'Dirty Bathwater' Expected in Company Earnings

Investors beware: Here come the autumn cleaners.

Corporate earnings for the third quarter, now being reported by many companies, are widely expected to be the worst in a decade as a sluggish economy hits many industries.

But the bathwater could become even dirtier as firms try to put as many expenses, writeoffs and special charges as possible into the wash right now so that future results look brighter.

The counterintuitive idea is to take the hit to the bottom line now when investors have already braced themselves for a disastrous quarter. Once that's done, future results will be squeaky clean by comparison, albeit a bit misleading. Profits will appear that much stronger in the widely expected recovery next year, as costs have been laundered out of balance sheets, making profits and profit margins look more impressive.

"It's all kind of the same thing -- take a lot of expenses in this quarter so you won't have to later," said Bob Willens, an accounting analyst at Lehman Brothers, who says the time is ripe for firms to take charges. "So that'll by definition improve your future profitability."

Firms have been hit as last month's devastating attacks crippled an already slowing economy. Earnings for S&P 500 companies are expected to be down more than 20 percent this quarter. As a result, one accounting analyst at a Wall Street firm said that in her marketing trips, many more clients and fund managers were asking questions about firms employing such earnings games.


The usual tactics are to write off inventory by excessive amounts or create inflated bad debt reserves. Companies can use their own judgment about how many of its unsold products are now worthless, or how many debts won't be repaid.

"A concern is always that that the estimation error is on the side of being too large or moving onto excessive," said Jane Adams, an accounting analyst at Credit Suisse First Boston.

There is so much uncertainty in the economy at present that it makes it hard for firms to estimate their charges accurately, said Pat McConnell, accounting analyst at Bear Sterns. And firms are just as likely to err on the side of underestimation as they are to overestimate, she said.

Other analysts aren't so sure.

"Firms are going to err on the side of being conservative," said Trevor Harris, accounting analyst at Morgan Stanley and professor at Columbia University. "They'll take a charge on anything that might come back to haunt them later on."

Restructuring costs, in particular, are likely to be the one area that companies can derive the most mileage this quarter, said some analysts.

"This is an opportune time to take a restructuring charge," said Willens. "And the danger with restructuring charges is that a company will include expenses that don't really belong there ... the guidelines are not all that clear."

Already, a plethora of firms from Gateway to Flextronics Intl. have announced in recent times that they will be restructuring their operations and incurring charges as large as $475 million, for example, in Gateway's case.


Complicating matters for this quarter are last month's attacks that ripped through New York and the revenues of most firms.

Accounting rule-makers, wary of misleading accounting practices, have said companies can't record losses stemming from the attacks as "extraordinary" but stopped short of not allowing them from being recorded as "unusual."

The accounting treatment for both items is different, but the message sent to investors is the same: Ignore it when evaluating the company's fundamentals.

It may be difficult to separate attack-related losses from those caused by the general economic downturn, said Credit Suisse's Adams. This will further cloud the picture of the underlying performance of a company's core business.

"Clearly, in press releases, you can be sure that companies will go to great lengths to distinguish those costs so there will be no mistaking that the results for this period are unusual," said Willens.

For example, wireless technology giant Motorola Inc.. raised some eyebrows when it recorded a $2 billion charge in its third-quarter results, including $1.3 billion in additional reserves for debt owed by Turkish cellular operator Telsim as part of a vendor financing agreement.

"What desperation caused them to negotiate such an incredibly poor deal on that scale," said Henry Asher, president of the North Star Group, a NY based investment advisor who owns Motorola shares. He questioned the use of the charge, saying. "Why is that one-time? Will they say from now on they will absolutely not finance their (Turkish) customers (bad debts)?"

A Motorola spokesman said it was taking a one-time charge now because Telsim had been uncooperative in restructuring the loan.