Overview//mike1st/mark2nd

By JASON BOOTH

Staff Reporter

Who would have thought that auditing would become corporate America’s latest contact sport?

As publicly held companies are continually pressured by Wall Street to bring in impressive earnings, quarter after quarter, it’s the number crunchers who find themselves caught in the middle. They’re the ones, after all, who must compute, report, analyze and finally sign off on a company’s performance.

Except that there are all kinds of ways to arrange the figures.

While creative accounting by public companies is as old as the stock market itself, the Securities and Exchange Commission is becoming concerned that things are getting out of hand.

In a recent speech, SEC Chairman Arthur Levitt said, “Too many corporate managers, auditors and analysts are participating in a game of nods and winks. In the zeal to satisfy consensus earnings estimates, wishful thinking may be winning the day over faithful representation.”

It’s a phenomenon that is clearly being felt among L.A.’s community of accountants, consultants and equity analysts.

“There have clearly been some failings,” said Gregory Garrison, who heads the Los Angeles office of PricewaterhouseCoopers LLP. “The SEC has taken a look and seen that the interpretation of certain rules has not been as rigid as it should have been. There is a problem, and we all have to listen to what the SEC is saying.”

Levitt says he is especially concerned about the excessive use of write-offs by companies involved in mergers or acquisitions.

Write-offs are typically expenses or debt that a company records as a one-time “exceptional” charge. While some of the charge-offs are for past or current expenses, an increasing number of firms have been writing off projected future expenses as well.

By booking future expenses, a company can effectively boost its reported profits in the years ahead. Those higher projected earnings, in turn, often result in a boost to the company’s stock price.

“They know they are going to have a bad quarter, so they load up the quarterly report with all the exceptional costs they can,” said Marla Harkness, head of research at Brentwood-based Oakwood Capital Management, and former president of the L.A. Society of Financial Analysts. “They load all the bad news into the one quarter so they can get it out of the way and Wall Street can forgive them. And as we get later in the economic cycle, we are more likely to see more bad quarters and more such write-offs.”

While write-offs are not in themselves inappropriate, there is growing concern that inflated or repeated charges could undermine the integrity of corporate financial statements, making it more difficult for investors to determine corporate values.

In Levitt’s words: “I fear that we are witnessing the erosion of the quality of earnings, and therefore the quality of financial reporting. Integrity may be losing out to illusion.”

And for those companies whose earnings projections have been based more on hope, and less on reality, there is the “restatement,” in which companies simply announce that earlier earnings reports had been wrong.

Garrison blamed the current rash of such corporate mea culpas on the fact that so many companies have gone public in recent years, particularly in the high-tech industry.

“We have had an increased number of young companies launching IPOs, and when you have more companies going through that process, mistakes will be made,” he said.

The fact that many IPOs are in high-tech, or other sectors of the “new economy,” further increases the chances of accounting irregularities. Whereas in years past a company’s financial results were relatively cut-and-dried, today they might include more subjective judgments, especially as it relates to evaluating intangible assets.

“If a high-tech company has no tangible revenue stream, or is spending all its money on (research and development) that won’t turn a profit for years, how do you value it?” asked Carla Hayn, a professor of accounting at UCLA. “Biotech firms are near impossible to value.”

Today, possibly more than ever before, there are compelling reasons for companies to use whatever accounting tricks they can muster to please Wall Street.

If their stock price falls, companies have a harder time raising capital. They also become potential takeover targets.

At the same time, executives see an increasing portion of their compensation tied to the performance of their company’s stock. In 1997, more than 70 percent of the income of the 10 highest paid executives in Los Angeles County was tied to stock options.

“There is no doubt that corporate leaders are under pressure to report earnings in line with analysts’ expectations,” said Garrison. “And there is no question that their compensation is tied to their ability to do that. You have to recognize these things and go in with your eyes wide open.”

A case in point is Santa Monica-based software maker CyberMedia Inc.

In mid-March, the company had to reissue its fourth-quarter results with significantly lower revenues than first reported. At the same time, company executives announced that its first-quarter earnings would fall far short of original estimates, and that its chief executive was resigning immediately.

In an April interview with the Business Journal, Kanwal Rekhi, CyberMedia’s chief executive at the time, explained the accounting irregularities this way: “It was a case of an entrepreneur (Cybermedia co-founder and former CEO Unni Warrier) wanting his company to grow a little faster than it was.”

With its stock price depressed, CyberMedia was acquired in September by Santa Clara-based Network Associates Inc. Rekhi left the company following its acquisition.

Another local high flyer whose accounting practices were called into question is Smart Talk Teleservices Inc.

Back in 1997, the telecom firm was among L.A.’s fastest-growing companies. The stock was also a winner, more than doubling from its IPO price in 1996 to a high of $36 in March of this year.

But in August the company announced that it had hired PricewaterhouseCoopers to investigate its past accounting practices related to a write-off taken in 1997. At the same time, the company, which has since moved out of state, announced that it was revising downward its 1997 and first-quarter 1998 results.

That was the signal for investors to jump ship, and as of last week the stock was trading at around $6.

Last March, Chatsworth-based Cohr Inc., a maker of hospital equipment, announced that its 1997 earnings had been overstated by more than 50 percent. As a result, the stock has fallen from more than $11 in March to below $3 as of last week.

Even Walt Disney Co. has raised eyebrows, specifically over its 1996 $18.9 billion acquisition of Capital Cities/ABC. Analysts have noted that Burbank-based Disney essentially wrote off around $2.5 billion in costs and expenses associated with that merger. While ABC continues to struggle, it has had little impact on Disney earnings.

It’s not easy for investors to keep tabs on such overstatement and restatements, given that securities analysts the people who are called upon to provide a disinterested picture of a company are themselves under pressure from their own brokerage houses to be less than candid.

“The biggest problem is that the analysts are often the hostages of the corporate finance department,” said Fred Roberts, president of Brentwood-based investment bank F.M. Roberts & Co., and former chairman of the National Association of Securities Dealers.

That pressure has heightened as changes in Nasdaq regulations have narrowed the spreads and booking profits for brokerage houses, Roberts said.

“The best way to restore those profits has been to link research coverage with investment bankers,” he said.

Analysts issue reports on companies they cover, recommending that investors either buy, hold or sell the companies’ stocks. Conflicts arise from the fact that most brokerages are also attempting to secure investment banking business (like underwriting stock or bond offerings) from the very same companies.

“It is hard to divorce yourself from the pressure being generated from other areas of your own company,” said Marc Margulis, managing director and head of valuations at Century City-based investment bank Houlihan Lokey Howard & Zukin. “The idea is that there is a wall between the analysts and the investment side. But it is very transparent. There is always pressure not to blow a deal for the investment bankers.”

As a result, “sell” recommendations have become increasingly rare.

CIBC Oppenheimer and Needham & Co., for example, issued “hold” and “market perform” recommendations on Cohr, despite the stock having lost 72 percent of its value since March. Both those firms also have underwritten stock offerings for Cohr.

Rather than issue “sell” recommendations, both firms opted to drop their coverage of Cohr altogether.

“When you don’t know what is going on with a company, you can’t recommend either a ‘sell’ or a ‘buy,’ so you hold,” said Needham analyst Bernard Livola in New York.

Oppenheimer officials were unavailable for comment.

And in August, just as SmarTalk was coming out with news of accounting irregularities and the stock was plunging Salomon Smith Barney downgraded the stock to “neutral” rather than “sell.”

As of last week, Salomon still maintained a “neutral” rating on SmarTalk; the analyst who covers SmarTalk was on vacation last week and unavailable for comment.