Profits Without Honor

Accounting is not normally thought of as an exciting subject. But on Wall Street these days, it is the focus of intense interest. The notion has taken root that corporate profit reports are not always what they seem, and investors' suspicions have been nourished by the accounting profession itself, a staid club that is usually a model of gray-flannel decorum.

Stocks of franchising companies, for example, have been among the Street's latest go-go favorites. But last fall Leonard Savoie, executive vice president of the American Institute of Certified Public Accountants, warned CPAs that they should reject a common--and profit-inflating--practice of franchising firms: counting as current income the payments that franchise operators agree to make over a period of years. As one result, Milwaukee-based Career Academy, which sells to local "directors" the right to distribute its vocational-training courses, announced that it probably would report a 1969 profit of only 45-c- a share v. the 90-c- it had originally estimated. The price of Career's stock has since fallen 57% .

Advice to Run. More recently, the A.I.C.P.A.'s 18-man Accounting Principles Board, top rule-making body in the profession, appointed a committee to study the bookkeeping practices of land-development companies. That move prompted Manhattan's Equity Research, an advisory firm, to counsel its clients who hold land companies' stocks to "take your money and run."

Last week the furor reached new heights when the board circulated proposed new rules that would force most merging companies to change the way they explain the deal to shareholders. The method used in many of the 6,000 mergers announced last year was to treat the combination as a pooling of interests. In effect, the accounts of two firms that merged were treated as if they had always been one. Abraham Briloff, professor of accountancy at Manhattan's Bernard M. Baruch College, compares the technique to bikini bathing suits. "What they reveal is interesting," he says, "but what they conceal is vital."

Overstated Profits? Critics insist that pooling usually conceals the true price that an acquiring company has paid to take over the assets of another firm. Hamer H. Budge, chairman of the Securities and Exchange Commission, complained in congressional testimony last month that some merger-minded companies in consequence can show "instant earnings." Briloff gives this example: In 1966, the Gulf & Western conglomerate issued stock worth $185 million in exchange for the stock of Paramount Pictures. At the time, Paramount's assets had a book value of $100 million, so Gulf & Western recorded the assets as costing only $100 million. One year later, G. & W. sold to television studios the right to show films from the Paramount library at a profit that it reported as $22 million. Briloff thinks that profit is misleading, because Gulf & Western showed on its books only part of what it had paid for Paramount's assets, including the film library. An investor who remembered the market value of the stock that G. & W. had issued could have made some different profit computations for himself, but few shareholders have the expertise to try.

Many accountants consider such record keeping perfectly proper, and point out that if Paramount had not merged with G. & W., the film firm could have pocketed the same profit itself. Mergers accomplished by an exchange of stock, suggest the accountants, should be regarded as a marriage in which "you do not buy your wife -- you merge your interests with hers." True enough--but the Accounting Principles Board's proposed rules would deny use of the pooling method to all but a handful of companies that merge. The key provision bars the pooling technique when one of the combining companies is more than three times the size of the other.

Yearly Write-Offs. Under the proposed rules, most companies that merge would have to use the "purchase method" of bookkeeping. With that system, a company that pays more than book value to buy another must frequently enter a considerable portion of the excess on its books as "goodwill." The effect can be judged from what accountants estimate would have happened to International Telephone & Telegraph Corp. if the proposed rules had been in effect during the ten-year reign of Harold Geneen. If forced to use purchase accounting for all the acquisitions it treated as poolings, so the estimate goes, ITT would have put $900 million of goodwill on its ledgers. To write off that amount over 40 years, the company would have to deduct $22.5 million per year from its profits at least until the year 2000.

Fortunately for ITT, the proposed rules are not retroactive. Whether any other company will have to follow them is questionable. The Accounting Principles Board itself is divided on the proposition. But the developing debate can only be enlightening. The public has too long accepted as gospel any figure that corporate managers have chosen to report as profit. The knowledge that experts argue bitterly over whether such figures can be trusted should be useful information to investors.

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