the reports that make it to the evening news are not the reports that shed the most light on the state of a company. Smart investors are finding different measures of profitability, rather than betting it all on earnings statements. The name of the game is not earnings, but the quality of earnings.

Ahmed Mohiuddin , CPA, manages the Securities Industry Practice Group at the Los Angeles office of Singer Lewak Greenbaum & Goldstein LLP, Certified Public Accountants & Management Consultants. He can be reached at [email protected].

Entrepreneur’s Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1759 with feedback and topic suggestions.