Under The Microscope

By Daniel Kadlec

As questions swirled around its accounting practices, Tyco International, an industrial and services conglomerate with $36 billion in annual revenues--and a beaten-down stock price--said last week it would split into four companies in a bid to "unlock tens of billions of dollars of shareholder value." The company's combative CEO, Dennis Kozlowski, predicted the breakup would add 50% to the stock price. Going him one better, Don MacDougall of J.P. Morgan Chase said the move would make the stock worth $80 to $90 a share--double the current price. Haven't they heard? Post Enron, any hint of questionable accounting is the functional equivalent of finding asbestos in everything a company makes. So a day that dawned with promise for Kozlowski quickly turned to loss. By week's end Tyco shares were at $45, down 3% from the day before its breakup was announced--and down 24% since fresh accounting worries surfaced at the start of this year.

Kozlowski insists that "Tyco has better disclosure in its financial statements than anybody out there." Almost two years ago, the company emerged from an informal Securities and Exchange Commission inquiry with no action against it, and in an unusual step, the SEC has put out word that no new inquiry is under way at Tyco. But while there appears to be nothing illegal about Tyco's bookkeeping, jumpy investors are suddenly setting a higher standard. They want to see clearly how a company earns, spends and invests. And Tyco--despite its planned reorganization--remains a complex conglomerate, with headquarters in tax haven Bermuda. Many investors feel it still doesn't reveal enough. Says James Chanos, president of hedge fund Kynikos Associates: "Investors just have to exercise a fair amount of diligence when looking at companies that appear confusing."

In a financial world shaking from the Enron scandal, many investors are viewing with fresh skepticism the bookkeeping methods of a range of companies, including even blue chips that are widely admired and accused of nothing illegal. Some of the companies that investors point to are American Airlines, the insurer American International Group, Coca-Cola, Electronic Data Systems, General Electric, IBM, J.P. Morgan Chase and Xerox.

These marquee names say it all. Even companies once considered above suspicion are being subjected to increasing scrutiny. Under current accounting rules, management can essentially do whatever it pleases, says David Dreman of Dreman Asset Management, based in Jersey City, N.J. It can scatter explanations in impenetrable footnotes it is confident no one has the time or capacity to decipher. "There are enormous overstatements of earnings and understatements of expenses," he says.

Enron's unraveling can be traced to investors' first whiff of "off-balance-sheet" partnerships that hid billions of dollars of the company's liabilities. By the time Enron crashed, it was primarily a trading firm. It had relatively few hard assets to cushion its fall when business faltered and hidden debts came due. The risks aren't nearly so great at asset-rich companies like Tyco and GE. But, as with Enron, seasoned analysts have trouble determining whence, exactly, they derive their profits.

Since the Enron fiasco blew wide open, the influential Moody's Investors Service has requested additional information from some 4,000 companies that use accounting methods that Moody's believes make it harder to judge their creditworthiness. Companies are also deciding on their own that confusing books just aren't worth it. Last Wednesday, Bank of America went to great lengths to explain a $418 million gain in the fourth quarter from a subsidiary set up last year to deal with problem loans. The gain resulted from tax savings after bad loans were shifted to the subsidiary. Not wanting an Enron-like taint, the bank clearly spelled out to analysts the legal maneuver, and investors rewarded the extra disclosure by pushing the stock up 4% in a week.

K Mart, which filed for Chapter 11 bankruptcy protection last week, announced on Friday that it was looking into internal accounting issues. The company offered no details. But the accounting getting closest scrutiny in the wake of Enron generally falls into three categories:

REVENUE RECOGNITION The SEC says its No. 1 line of inquiry is into the ways that companies book their sales. The most glaring example of revenue fraud occurred at Sunbeam five years ago. (The company's infamous former CEO, "Chainsaw" Al Dunlap, just last month settled a shareholder suit stemming from his stint at the small-appliance maker.) Sunbeam recorded the sale of gas grills and other goods well before they left the warehouse. Many of the items never did get shipped. By offering retailers deep discounts to place orders months before they normally would and by booking those sales immediately, Dunlap was able to show escalating revenue and earnings. Eventually, though, the scheme collapsed as retailers couldn't sell enough appliances even at discount prices and had to cancel orders.

The SEC warned Xerox three weeks ago about booking sales of copiers that, technically, are leased, not sold. Revenue from a lease is generally reported over the life of the lease, not up front. Xerox has said it will contest the SEC on this issue.

Some telecom companies are getting a second look, partly because more than a few use Arthur Andersen, Enron's auditor, but also because many achieved their once spectacular growth partly by immediately recognizing revenue from long-term contracts, analysts say. Qwest has received the most attention because its merger with US West opened the door to other accounting issues. Qwest has denied that it did anything wrong. "Think about a bottle of wine," former SEC chairman Arthur Levitt said in a speech two years ago. "You wouldn't pop the cork on that wine before it was ready. But some companies are doing this with their revenue, recognizing it before a sale is complete, before the product is delivered to a customer or at a time when the customer still has options to terminate, void or delay the sale."

MANAGED EARNINGS Critics of Tyco, which has bought hundreds of companies over the years, charge that it inflates write-downs for the costs of its acquisitions, in effect creating stored earnings it can summon at will to pump up quarterly results in a way that makes earnings growth appear to be the result of expanding sales or higher margins. These allegations are "totally inaccurate," Kozlowski says. But those denials aren't persuasive to David Tice, who runs the Prudent Bear Fund and practices short selling, a technique that bets on a stock to fall. He has sold Tyco stock short and asserts that Tyco's core growth rate is just 7% or so a year--not the 15% to 20% that the company reports.

While investors sort that one out, they can also look at GE, famous for its steadily rising earnings and steadily rising stock price. GE is an acquisitive conglomerate known for reporting one-time gains and one-time losses in striking balance, keeping growth on a calm and steady course. The company has also benefited from earnings that flow from its overfunded pension plan. Last year, with the broad stock market down 13%, GE reported a whopping $1.7 billion of income from pension-plan investments. How could that be? Here's one possibility cited by stock analysts: by raising the estimated rate of return on the money set aside to fund employee pensions in the future, a company can immediately cut the amount of money it sets aside and let that flow to the bottom line. But if the higher returns never materialize, there will be an earnings hit later on. GE denies that it manages its earnings. "I don't want to be painted with that brush," CEO Jeffrey Immelt told analysts last week.

Stock analysts also question the pension accounting of IBM, which two years ago assumed a 9.5% rate of return on pension investments and has upped that expected return to 10%. IBM has said the increase was based on its experience in managing the fund.

Insurance companies routinely set aside reserves for future claims. Because insurer AIG has posted steadily rising profits for years, some analysts believe the company may over-reserve in good times and use the stored earnings to pump up results in bad times. AIG has said its policy for setting aside reserves is appropriate and fully disclosed in regulatory filings.

Cisco has come under the lens, as have a slew of other tech companies, for its use of so-called pro forma earnings, which may leave out recurring expenses and are often referred to as "earnings before all the bad stuff." Last year Cisco asked investors to ignore a $2.2 billion charge for inventory loss, which most accountants consider to be a normal business expense rather than something extraordinary.

HIDING DEBT This is where Enron got into trouble. Yet hundreds of companies shift liabilities off their books without breaking any laws or accounting rules. Many, like Enron, use special-purpose entities (SPE) that, as long as the entities receive at least 3% of capital from outsiders, can be left off the consolidated books of a parent company.

There are other ways to hide debt. In the 1980s Coke divested most of its bottling operations and saddled them with most of the parent company's long-term debt. Coke kept stakes of just under 50% in the bottlers, giving it the leverage to force price increases for syrup even when the bottlers couldn't pass on those costs. Coke's large ownership interest means that it is on the hook for much of the bottling companies' liabilities, yet the bottlers' debts do not show up on Coke's balance sheet. For that reason, some analysts consolidate the bottlers with Coke in looking at the company's financial picture.

Liabilities can also be covered over with extensive lease agreements. Both United and American airlines owe billions of dollars on long-term leases for aircraft. Those are real obligations but do not show up as debt. Data processor EDS is potentially liable for $500 million in financing costs for computers that its customers use--an item that appears only in a footnote to a company report. And J.P. Morgan Chase has a nearly $1 billion liability as a 49% partner in an SPE called Mahonia that traded energy contracts with Enron. In accounting, there's always more than meets the eye.

--With reporting by Bernard Baumohl and Unmesh Kher/New York

With reporting by Bernard Baumohl and Unmesh Kher/New York