Of managed earnings and fabricated golf handicaps

爱德华

　　[Headnote]
　　Legendary investor Warren Buffett is increasingly outspoken on perceived excesses of American management, from "no-cost" stock option repricings to managing earnings to meet securities analysts' expectations. Mr. Buffett is chairman of Berkshire Hathaway Inc., the $117 billion holding company with major investments in such American corporate icons as Coca-Cola, Gillette, Walt Disney, American Express and the Washington Post Company (and more recently in GEICO, General Re and Executive Jet Aviation).
　　At this year's annual meeting in Omaha (the "Woodstock for Capitalists") Mr. Buffett said "We don't worry about the performance of the stock; we worry about the performance of the company." His chairman's letter in the Berkshire Hathaway annual report is famous for its self-deprecating analysis of his own performance and for its pithy commentary on American financial management practices in general. With permission, Directorship is presenting three mini-essays from the 1998 annual report chairman's letter. The first article appeared in the June issue and took to task accounting (or lack thereof) for stock options. The article below discusses manipulating earnings. In a future issue, we will publish Mr. Buffett's thoughts on M&A accounting.
　　Accounting-Part 2
　　The role that managements have played in stock-option accounting has hardly been benign: A distressing number of both CEOs and auditors have in recent years bitterly fought FASB's [Financial Accounting Standards Board] attempts to replace option fiction with truth, and virtually none have spoken out in support of FASB. Its opponents even enlisted Congress in the fight, pushing the case that inflated figures were in the national interest.
　　Still, I believe that the behavior of managements has been even worse when it comes to restructurings and merger accounting. Here, many managements purposefully work at manipulating numbers and deceiving investors. And, as Michael Kinsley has said about Washington: "The scandal isn't in what's done that's illegal but rather in what's legal."
　　It was once relatively easy to tell the good guys in accounting from the bad: The late 1960s, for example, brought on an orgy of what one charlatan dubbed "bold, imaginative accounting" (the practice of which, incidentally, made him loved for a time by Wall Street because he never missed expectations). But most investors of that period knew who was playing games. And, to their credit, virtually all of America's most-admired companies then shunned deception.
　　In recent years, probity has eroded. Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers-CEOs you would be happy to have as spouses for your children or as trustees under your will-have come to the view that it's okay to manipulate earnings to satisfy what they believe are Wall Street's desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.
　　These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence. But when operations don't produce the result hoped for, these CEOs resort to unadmirable accounting stratagems. These either manufacture the desired "earnings" or set the stage for them in the future.
　　Rationalizing this behavior, these managers often say that their shareholders will be hurt if their currency for doing deals-that is, their stock-is not fully-priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does. Once such an everybody's-doing-it attitude takes hold, ethical misgivings vanish. Call this behavior Son of Gresham: Bad accounting drives out good.
　　The distortion du jour is the "restructuring charge," an accounting entry that can, of course, be legitimate but that too often is a device for manipulating earnings. In this bit of legerdemain, a large chunk of costs that should properly be attributed to a number of years is dumped into a single quarter, typically one already fated to disappoint investors. In some cases, the purpose of the charge is to clean up earnings misrepresentations of the past, and in others it is to prepare the ground for future misrepresentations. In either case, the size and timing of these charges is dictated by the cynical proposition that Wall Street will not mind if earnings fall short by $5 per share in a given quarter, just as long as this deficiency ensures that quarterly earnings in the future will consistently exceed expectations by five cents per share.
　　This dump-everything-into-one-quarter behavior suggests a corresponding "bold, imaginative" approach to golf scores. In his first round of the season, a golfer should ignore his actual performance and simply fill his card with atrocious numbers-double, triple, quadruple bogeys-and then turn in a score of, say, 140. Having established this "reserve," he should go to the golf shop and tell his pro that he wishes to "restructure" his imperfect swing. Next, as he takes his new swing onto the course, he should count his good holes, but not the bad ones. These remnants from his old swing should be charged instead to the reserve established earlier. At the end of five rounds, then, his record will be 140, 80, 80, 80, 80 rather than 91, 94, 89, 94, 92. On Wall Street, they will ignore the 140-which, after all, came from a "discontinued" swing-and will classify our hero as an 80 shooter (and one who never disappoints).
　　For those who prefer to cheat up front, there would be a variant of this strategy. The golfer, playing alone with a cooperative caddy-auditor, should defer the recording of bad holes, take four 80s, accept the plaudits he gets for such athleticism and consistency, and then turn in a fifth card carrying a 140 score. After rectifying his earlier scorekeeping sins with this "big bath," he may mumble a few apologies but will refrain from returning the sums he has previously collected from comparing scorecards in the clubhouse. (The caddy, need we add, will have acquired a loyal patron.)
　　Unfortunately, CEOs who use variations of these scoring schemes in real life tend to become addicted to the games they're playing-after all, it's easier to fiddle with the scorecard than to spend hours on the practice tee-and never muster the will to give them up. Their behavior brings to mind Voltaire's comment on sexual experimentation: "Once a philosopher, twice a pervert." m