Make room, earnings management. Despite recent reports that the Securities and Exchange Commission is intensifying its crackdown on accounting fraud, agency officials are warning that their investigative spotlight may now also be trained on disclosure issues.
In March, Robert Bayless, chief accountant at the SEC’s Division of Corporation Finance, predicted that if registration of initial public offerings dropped dramatically — and they have — the agency would be able to refocus its enforcement efforts. Companies, he said, ”may be hearing from us. And what they may hear from us about is segment disclosure. Our patience with deficient segment disclosure,” he added, ”has been exhausted.”
Specifically, the SEC is threatening to focus on compliance with FAS 131, which in 1997 defined how segment data should be reported. Most companies, however, did not have to supply compliant information until 1999, when there were many other demands on the SEC, including innumerable IPO filings. Last year, in fact, the SEC was able to review only about 1,100 annual reports, and there were no announced enforcement actions that cited segment disclosure. This year, however, the SEC expects to more than triple its reviews, with an eye on such violations.
Whether new Commissioner Harvey Pitt has the resources to pursue these investigations remains to be seen. A change in administration has not left the commission in top form. On the same day Bayless made his speech, previous Commissioner Laura Unger admitted that ”we face a staffing crisis.” What’s more, the agency’s Director of Enforcement Richard Walker and Chief Accountant Lynn Turner — both key enforcers of recent Commission crusades against earnings management — are also stepping down.
Still, finance executives have to take such threats seriously. ”SEC speeches do set standards,” says Kevin Thompson, CFO of Durham, North Carolina—based Red Hat Inc., who says he scrupulously follows FAS 131, despite his own skepticism. ”FAS 131 had a good theory behind it,” he says, ”but the rules missed the mark.”
The Unstandard Standard
Scrutinizing segment reporting is not new, of course. FAS 14, the statement that FAS 131 replaced, required that segments be reported on a geographic and industry basis, and was criticized for being too vague and circumventable. Analysts complained that it allowed too many companies to consider themselves single-segment firms. A study by the Financial Accounting Standards Board of almost 7,000 public companies, in fact, found that some 75 percent said they operated in only one industry segment during the 1985—1991 time frame.
In response, FAS 131 was developed to appease ”analysts who wanted to see how the company is managed through the eyes of management,” says disclosure expert James F. Harrington, a partner with PricewaterhouseCoopers. According to FASB, that meant that companies had to start reporting the same information ”that is used internally for evaluating segment performance and deciding how to allocate resources to segments.”
Now the SEC wants to find out if the internal information being provided by companies is the same as that presented to and acted on by their ”chief operating decision maker,” says Harrington. But what information is shared with which top decision maker can vary from company to company, and create compliance hassles. ”All of these are very subjective types of rules that are open to interpretation,” he says.
Take Red Hat, for example. Its board has historically viewed numbers on advertising sales generated by the software firm’s Web site. Consequently, even though Web advertising involves only 2 of Red Hat’s 650 employees and represents only 2 to 3 percent of the company’s revenue, Thompson says, he felt compelled to present it as a segment in the company’s fiscal 2001 10-K. ”That’s what the rules required, but it doesn’t provide any value,” he says. Thompson adds that he intends to ”stop showing the board those numbers so I don’t have to show [Web advertising] as a segment again.”
Complicating matters, of course, is that defining just which information decision makers actually use is tricky in an era of desktop access to enterprise resource planning and other financial systems. ”Given IT today,” points out Patricia McConnell, senior managing director of Bear, Stearns & Co. in New York, ”you can slice and dice the information a gazillion different ways.”
Consistency is a Virtue
The SEC, notes Harrington, also intends to investigate whether ”companies are aggregating businesses that are not similar or are limiting the amount of information.” And one test of compliance, according to Bayless, will be whether companies refer to segments consistently in their investor communications.
Achieving such consistency, however, is easier said than done. Just ask San Antonio—based SBC Communications Inc. Ostensibly, its segments are defined as Wireline, Wireless, Directory, International, and Other. But that depends on what page of the annual report you read. The chairman’s letter in the annual report, for example, never mentions these five segments, focusing instead on ”growth engines,” referred to as ”data and broadband,” ”long distance,” and ”wireless.” Only the last of these is later described as a segment.
Such discrepancies are well within the parameters of FAS 131, insists company spokes-man Tony Katsulos. ”Public companies are not required to write a chairman’s letter,” he maintains. ”We are trying to highlight issues that would be of interest to investors. The letter is accompanied by the financial statements, which do, according to FAS 131, report out by segment.”
SBC’s annual report does include an extensive section on segment results. But its income statement breaks out operating revenue into six categories: Landline Local Service, Wireless Subscriber, Network Access, Long Distance Service, Directory Advertising, and Other. This breakdown is not required by FAS 131, either. But like the chairman’s letter, it does not seem to correspond to the company’s FAS 131 segment definitions. ”This is traditionally how we have reported results to investors and how they are used to seeing them,” explains Katsulos.
”SBC seems to be the poster child for lack of consistency between disclosure documents,” notes one analyst, who asked not to be named. ”That was one of the objectives of FAS 131: consistency between financial statements, the chairman’s letter, and the footnotes on the segments.”
What happens if a company, in the SEC’s view, fails the consistency test? ”Expect the staff to request an amendment, rather than suggest compliance in future filings,” Bayless warned in his speech.
”There’s also the possibility,” says McConnell, that ”the SEC will pick a company and make a big example out of it. That’s the way the SEC does things; it doesn’t have the resources to do anything more than moral suasion.”
The SEC may have plenty of companies to choose from, since the same economic downturn that freed it to pursue disclosure violations is likely to result in a wave of reorganizations and consolidations. ”One of the bad parts of the management approach to segments is that every time companies reorganize or restructure, there is a high probability that the segments will change,” says McConnell.
That’s what happened at Minneapolis- based Apogee Enterprises Inc. By June 2000, the troubled glassmaker’s stock had tumbled to $3.50 a share from approximately $15 a year earlier, and in late summer, the company began a process of realigning its reporting segments ”to match the markets” it serves. ”This was not driven at all by FAS 131,” says CFO Michael Clauer, who joined the company in November 2000. ”It was driven by the need to run this company differently.” Nevertheless, to comply with FAS 131, the company provided three years’ worth of restated financials and added two years’ worth of revised quarterly statements ”to make the job easier for analysts.”
Clauer, a former Arthur Andersen auditor with plenty of segment- reporting experience, says that the process wasn’t overly burdensome. And since the redefinition of Apogee’s segments, he says, ”it has become much easier to talk about this company to investors and Wall Street.” In fact, says Clauer, if a company’s segments make sense from a business perspective, FAS 131 compliance should follow naturally.
But other industries are far more variable. Again take SBC, whose acquisitions and mergers have caused it to shuffle its segments around every year since FAS 131 took effect. For example, the Directory segment described in its 2000 annual report was spun out of the previous year’s Information and Entertainment segment — which in turn was an expansion of a 1998 segment called Directory.
That’s not much help to an analyst or a competitor trying to track, say, SBC’s directory advertising sales for all three years. But FAS 131 is not intended to support comparisons among companies, says McConnell, although she notes that most companies are likely to find FAS 131’s focus on internal management offers less a basis for competitive comparison than FAS 14. ”Analysts and investors can’t have everything,” she say. ”The trade-off is between information that might be comparable among competitors versus information that is useful to understanding the company.”
Unfair to Compare
In fact, although analysts asked for it, most admit that FAS 131 is something of a mixed blessing, eliminating an admittedly shaky basis for comparison between different companies in favor of greater — but highly individualized — insight into the management strategy of a single company. ”It was the best of all possible alternatives, none of which were very good,” says McConnell.
Still, even this small peek under the shroud of companies with multiple business lines can shed a lot of light. ”I find the segment reporting very useful for [such companies as] Motorola, Tyco, and IBM,” says Albert Meyer, an analyst for the Dallas-based investment research firm David Tice & Associates. ”You can’t look at those companies without looking at their segments.”
In January 2000, for example, Motorola’s stock price was $139, on its way to a March peak of $180. But Meyer didn’t buy the Street’s analysis. ”The market was valuing each segment at best-in-class multiples,” he says. ”But Motorola was not best in class in semiconductors, or wireless, or satellites.” The margins of each of Motorola’s segments compared poorly with top performers such as Intel, and Meyer issued warnings that accurately foreshadowed the stock’s subsequent plunge. ”It was the segment information that helped me to really get a grip on the company,” he says.
That’s the sort of comment that’s likely to cause the SEC to tighten its grip, too