Changes coming that will benefit all investors.

There appears to be a good chance that the public auditors and the analysts will start cleaning up their acts in 2002. The Enron debacle, a disgrace whichever way you look at it, seems to have brought the problem of sham accounting to a head.

A group of New York investment bankers, enraged by the bizarre high-tech reporting in 2001, is calling for a ban on pro forma statements except in extraordinary circumstances. The U.S. National Investor Relations Institute is also very concerned and has issued guidelines for the use of pro forma numbers in press releases. Most important, the SEC recently stated that in future it intends to commence fraud probes if any pro forma statements are misleading. Isn’t a pity that we didn’t have all this uproar a year or so ago?

What are pro forma statements? Well, as the Latin implies, they are documents issued in place of the real thing. I first came across the term years ago when accountants were using it on forecasts as a warning that these were not actual numbers. In the last few years, though, analysts and auditors have stood that meaning on its head. Companies now selectively edit their true earnings and issue so-called pro forma figures in order, they claim, to give investors a better insight into what is really happening. Or, to put it another way, CEOs, aided and abetted by the analysts and auditors, are publishing what they like, which is why so many of the high-tech numbers have been misleading.

To give you an example, Amazon.com lost US$168 million in the second quarter last year but management promptly reported a pro forma loss of US$58 million. The company felt that eliminating certain expenses from the income statement would shed more light on the proceedings, never mind about accounting principles.

This blatant manipulation has become widespread and of course all the adjustments are one way. I cannot recollect one set of pro forma statements that gave a worse picture than the GAAP results. And the numbers involved are significant. In 2001, PMC-Sierra showed one quarterly pro forma loss of US$13.4 million when the real loss amounted to US$233.0 million.

Analysts too have dropped into the habit of publishing their own adjusted earnings, often as a way supporting a buy recommendation when the stock is expensive by traditional standards. Recently I came across an optimistic report on Nortel in which the analyst started by saying that he expected the company to be profitable in the first and second quarters of 2002. Astonishing and encouraging news! In fact, he was referring to EBITDA (earnings before interest, taxes, depreciation and amortization) and later in the report mentioned that Nortel could default on its debt this year. The truth is that this company is unlikely to make money in 2002. Even the 2003 results are a toss-up. So beware of EBITDA calculations. Fortunately, the OSC is showing interest in the problem and now wants much less use of cash earnings or other non-GAAP numbers.

Hopefully, public opinion and the various Enron enquiries will force a return to accepted accounting principles. Until then, I suggest that you regard all EBITDA and pro forma figures suspiciously. They are more likely to mislead than to inform. Just focus on a company’s final bottom line. At the end of the day, that’s all we are left with and even then it’s just an educated guess. A much better way of measuring a company’s strength and potential is to watch the earnings trend and rate of change. Make sure the figures are comparable, though, and based on GAAP.