The lawsuits by Sunbeam shareholders alleging overstatement of earnings may be a sign of things to come. There is good reason to believe that the earnings growth reported by many top American companies in the past few years is largely illusory, more the product of questionable accounting practices rather than business success. As investors wake up to this fact and share prices inevitably fall to their proper values, many thousands of angry shareholders and mutual fund owners will be demanding to know why this was allowed to happen.
The Economist in its April 18th issue, page 69, gives an example. Stock options issued to management and staff are part of their compensation package and this cost to the company is properly part of wages and salaries expense. However, accounting for these stock options bypasses the income statement and this has "caused profits for 100 of the largest American firms to be overstated by 42% in 1995 and 57% in 1996".
Warren Buffet says this "accounting practice of ignoring the cost to a business of issuing options" is "dead wrong" according to quotes in the May 18 issue of Forbes Magazine. Also, there is an inflation impact. Recognizing options as employment income would increase the growth of income by 2.5%. Forbes asks the question (page 215) "Would the market have risen 20.3% in 1996 if the 100 biggest companies had reported earnings gains of only 11%? Doubtful."
Forbes goes on to quote an analyst saying that "the current P/E multiple on the S&P; 500 is 35, not the 28 usually shown." The Price/Earnings multiple is one of the key indicators which investors use to value stocks.
The accounting treatment for options is only one of the tricks corporations are using to inflate earnings. For example, Forbes says that Kellogg's has taken "one-time charges" nine times in the past 11 quarters. "One-time charges" are another misuse of accounting designed to artificially enhance earnings because they bypass operating income and expense in the income statement.
Forbes, March 23 issue, discusses at length the various tricks now being used by corporate management to enhance the value of their share options by overstating earnings. Other tricks include reporting acquisitions as mergers so that companies can avoid reporting "goodwill" (which must be amortized over 40 years, thus reducing earnings for a long time into the future), and improper reporting of revenues and expenses to bolster the current quarter. Companies reported to be engaging in these frauds include General Motors, Boeing, Kellogg's and many others. Forbes quotes an analyst who suggests that cash flow and earnings should generally track together, and if earnings leave cash flow behind then something is wrong. The problem is that "looking at stock prices versus cash flow for the S&P; 500, you get an alltime reported high..." The phenomenon is very widespread.
The use of options to supplement the compensation of management and employees has become common only in the past few years. There seems to be good evidence that this practice is leading to deceptive accounting, artificially inflated earnings, and a bull market based on widespread fraud and deceit. Mainstreet America is being mugged by Wallstreet once again. The truth now coming out could bring disaster to many small investors who have put their retirement savings into equity mutual funds.
This is perhaps the greatest story of the bull market. The bull market does not need a rise in interest rates for it to come to an end, nor a crash in the far east or a Year 2000 problem. All the bull market needs to bring it to an end is for a majority of investors to realize that they are being lied to, that corporate earnings are to a large extent non-existent, that American shareholders are falling victim to the same corrupt accounting that is criticized in Korea and other developing economies.
The Economist reported options "caused profits for 100 of the largest American firms to be overstated by 42% in 1995 and 57% in 1996". What was it in 1997? What happens to earnings if you remove all the other tricks? When the market crashes and people lose their savings, their consumption will go down and the economy will contract. What will earnings be then? Given that stocks after a crash will trade at much lower multiples of earnings, how far down can the market go?