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The Accounting Cycle
How Wall Street Helps Managers Fudge EPS

March 2006Managers are smart enough to know that earnings per share (EPS) is the most important statistic found within a financial report. Since they are evaluated on the basis of financial performance and performance is gauged by EPS, business executives do a number on EPS. If you can't earn it legitimately and if you don't want to out-and-out make it up, do the next best thing. Just stretch the truth as far as you can and hope nobody finds out. Wash, rinse, and spin: that's their motto!

Accelerated share repurchase (ASR) programs are the new game in town. They involve derivative contracts on the business enterprise's own stock in an attempt to inflate EPS. Managers seek ways to reduce the denominator in EPS, and, for a fee, Wall Street is happy to oblige.

Not that derivatives on one's own stock are new. In the heyday of the late 1990s and early 2000s, firms would write put options or go long on forward contracts on their common stock. Neither instrument hedged anything; they were merely contracts that bet that their stock prices would climb over the life of the derivative. If they did, the company would gain the premium in the case of the written put options, for the buyers of these instruments would let the options lapse. In the case of the forward purchase contract, the corporation would buy back its own shares at old, cheaper prices. Alternatively, the participants in the forward contract could cash-settle the gain/loss on the forward.

These cute derivatives paid handsomely as long as the stock market cooperated by generating higher prices. As soon as the market turned south, the shareholders in these business enterprises discovered huge losses. Recall the saga of EDS, which engaged in both activities, writing put options and having forward purchase contracts. The stock price of EDS took a nosedive in 2001 and 2002, and the firm lost $225 million on their gamble.

Today those games have been replaced with the ASR racket. SFAS No. 150 has virtually eliminated the incentive for writing put options or engaging in forward purchase contracts on one's stock because it requires the firm to mark the instruments to market, placing gains and losses into the income statement. Until and unless the FASB amends SFAS No. 150 to do the same with ASRs, business entities can employ ASRs without marking them to market. Any gains or losses bypass the income statement and go into equity.

ASRs work like this. The counterparty, usually a financial institution, borrows the company's shares from investors and sells the stock short. The company purchases shares from the counterparty and simultaneously enters into a forward sale contract with the counterparty. Later the counterparty purchases shares in the open market to cover its short position. At maturity the forward contract is settled by selling the shares at the exercise price or by the net cash amount.

What's special about ASRs is that the business firm simulates a normal repurchase program but enjoys an immediate EPS jump. The accounting rules seem to allow the entity instantly to reduce the number of shares outstanding.

Managers in a variety of corporations have participated in ASRs, and they have accounted for them in the manner described. They include Cardinal Healthcare, Cendant, Duke Energy, Hewlett-Packard, and Waste Management. (Gee, haven't we seen these firms in recent news stories?)

The problem with ASRs is that it is all nonsense. The forward should be marked to market rather than bypassing the income statement. Moreover, while the firm has repurchased the common shares, it also has promised to sell them (or cash-settle) in the forward contract. In my mind the forward negates the repurchase aspect and so the denominator ought to stay the same. Instead of treating the two transactions separately, the corporation should account for them as joint set of transactions.

Why do these managers persist in exaggerating financial statements to improve their performance evaluation? Why don't they try to tell it like it was instead of telling it like they wanted it to be? Don't these managers care to tell investors and creditors the truth?

And why are investment bankers playing the huckster? They are playing with fire when they peddle these tricks to managers. Didn't they learn anything from the financial meltdown in 2001-2002? Weren't they humiliated by criminal investigations by the Justice Department? Didn't they lose enough money in the lawsuits they settled out of court, and aren't they bothered by the remaining lawsuits still in play? How many more criminal investigations and how many more civil suits do they wish to face? These games have to end -- if they endure, more financial implosions are in the forecast, hurting managers and investments bankers as well as investors and creditors.

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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries.

2006 SmartPros Ltd. All Rights Reserved.

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