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Creative Accounting!

By Larry Doyle on March 28, 2009 at 9:10 AM in Economy, Sense on Cents (Larry Doyle blog)

Tune in to our Saturday Sense on Cents Central Station, now with live chat. Arrive early at 10:15 or as we start officially at 10:30 a.m. ET! Catch the entire archived show.

I will readily admit that my preferred source for market news is Bloomberg. Having seen enough media outlets covering market activity, in my opinion, there really is no alternative to Bloomberg. Why? Literally every day I am learning and being introduced to new and useful information. The information emanates not only from those they interview, but often from their own in-house research and analysts.

To wit, I just caught a segment with Jonathan Weil, a Bloomberg reporter focused on corporate accounting. With 1st quarter earnings a few weeks away, Weil’s insights are the stuff that stops you in your tracks.

In short, Weil highlights how companies effectively massage their earnings and income statements. Massage? Where’s Sarbanes-Oxley when you really need it to check the numbers?

The critical statistic used to measure the relative value of the S&P 500 is the Price/Earnings ratio. Weil truly distinguishes himself by exposing the fact that real earnings are non-existent. He writes about earnings:

The earnings gauge I’m referring to is called comprehensive income. While there’s a good chance you have never heard of this before, it’s a far more inclusive measure of profitability than the better-known subset, net income. The term also has a well-defined, standardized meaning under the accounting rules.

Comprehensive income is the change in a company’s shareholder equity during a given period, excluding the effects of new capital injections and dividend payments. By this measure, S&P 500 companies had combined losses in the past four quarters of about $200 billion, according to data compiled by Bloomberg and my own review of the companies’ financial reports. In other words, there is no P/E ratio, because there is no E.

By contrast, S&P 500 companies had about $295 billion of combined net income during the same period, which translates into a P/E ratio of about 25 times earnings for the index. That’s not cheap, by historical standards. And it’s a lot to pay for Botox earnings that are unnaturally stiff and cosmetically enhanced.

While I know that manufactured beauty has become a big business in this country, I much prefer the natural beauty of my wife and a truly robust earnings and income statement.

If Weil’s analysis has stopped you like it did me, read Botox Earnings Put Crooked E in Stock Market P/E .

lizzy

We expect acountants to give an accurate reflection of a company’s fiscal health. This article makes it sound like principles are fluid and liquid; easily changed. Very intimidating to a novice investor.
Cubs in 09

LD… I’ve learned so much from you. Your input here at NQ is invaluable.

I’m a rookie when it comes to economics and finance, so bear with me.

Q: What precisely does “a P/E ratio of about 25 times earnings” mean?

Please use layman’s language. I presumed it means that the price of the stock is 25 times the earnings of the company.

Q: Whatever the explanation, what is the implication for the price of stocks, the index, and/or the market? Does it imply that the stock market is oversold?

Of course, maybe I’m assuming an explanation that isn’t there.

A lot of that going around these days…
jbjd

I, too, am economically challenged. I am spending this week-end studying capital markets and such, to get up to speed. (I resent having to become an expert on everything because my elected officials cannot be trusted to work in my best interest.) However, I know enough to know that, basing fiscal policy on figures derived from a market where a company’s stock has both a P/E ratio of zero and a P/E ratio of about 25 times the index means, something wicked this way comes.

L and L, thank you for these economics lessons.
Citizen70

I agree with you Larry. Bloomberg business news is by far the best station for insightful news, analysis and interviews. As a woman, I also appreciate that the female reporters and anchors are serious, know their stuff, and don’t seem to be required to show cleavage, wear tight sweaters, and show lots of leg.
In the print media, Business Week is terrific.
LD

The P/E is exactly as you state. A P/E can be for a specific company, an industry or an entire index (companies included in an index). The price of the stock we can get in daily market trading. That price implies a level of earnings and the “multiple” paid for those earnings.

As Weil points out, the manner in which those earnings are determinee is not only critical to the process , it IS the process.

A fair multiple is typicallly anywhere from 12 to 18. If earnings, as defined by net income in weil’s piece, are used and we see where the S&P 500 is trading (815) it would imply a multiple of 25!!!

What does that tell us? the market is currently VERY rich or expensive. Earnings need to go up or prices of the stocks need to come down or both.

For what it is worth, a wealth of these financial topics and definitions are included in an Investing Primer at Sense on Cents. I will embed it here.

http://www.investopedia.com/rotate.aspx?invsection=home&backurl=http%3a%2f%2fwww.investopedia.com%2f
Peggy Sue

According to my husband this has been going on for years. He worked in Public Accounting when he first graduated from college, always liked crunching numbers, but quickly realized that it wasn’t about the numbers or what they told you. It was all about the narrative you could create around the numbers.

We had this conversation last week after I read Weil’s article: “Accounting Brothel Opens Doors for Bankers’ Fiesta.”

I thought it was appalling. My husband wasn’t surprised. “And that’s why,” he said, “I had never had a future in public accounting. I’m a numbers guy. I wasn’t any good at fiction writing.”

Depressing.
LD

Peggy Sue….makes one wonder about the real foundation of a lot of companies.

Very interesting color.

Thanks for sharing.
Cubs in 09

Thanks! I’ll bookmark that page. That’s easier than googling every technical phrase and trying to understand the definition—which is often full of technical concepts. This leaves the head of the uninitiated spinning.
I’m a Linda too

Auh yes, MASSAGING the books. Wasn’t Franklin Raines of Fannie Mae doing this…mmmm about a decade ago?
http://www.senseoncents.com LD

Franklin and his cronies were the MASTERS!! They had bought off the crowd on the Hill in the process.
http://noquarter foxyladi14

i learn a lot here.thanks D.L
WMCB

Larry, your posts are wonderful. I don’t comment often, because frankly I often don’t have a lot intelligent to say. But I do read them, and appreciate what you do.
Ellen D

Hi Larry. What do you think of the proposed mark-to-market change in accounting rules to make the banks happy? If you’ve answered this before, sorry. I don’t get a chance to read everything.
http://www.senseoncents.com LD

Ellen…I am not a fan of changing the mark to market. I view a change as a means for banks to “manage” losses as in hide or disguise them as opposed to identify them and make sure they have enough capital to support them.

For a handful of assets a relaxation of the mark to market does make sense because transactions are very infrequent. However an across the baord change in the mtm is an accounting trick to manipulate the books.

I think it increases the risk in potentially investing in the banking industry. How can you invest if you do not knwo what assets are marked at.

There are markets for assets the banks just do nto want to transact at those markets because the bank would be insolvent if they did.
Linda C.

Enron is still with us. I remember after the Enron scandal broke multiple business revised their previous earnings statements downwards. I guess we still have magical accounting.

One really can’t trust any information these companies are putting out anymore.
P3

The debate between “net income” versus “comprehensive income” is an old debate. Both measures have various degrees of merit and issues. The devil is typically in the details – and in knowing what each measure really means.
Ellen D

Thank you, Larry. I concur and I think this is very dangerous.

Here is part of my e-mail to the fasb.

Getting rid of rules and regulations started this mess. If you do this, no one can trust the U.S. financially any more.

Stop this madness.

They are going to change the rules next week. Please e-mail the director (below) to voice your opposition. We have until April 1 for public comment.

director@fasb.org

Apologies if typos – Earth hour.
http://www.rogercpareview.com CPA Exam Review consultant

Sadly, the banks needed a scapegoat and found one in “obscuring the details” as others have said. This doesn’t make the problem go away, and in fact it will exacerbate the issue as it will either resurface later as a new issue or continue to chew away at balance sheets like the cancer it is. To say nothing for regulation, which is about to take a beating, and allowing moral hazard in cases where fiscal sanity and risk management should be first and foremost.

It is truly a mess.

But it’s beautiful that you feel that way about your wife
vivi

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