In case you've never heard of her, Lady Godiva was the woman who rode bareback (literally) through Coventry, England in 1040 in order to get the Lord of Coventry to lift a tax on the people. Just as the Lady provided "full disclosure" to help her fellow citizens, corporations are starting to do the same thing with their financial disclosures to maintain their credibility with investors and avoid being painted with the scarlet "E".
This newfound desire to be upfront with investors will be an interesting addition to what was already expected to be a lively earnings season. Even before Enron and LGAP, this earnings season was expected to be very different because of two main factors: new goodwill accounting rules and increased pension expenses.
New accounting rules for goodwill (FAS 142) will boost EPS and are expected to result in significant charge- offs, especially for telco's and the remaining dotcoms. (For more on FAS 142, see this article.) FAS 142 eliminates goodwill amortization expense, but does not require companies' past/historical results to be restated. If companies do not provide historical pro forma EPS with similar adjustments, EPS growth will be overstated throughout 2002. Also, under FAS 142, companies have an incentive to charge-off in the first quarter of 2002 the "impaired" goodwill that resulted from overpaying for acquisitions during the dotcom market. (Goodwill is deemed "impaired" if the current valuation of the asset is less than the book value.) This marking-to-market has already resulted in multi-billion dollar write-offs for AOL, Clear Channel, Bertelsmann and Vivendi.
The second and less obvious factor is the need for companies to resume funding their defined benefit pension plans; we can expect to see earnings reduced because of this. During the bull market (pre-2001) companies were able to reduce pension expenses as pension portfolio returns exceeded expectations. Returns were so good that companies did not have to accrue pension expense to meet their annual obligation, which boosted EPS. In some cases, companies used these paper profits to boost EPS, but now it's time to pay the piper. The crash of 2001 wiped out the "gains" that were used to fund pension obligations. Companies must now not only start making the "usual" contributions, but they must also make up the shortfall, which will be another drag on EPS.
If we are lucky, LGAP will be a bright spot in all earnings seasons to come. With earnings getting clobbered by recession, new accounting rules and pension expenses, investors may find solace in the corporate effort to come clean. Under LGAP companies will do the following:
- Fully disclose all off-balance sheet risk. (To learn more about these risks, see the article Off-Balance-Sheet Entities: The Good, The Bad, And The Ugly.) To fully evaluate the risk of a company, investors should note all off-balance-sheet items. These include contingent liabilities (loan commitments, standby letters of credit), special business units, loan guarantees and synthetic leases.
- Clearly describe how new goodwill accounting rules will impact EPS. The new FAS 142 accounting rule eliminates the amortization of some forms of goodwill. In some cases this will provide a big boost to EPS - companies should make it easy for investors by clearly showing how EPS is impacted. Comparisons among peer groups can then be made.
- Disclose the impact of stock options issued in lieu of salaries. Under GAAP, using stock options to pay workers is not considered an expense, but many dot-bombs used stock options as a way to boost what little earnings they had. Ironically, companies are allowed to call this an expense for tax purposes, which results in a type of "double dip". Expenses should have consistent treatment on both GAAP and tax sets of books. Until the government can plug this loophole, LGAP requires that companies show the expense claimed on their taxes when determining EPS.
- Reveal how they account for pension expense and the earnings impact. During the bull market many companies had pension portfolios that did very well. Firms with defined benefit plans were able to withdraw these paper profits and book it as income. Under LGAP, there would be a new line item that would show the impact of pension treatment on EPS.
LGAP also requires that companies provide this information on a retroactive basis so that investors can evaluate the true core earnings growth of a company. Under LGAP, companies can use pro forma numbers to show how GAAP-reported EPS is adjusted to determine "undressed" EPS. With LGAP, companies will not use pro forma data to boost earnings by excluding operating expenses such as options issued in lieu of salary.
LGAP may be a fairy tale now, but hopefully it will soon become the norm. Not because it is a fad, but because the markets demand it. Politicians cannot create new regulations mandating honesty because, as we have seen, what the government tries to regulate, accountants and lawyers circumnavigate. Politicians, who cannot balance their own checkbooks nor the federal budget, do not have the ability to create effective regulation that prevents other dotcom bubbles or Enrons.
If market forces demand LGAP, and if investors decide to require LGAP by voting with their investment dollars, companies that are suspected of violating LGAP will be penalized with a low price-credibility ratio. Companies that provide important details should be accorded a high P/C ratio. Stocks will rise or fall based not only on reported results, but also upon how transparent their financial statements are.
In every generation there is a defining moment. How we as a society react to these challenges will determine whether we make the world a better place. LGAP can be achieved if the markets demand it. If the markets do not demand ongoing full disclosure, we will have missed our opportunity, and LGAP will only become the emperor's new clothes.