Risk & Compliance

The Fear of All Sums

To restore investor trust, many companies are disclosing more information, according to a CFO survey. But it may not be enough.
Ronald FinkAugust 1, 2002

There’s no telling exactly what will dispel the crisis of confidence dogging the markets for corporate equity and debt. The crisis only deepened in June when WorldCom, the former high-flying telecommunications company, disclosed that it had overstated its cash flow for the previous five quarters by almost $4 billion. With the S&P 500 and Nasdaq Composite indices dropping to five-year lows, the stakes for CFOs obviously are huge. But CFOs themselves surely can extinguish doubt by improving their financial reporting practices and, at least in some cases, by frankly acknowledging the need for improvement in the first place.

Some companies are taking steps in that direction, however haltingly. Among them are Cisco Systems, General Electric, IBM, Krispy Kreme, Priceline.com, and Sears, Roebuck. And a new survey of senior financial executives at publicly traded companies by CFO magazine points to others. Almost 60 percent say they have disclosed more information to investors during the past 3 months, and a similar proportion plans to disclose more during the next 12 months. On the other hand, the remaining 40 percent saw no need to disclose more.

However, the survey also suggests that many companies must do much more. Over half (54 percent) of the 141 respondents say they report pro forma results in quarterly earnings releases, but 18 percent of those that use pro forma don’t reconcile those results to U.S. generally accepted accounting principles (GAAP), even though the Securities and Exchange Commission has advised companies to do so. Even more troubling, 17 percent of all respondents report being pressured to misrepresent their results by their companies’ CEOs during the past five years.

Of all respondents, 5 percent say their reporting practices have violated GAAP. Those abuses most often involve reserves and revenue recognition.

How likely is it that the offending companies will clean up their acts? Both our survey results and anecdotal evidence suggest that companies are changing their practices so reluctantly that they risk undercutting whatever trust such moves might regenerate.

Under Suspicion

The need for improvement, and for acknowledging it, seems indisputable. Although the economy shows signs of recovery, the capital markets continue to labor under a cloud of suspicion, much of it directed at the integrity of corporate financial statements.

Some CFOs concede that they have a responsibility to help restore trust. “Because of Enron, companies are really held to a higher standard in terms of what they’re reporting,” says Randy Casstevens, CFO of Krispy Kreme Doughnuts Inc., a doughnut retailer and franchiser based in Winston-Salem, North Carolina. “We want to do whatever we can to increase public confidence in us.”

A big question, however, is whether companies are capable of that in the absence of new rules and regulations. Says Casstevens: “It will take a combination” of action in the private and public arenas to restore confidence.

The CFO survey of corporate financial reporting suggests that other financial executives are resisting the kind of change that might go some ways toward alleviating investor suspicion. Of the respondents to our survey who take debt off the balance sheet through special-purpose entities (SPEs), almost 80 percent say they have no plans to consolidate any of it. And that’s so despite the fact that almost 42 percent guarantee the investments of outside investors in such deals. Under existing accounting rules, the assets of SPEs must be consolidated when outside investors’ stakes are protected in that fashion.

Slow to Change

Resistance is also clear in individual cases. Consider IBM Corp. Although criticized for years for counting gains on asset sales as reductions in its overhead, artificially inflating its reported profit margins, the company fought tooth and nail to continue the practice. According to press reports, it even resisted demands from the SEC to cease and desist. The company finally acquiesced in the 10-K it issued last spring, excluding one-time gains from SG&A costs and reporting them on a separate line on its income statement. That change, along with the exclusion of intellectual property income from R&D expense, revealed that the company’s actual overhead costs in 2000 were $17.5 billion, 12 percent higher than the $15.6 billion it reported in its previous 10-K.

IBM’s CFO, John Joyce, told Business Week magazine that the changes would better display the company’s financial strength. Others suggest that Big Blue has belatedly come to appreciate the virtues of transparency, which, all things being equal, should reduce its cost of capital. “They got religion,” says Charles Mulford, an accounting professor at Georgia Institute of Technology. Yet IBM’s change of heart looks to have been coerced — hardly the sort of conversion likely to impress skeptics.

Another company that has improved its reporting practices is Priceline.com. Analysts credit the online travel discounter with making it easier to compare the pro forma results it reports in press releases with its results according to U.S. GAAP. As recently as last year, for instance, David Kathman of Chicago-based Morningstar says he had to hunt for the information necessary to compare Priceline’s results under GAAP with its pro forma numbers, to which the company called investors’ attention in the first few lines of its earnings press release. In contrast, the data needed to come up with GAAP-based numbers, says Kathman, “was buried in a table.” But now Priceline’s GAAP-based numbers are given almost equal prominence.

Company spokesman Brian Ek rejects the notion that the company has changed its reporting practices in any way. “We’d like to take credit for improvement,” says Ek, but he contends there hasn’t been any. “We’ve always reconciled pro forma results to GAAP,” he says.

Maybe. Yet in the first few lines of text of Priceline’s Q1 2001 earnings release, the company stated that it had a pro forma loss of 3 cents a share, before restructuring and special charges. Only in the table that followed did the company show what those items were. In the release for Q1 2002, however, the company reported its pro forma and GAAP earnings, both of which happened to be 2 cents, within a few sentences of each other.

Of course, Priceline has less reason to make the comparison between pro forma and GAAP results difficult, now that the Internet bubble has burst and the company has managed to move into the black according to generally accepted accounting principles as well as its own. “They’ve gotten a lot better now that they see themselves as a niche player in the travel market instead of an E-commerce giant,” says Kathman. “And their GAAP earnings are the same as pro forma.”

Synthetic Choices

Some companies simply won’t budge. Symantec Corp., a maker of Internet security technology, is one of a number of companies that have continued to use synthetic leases to keep real estate financing off their balance sheets, despite the hue and cry that has arisen over such devices in the wake of Enron. The company defends its practices by pointing out that the arrangements meet existing accounting rules. Indeed, the Financial Accounting Standards Board has yet to finalize a proposed change with regard to SPEs, including those involving synthetic leases. The new rule would make it much harder, if not impossible, to make use of such arrangements when they involve SPEs.

Synthetic leases that don’t involve SPEs, like Symantec’s, wouldn’t be affected by that change. But most lenders have to get a regulatory exemption to offer such leases without the use of SPEs, and only a handful have done so. While the debt reflected by Cupertino, California-based Symantec’s synthetic leases is indeed kept off the balance sheet, the amounts involved appear on the balance sheet under “restricted cash.”

And Symantec CFO Greg Myers sees no need to revisit its use of off-balance-sheet financing in light of Enron. “I don’t think you try to alter a solid financial transaction because there’s been fraudulent and criminal activity at another company,” he says.

But the distinction Myers draws is largely beside the point, notes Krispy Kreme’s Casstevens, because after Enron, the legitimacy of off-balance-sheet financing depends less on rules than on public perception. “We don’t want to be the judge of that [legitimacy],” says Casstevens. “It depends on what the public thinks.”

For that reason, Krispy Kreme has unwound a non-SPE synthetic lease that was slated to finance a new mixing plant in Illinois, and will instead carry some $33 million to $35 million of the debt on its balance sheet. And its confidence-building moves haven’t stopped there.

Cisco Systems Inc. has also decided to abandon its use of synthetic leases no matter what comes of FASB’s proposal, announcing last March that it would unwind all the leases it has used to finance its San Jose, California, headquarters and several manufacturing facilities in California and New England. In so doing, Cisco will consolidate roughly $1.6 billion in real estate assets by the end of the current fiscal year, adding some fat to its famously lean balance sheet.

Yet in today’s climate, Cisco has concluded that it’s better to have investors see a bigger balance sheet than suspect that it’s hiding debt. “This should remove any concern that investors may have about off-balance-sheet financing,” says company spokeswoman Terry Anderson.

In some cases, at least, investors seem so eager for greater transparency that they’re willing to ignore the decrease in reported returns on capital that stem from bigger balance sheets. For instance, when Sears, Roebuck and Co. returned $8 billion in credit card receivables from an SPE to its balance sheet, in early 2001, the move was partly to blame for slashing the company’s reported return on assets from 3.6 percent in 2000 to 1.6 percent last year. Even so, Sears’s stock has soared by almost 70 percent since the change, more than doubling the gains seen by its peers.

Krispy Kreme, for its part, doesn’t expect to be penalized for having more debt on its balance sheet, says CFO Casstevens. After all, he notes, the company’s plans for a synthetic lease were fully disclosed. And while few investors might once have disregarded its off-balance-sheet treatment and considered the facility Krispy Kreme’s, Casstevens says that, post-Enron, that’s no longer likely. Today, he says, “more investors understand that nothing has changed” when assets are moved off the balance sheet through such arrangements.

Coming Clean

Indeed, more investors can now be expected to disregard any accounting change that has no bearing on a company’s financial condition. Needless to say, IBM’s income-statement changes concerning one-time gains have nothing to do with its fundamentals. When all is said and done, IBM’s nonfinance debt level remains a relatively insignificant 7 percent of total capital. And the company’s cash flow grew a healthy 10 percent last year, even after discounting changes in working capital. So long as any stock repurchases, which IBM typically makes when its share price falls, are funded out of free cash flow and are not large enough to weaken its equity base, credit analysts are likely to approve.

“We realize IBM has been caught performing some sleight-of-hand with nonrecurring items,” wrote Carol Levenson, an analyst for New York advisory firm Gimme Credit, in a recent report. But Levenson noted that she was satisfied that this legerdemain “will come out in the wash of the cash flow statement.”

On the other hand, additional disclosures that may at first glance seem trivial, such as additional footnote detail, can reveal important information about a company’s financial condition. Witness what General Electric has brought to light through added disclosure.

Granted, the company has made significant changes in the wake of Enron, not in its accounting but in its funding practices. For starters, its finance subsidiary, GE Capital, has increased its backup lines from a relatively paltry 30 percent of short-term debt to somewhere between 50 percent and 60 percent. (Standard corporate practice among lower-rated companies is 100 percent.) The company also is decreasing its dependence on commercial paper — which, at $117 billion at the end of 2001, amounted to roughly 67 percent of its total funding — to no more than 35 percent by the end of 2002, and has issued some $58 billion in longer-term debt so far this year with that goal in mind.

These moves have reassured some analysts that GE remains deserving of a triple-A credit rating. As GE CFO Keith Sherin recently told us, “We want a triple-A rating, and we don’t want to have investor concerns about liquidity.”

But skepticism about GE lingers. Toronto-based credit-rating agency Dominion Bond Rating Service figures that if all of GE Capital’s off-balance-sheet securitizations were added back to the debt it consolidates, the finance subsidiary’s leverage ratio would rise from 13.5 times tangible assets to closer to 16 (as of year-end 2001). And even with its longer footnotes, “it’s still difficult to fully understand GE Capital’s operations,” Gimme Credit’s Kathy Shanley recently wrote. As a result, the credit analyst added, “it is entirely fair for investors to keep the heat turned up.”

It may be small consolation to GE, but our survey suggests that other companies will also be sweating for some time.

Ronald Fink is a deputy editor of CFO.

No More Holes?

While unwinding a synthetic lease for a $35 million mixing plant, doughnut retailer Krispy Kreme Doughnuts Inc. has plugged other gaps in its disclosure and governance. For starters, the company has added new detail to its footnotes concerning loan guarantees to franchisees. Previously, the amounts involved were reported only in the aggregate. But in its fiscal year 2002 annual report, Krispy Kreme’s footnotes specify the amounts of each guarantee.

Why not go a step further and put them on the balance sheet? CFO Randy Casstevens explains that different treatment is called for because the company’s obligations are much less certain under the loan guarantees than they were under the synthetic lease. Whereas Krispy Kreme would have been required to take action at the end of the lease’s term by refinancing or purchasing the facility, it has to make good on its loan guarantees only if the franchisees cannot meet their financial obligations. And while he says Krispy Kreme must analyze that likelihood on a quarterly basis, performance is by no means a foregone conclusion. As a result, says Casstevens, “there’s a smaller likelihood that you’ll have to perform under the terms of the guarantee.”

The company has also taken other steps to improve its governance practices. To eliminate potential conflicts of interest, it has abandoned an arrangement that allowed some 30 managers and the company’s shareholders to invest in franchisees. Also, Krispy Kreme has agreed to start reporting insider stock transactions on its Web site within two business days, established a governance committee, and decided to seek two more independent directors for its 11-member board, thus providing a majority of seven independent directors.

Casstevens concedes that it is difficult to draw any definitive connection between these efforts to improve governance and disclosure practices and the performance of the company’s stock. But, he insists, “we aren’t doing it to get kudos, we’re doing it because we felt it was the right thing to do.”

Yet in the current environment, doing the right thing can’t hurt. —R.F.

Better Numbers?

The CFO survey of corporate financial reporting.

This past June, CFO magazine E-mailed a questionnaire on financial reporting practices to some 3,000 senior financial executives, drawn randomly from our circulation list. We received 180 responses, 141 from executives at publicly traded companies, the majority with annual revenues exceeding $1 billion. The results below are based on the responses from the public companies.

The sample is too small for drawing definitive conclusions about the financial reporting practices of America’s 17,000 public companies. Nevertheless, the results are suggestive and even surprising. For example, 42 percent of the companies in the survey that use special-purpose entities (SPEs) to keep debt off their balance sheets guarantee or otherwise protect the investment of third parties in those SPEs — precisely the practice that led to Enron’s downfall.

This is the first in a series of surveys on corporate finance. In coming issues, we will be asking CFOs about practices in auditing, investment banking, and corporate governance.

1. What is your title?

  • CFO or Finance Director: 19%
  • EVP or SVP of Finance: 4%
  • VP of Finance: 18%
  • Director of Finance: 31%
  • Controller: 19%
  • Other: 9%

2. What were your company’s (or business unit’s) approximate revenues for the most recently completed fiscal year?

  • Less than $99M: 4%
  • $100M to $499M: 15%
  • $500M to $999M: 15%
  • $1B to $4.99B: 27%
  • $5B to $9.99B: 13%
  • $10B to $19.99B: 12%
  • $20B to $29.99B: 6%
  • More than $30B: 8%

3. Have you disclosed more information in your financial statements during the past three months?

  • Yes: 59%
  • No: 41%

4. Where did such additional disclosure take place? (Based on those who answered “yes” to question 3.)

  • Income statement/balance sheet: 9%
  • Footnotes: 72%
  • Both: 19%

5. Will you disclose more information during the next 12 months?

  • Yes: 57%
  • No: 43%

6. Where will such additional disclosure take place? (Based on those who answered “yes” to question 5.)

  • Income statement/balance sheet: 12%
  • Footnotes: 70%
  • Both: 18%

7. What percentage of your debt or other liabilities is not reflected on your balance sheet?

  • None: 73%
  • 25% or less: 20%
  • More than 25% but less than 50%: 4%
  • 50% or more: 3%

8. Do you use special-purpose entities to achieve that result? (Based on those who did not answer “none” to question 7.)

  • Yes: 61%
  • No: 39%

9. Do you guarantee or otherwise protect the investment of third parties in such entities? (Based on those who did not answer “none” to question 7.)

  • Yes: 42%
  • No: 58%

10. How much of your off-balance-sheet debt would you have to consolidate if, as expected, FASB increased the minimum level of investment required by a third party from 3 percent to as much as 10 percent? (Based only on those who did not answer “none” to question 7.)

  • None: 71%
  • Some: 21%
  • Most or all: 8%

11. Do you report pro forma results in your quarterly earnings press releases?

  • Yes: 54%
  • No: 46%

12. What items do you typically exclude from EPS as calculated under U.S. GAAP? (Based only on those who answered “yes” to question 11. Check all that apply.)

  • Goodwill charges: 41%
  • Restructuring charges: 67%
  • Gains or losses on asset sales: 29%
  • Pension gains or losses: 10%
  • Other: 21%

13. Do you reconcile your pro forma results to U.S. GAAP? (Based only on those who answered “yes” to question 11.)

  • Yes: 82%
  • No: 18%

14. Will you continue to use pro forma results in your quarterly releases during the next 12 months? (Based only on those who answered “yes” to question 11.)

  • Yes: 93%
  • No: 7%

15. How often have you felt pressure from your company’s CEO to misrepresent its financial results during the past five years?

  • Never: 83%
  • Once: 4%
  • Twice: 1%
  • Three times: 1%
  • More than three times: 11%

16. How often have you engaged in aggressive accounting practices during the past five years?

  • Never: 93%
  • Once: 1%
  • Twice: 1%
  • Three times: 0%
  • More than three times: 7%

17. How often have your accounting practices violated U.S. GAAP during the past five years?

  • Never: 95%
  • Once: 1%
  • Twice: 1%
  • Three times: 0%
  • More than three times: 4%

(Total exceeds 100% due to rounding.)

18. What did such practices involve? (Check all that apply.)

  • Reserves: 63%
  • Revenue recognition: 33%
  • Business combinations: 21%
  • Fixed assets: 21%
  • Investments: 17%
  • Leases: 13%