Alex Berenson - The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America

Contents

FOR MY BROTHER DAVID,

A TRUE FRIEND

It is difficult to get a man to understand something
when his salary depends on his not understanding it.

UPTON SINCLAIR

Prologue

One of Many

January 22, 2001, 5:30 P.M. Darkness has settled over the East Coast, but the mood is sunny in the executive suites at the Islandia, New York, headquarters of Computer Associates. The worlds fourth-largest independent software company has just released its quarterly earnings for the three months ending December 2000, and the report is a good one. Sales and profits are higher than Wall Street anticipated.

No one will benefit from the news more than Charles Wang, the chairman of Computer Associates, and Sanjay Kumar, the companys chief executive, good friends who have just bought the New York Islanders professional hockey team. Wang owns 30 million shares, more than $1 billion, of the companys stock. Kumar, a relative pauper, has about $200 million in Computer Associates shares. Those fortunes will grow the next day, as investors bid Computer Associates stock up almost 6 percent.

After issuing the report, Computer Associates holds a conference call to discuss its results with the Wall Street analysts who follow the company. Kumar cant resist bragging. Although the software industry is in its worst downturn in a decade, his company has demonstrated its strength. Were extremely pleased with the performance we pulled off, he says.1

If she had been on the call, that news would have come as a surprise to Mary Welch. Welch, a Computer Associates sales rep, had been fired by the company a week earlier, one of three hundred employees laid off as 2001 began. Like most of the fired employees, Welch was told she would not receive any severance pay, because she had been dismissed for poor performance. Yet she had received a positive job review only two weeks before. Welch and many other fired employees believed that Computer Associates wanted to avoid paying severance by disguising a company-wide cutback as individual firings. The layoffs were necessary because the companys sales had plunged in the December quarter, the fired employees claimed. They did a mass layoff, Welch said.

At the time, Welchs complaints seemed nothing more than the gripes of a disgruntled ex-employee. After all, Computer Associates financial statements showed that business had been better than ever in the December quarter, with sales up 13 percent and profit up almost one-third. Surely the company couldnt just make up its results.

But Mary Welch was right. Thanks to an audacious accounting trick, Computer Associates had found a way to rewrite its financial statements. The company had divorced the reality of its business, a business in decline, from the profit-and-loss picture it presented to Wall Street. Breaking the most basic conventions of accounting, it was rebooking sales and earnings that it had already reported.

Computer Associates was not a penny stock operating in the shadows of the market. It had eighteen thousand employees, tens of thousands of shareholders, and a market value of more than $20 billion, more than Nike or Federal Express. Yet no onenot the analysts paid to decipher the truth of Computer Associates fortunes, not the accountants legally required to certify its books, not the mutual fund managers who bought its stock, and most certainly not the regulators who oversaw the U.S. securities marketshad blown the whistle on the companys accounting maneuvers.

There are fourteen thousand publicly traded companies in the United States. Expecting all of them to be honest is unrealistic. Like any town of fourteen thousand, the market is bound to have its share of grifters and shoplifters. But the deception at Computer Associates was dangerous precisely because it wasnt an aberration. By January 2001, all manner of companies were abusing accounting rules to mislead their investors, seemingly without fear of being caught. A strange madness had gripped the market. Even its most solid citizens were running red lights and breaking windows. And the police were nowhere in sight.

Introduction

System Failure

On Wall Street, not all numbers are created equal.

New home starts. The consumer confidence index. Retail sales. Overnight television ratings. Unemployment claims. PC shipments. Casino winnings in Atlantic City and the Las Vegas Strip.

The figures roll out every day from government agencies and industry trade groups and independent analysts. Watching them all is impossible; most speed by unnoticed.

But one set of numbers burns brighter than the rest. Every three months, publicly traded United States companies report their sales and profits to their shareholders. Those quarterly announcements are the lodestar that investorsand these days, thats most of ususe to judge the health of corporate America.

It makes intuitive sense that corporations must regularly tell their shareholders how much money they have made or lost. Whats your weekly paycheck? Did you get a bonus last year? All in all, how much money did you make? You know the answer, without much trouble. Why shouldnt Exxon and General Motors?

They should, and they do. Every quarter they add up their sales and costs, and figure out where they stand. Then they tell the world, in press releases and conference calls and most important in reports that they file four times a year with the Securities and Exchange Commission, the federal agency that regulates U.S. stock markets. To be precise: Three quarterly reports, or 10-Qs, submitted to the S.E.C. within forty-five days after a quarter ends. One 10-K, the big one, the audited annual report, to be filed less than ninety days of the end of a companys fiscal year. Qs and Ks, in Wall Street shorthand.

Qs and Ks are monuments to numbers. Revenue. Selling, general, and administrative expenses. Operating income. Interest paid. Columns of huge numbers, eight, nine, or ten figures long, fall down the page in black and white to land with a bang disguised as a whimper at one small number: earnings per share.

Earnings per share is usually no more than a couple of bucks, an unprepossessing sum compared to the giant figures above. But its small size is deceiving. Multiply a dollar or two per share by hundreds of millions of shares, and you have real money. A stray penny on the 10 billion shares that General Electric has outstanding turns out to be $100 million.

Even within a profit report, not all numbers are equal. For traders and investors of all sizes, earnings per share is the ultimate benchmark of a companys success or failure. Has it risen from the previous quarter and the previous year? Has it met the consensusthe average estimate of the Wall Street analysts who follow the company? More than any other number, earnings per share determines whether a companys shares will rise or fall, whether its chief executive will be rewarded or fired, whether it will build a new headquarters or endure a round of layoffs.

On Wall Street, a place of little subtlety, earnings per share is known simply as the number. As in What was the number for Pfizer? Earnings per share is the number for which all the other numbers are sacrificed. It is the distilled truth of a companys health. Earnings per share is the number that counts.

Too bad its a lie.

Under the best of circumstances, the figures in a quarterly reportearnings per share most of allare approximations, best guesses based on a thousand other best guesses. Earnings reports are about accounting, and the accounting that big companies use to measure their financial health has as much in common with the way you balance your checkbook as a five-alarm fire has with a backyard barbecue.