Plus: How the pros do it


                    [I]n January, for the 41st time in the 42 quarters

                        since it went public, Microsoft reported earnings

                        that met or beat Wall Street estimates. The 36

                        brokerage analysts who make the estimates were, as a

                        group, quite happy about this--the 57 cents per share

                        announced by the software giant was above their

                   consensus of 51 cents, but not so far above as to

                   make them look stupid. Investors were happy too,

                   bidding the already high-priced shares of the company

                   up 4% the first trading day after the announcement.


                   In short, for yet another quarter, Microsoft had kept

                   its comfortable spot in the innermost sphere of

                   corporate paradise. This is what chief executives and

                   chief financial officers dream of: quarter after

                   quarter after blessed quarter of not disappointing

                   Wall Street. Sure, they dream about other things

                   too--megamergers, blockbuster new products, global

                   domination. But the simplest, most visible, most

                   merciless measure of corporate success in the 1990s

                   has become this one: Did you make your earnings last



                   This is new. Executives of public companies have

                   always strived to live up to investors' expectations,

                   and keeping earnings rising smoothly and predictably

                   has long been seen as the surest way to do that. But

                   it's only in the past decade, with the rise to

                   prominence of the consensus earnings estimates

                   compiled first in the early 1970s by I/B/E/S (it

                   stands for Institutional Brokers Estimate System) and

                   now also by competitors Zacks, First Call, and

                   Nelson's, that those expectations have become so

                   explicit. Possibly as a result, companies are doing a

                   better job of hitting their targets: For an

                   unprecedented 16 consecutive quarters, more S&P 500

                   companies have beat the consensus earnings estimates

                   than missed them.


                   Microsoft's prodigious record of beating expectations

                   is due in large part to the company's prodigious

                   growth, from annual revenues of $198 million at the

                   time of its IPO in 1986 to more than $9 billion now.

                   It also helps that it dominates its industry. But

                   even the Microsofts of the business world have a few

                   tricks up their sleeve. The most obvious is to manage

                   earnings. "Managing earnings" has a pejorative,

                   slightly sleazy ring to it, but even at the most

                   respected of companies, accounting and business

                   decisions are regularly made with smoothing or

                   temporarily boosting earnings in mind. Not all are as

                   up front about it as General Electric, where

                   executives say openly that they don't think their

                   company would be as popular with investors if its

                   profits weren't so consistent and predictable. But

                   neither can it be a complete coincidence that of the

                   top ten companies on FORTUNE's 1997 Most Admired

                   list, seven--Coca-Cola, Merck, Microsoft, Johnson &

                   Johnson, Intel, Pfizer, and Procter & Gamble--have

                   missed fewer than five quarters in the past five

                   years, according to I/B/E/S (and two of the other

                   three don't have any earnings estimates to meet).


                   Meeting the estimates is made easier by the fact that

                   they're not set in a vacuum--analysts rely heavily on

                   guidance from companies to form their forecasts, and

                   companies have in recent years figured out that it

                   pays to guide the analysts to a lower rather than a

                   higher number. At least partly as a result of this

                   expectational interplay, the price of missing a

                   quarter has risen sharply, particularly among

                   high-priced growth stocks. In the growth stock

                   fraternity, "missing by a penny" now implies the

                   height of corporate boneheadedness--that is, if you

                   couldn't find that extra penny to keep Wall Street

                   happy, then your company must really be in trouble,

                   and since missing by a penny is already going to send

                   your stock plummeting, you're better off missing by a

                   dime or two and saving those earnings for the next




                                                Microsoft missed by a penny

                                        once--back in 1988, when such

                                        behavior was not yet considered

                   unbearably gauche. Nowadays its executives treat

                   analysts to a constant patter of cautionary and even

                   downbeat words about the future that the analysts say

                   is a mix of genuine paranoia and astute expectations

                   management. After a typically grim presentation by

                   CEO Bill Gates and sales chief Steve Ballmer at an

                   analysts' meeting two years ago, Goldman Sachs

                   analyst Rick Sherlund ran into the pair outside and

                   said, "Congratulations. You guys scared the hell out

                   of people." Their response? "They gave each other a

                   high five," Sherlund recalls. But Microsoft, unlike

                   some companies less attuned to the rules of this

                   game, also lets analysts know when they're too

                   pessimistic. That's what CFO Mike Brown did, along

                   with the usual warnings about slower growth ahead,

                   during his regular quarterly conference call after

                   the January 17 earnings release. He told the hundreds

                   of analysts, money managers, and journalists

                   listening in that earnings would be "more than a

                   nickel, less than a dime" higher than predicted for

                   the current quarter, and another penny higher in the



                   How did he know this? That involves something that

                   looks a lot like earnings management--although not of

                   the sort that provokes penalties from the Securities

                   and Exchange Commission or nasty newspaper articles

                   about inflated profits. Starting around the unveiling

                   of Windows 95 in August 1995, Microsoft has followed

                   a uniquely conservative method of accounting for the

                   software it ships--deferring recognition of large

                   chunks of revenue from a product until long after the

                   product is sold. The reasoning is that when somebody

                   buys software in 1996, they're also buying the right

                   to upgrades and customer support in 1997 and 1998. If

                   it hadn't been for the new accounting technique, the

                   company would have had to report a sharp rise in

                   profits in the latter half of 1995, then a sharp drop

                   in the first half of 1996--a turn of events that

                   might have sent its stock price reeling--instead of

                   the smoothly rising earnings that it did post. By the

                   end of 1996, Microsoft had taken in $1.1 billion in

                   "unearned revenue" that it had yet to recognize on

                   its income statements. "Because of this, they know

                   what they've got in the bag from one quarter to the

                   next," says Marshall Senk, a Robertson Stephens

                   analyst who follows the company. Which leads him to

                   conclude that "Microsoft does a better job of

                   leveraging accounting--I would almost say it's a

                   competitive weapon--than anybody else in the



                   Microsoft treasurer Greg Maffei doesn't like this

                   interpretation. "I'm a financial officer of this

                   company, and I would be in deep doo-doo with the SEC

                   if that was what was driving our revenue recognition

                   policies," he says. "Our revenue recognition policies

                   are driven by GAAP." Which isn't quite true. In fact,

                   GAAP--the Generally Accepted Accounting Principles

                   companies follow in preparing financial

                   statements--may in this area be driven by Microsoft.

                   Virtually no other software company does its

                   accounting the way Microsoft does, but standards

                   setters, egged on by the industry leader, are

                   starting to push in that direction.


                   That's how GAAP works. It's constantly changing and

                   evolving, particularly in businesses that haven't

                   been around for long. This is only natural, but it

                   can be maddening for people trying to understand what

                   a company's reported earnings really mean. "With

                   industries that haven't been in the market before,

                   you tend to see a lot of monkey business because

                   accountants, even if well intentioned, don't know

                   what the standards are," says Martin Fridson,

                   high-yield debt strategist at Merrill Lynch and a

                   financial statement analysis guru. "Underwriters of

                   small companies and people who make a living doing

                   IPOs are very conscious of the market's inability to

                   see what the correct measures are." Add that

                   confusion to the general cacophony of accounting

                   quirks and judgment calls in financial statements,

                   and you begin to realize that earnings are nothing

                   but a vague, approximate measure anyway.


                   One of modern accounting's guiding principles is that

                   of matching revenues and expenses over time. That's

                   why the cost of building a factory that will be

                   churning out cars for 20 years gets expensed over

                   those 20 years, not when the money is actually spent.

                   But such matching requires making all sorts of

                   guesses and estimates about the future. These

                   judgments--how much to set aside for potential loan

                   losses, what rate of return to expect on a pension

                   fund, over how many years to spread out the cost of a

                   factory--make earnings a better reflection of the

                   long-term economic health of a company. They also

                   provide ample room for managers to fudge. This is why

                   financial analysts and money managers are supposed to

                   know how to look beyond a company's bottom line to

                   find the true economic value in its balance sheet or

                   cash flow statement or, best of all, the footnotes to

                   its financial statements. In the bull market of the

                   past 15 years, however, analytic rigor hasn't always

                   been required to make good stock picks. "Nobody's

                   paying attention," says Robert Olstein, who in the

                   1970s co-authored an influential newsletter called

                   the Quality of Earnings Report and now runs the $140

                   million Olstein Financial Alert fund.


                   If Microsoft is the archetype of a hugely successful

                   company trying to tone its earnings down so people

                   don't get their expectations too high, Boston Chicken

                   bespeaks an altogether different and more common

                   phenomenon. It is a business that isn't successful

                   yet but has used accounting to help convince

                   investors that it already is, or at least will be

                   soon. This has enabled it to raise more than $800

                   million in stock and convertible debt offerings,

                   money which has been essential not only to the

                   company's rapid growth--from 175 Boston Chicken

                   restaurants when it went public in one of the

                   decade's hottest IPOs in November 1993 to 1,100

                   restaurants (rechristened Boston Markets) and 325

                   Einstein Brothers and Noah's bagel stores today--but

                   to its very survival. That's because, economically

                   speaking, Boston Chicken is still a big money loser,

                   as probably can be expected of a startup restaurant

                   chain. All the losses, however, have been incurred by

                   "financed area developers," or FADs, which is Boston

                   Chicken lingo for large-scale franchisees that act a

                   lot like subsidiaries but aren't. If they were, their

                   losses would have to be reported on Boston Chicken's

                   income statement (they are instead disclosed, on an

                   annual basis only, deep in the text of the company's

                   SEC filings). The FADs get 75% of their startup

                   capital in loans from Boston Chicken, and with that

                   money they pay the company the royalties, franchise

                   fees, and interest that allow it to report

                   ever-rising profits. Once the restaurants start

                   making money, Boston Chicken exercises its right to

                   convert the loans into equity, officially dubbing the

                   FADs subsidiaries and allowing their profits to flow

                   to its bottom line.


                   That's the plan, at least, as

                   outlined with somewhat more

                   delicacy in the company's 1993

                   annual report. And so far it has worked. Sure,

                   business publications have printed nasty articles

                   about the company, accounting professors have warned

                   their students about it, and shortsellers have lined

                   up in droves to place bets that its stock price will

                   crash. But Boston Chicken's stock price has more than

                   held its own. Part of investors' sanguinity has to do

                   with the track record of the two former Blockbuster

                   Entertainment bigwigs who run it, CEO Scott Beck and

                   President Saad Nadhir, and the belief that America

                   really is hungry for takeout chicken, ham, and meat

                   loaf. But it sure doesn't hurt, analysts and money

                   managers say, that not only is Boston Chicken able to

                   report earnings every quarter, but those earnings

                   have so far never failed to meet or surpass analysts'

                   expectations--even though those analysts all know

                   that the earnings in no significant way reflect how

                   the company is doing. "It's a very smart strategy,"

                   says Michael Moe, a growth stock strategist at

                   Montgomery Securities. "It has made enormous amounts

                   of capital available to them at an attractive price

                   that most companies can only dream of."


                   Boston Chicken CFO Mark Stephens says his company was

                   structured not to please Wall Street but to provide

                   flexibility and motivate its franchisees. But he

                   acknowledges that "a byproduct of where we are with

                   the structure is that we have a public entity with an

                   earnings complexion that is attractive." He adds:

                   "It's like sausage. I love the product; just don't

                   show me how it's made."


                   Another company that has used aggressive accounting

                   to raise money is America Online. AOL's practice of

                   capitalizing and writing off over two years the cost

                   of those ubiquitous free disks and ads it used to

                   lure members was highly controversial, and was

                   abandoned in October. But for years it allowed the

                   company to post earnings most of the time instead of

                   losses, which helped it to raise more than $350

                   million on the stock market. Says Wharton School

                   accounting professor Richard Sloan, referring to both

                   Boston Chicken and AOL: "They just view accounting as

                   another marketing tool that they should use to try

                   and promote their ideas."


                   Boston Chicken and America Online are extreme cases.

                   So is Microsoft. The mass of companies lead lives

                   somewhere in between. When they manage earnings, they

                   do it simply to smooth the ups and downs of business

                   life, and of course to meet those Wall Street

                   earnings estimates. Is there evidence of widespread

                   earnings management? You bet. Looking at 17 years of

                   I/B/E/S data on more than 1,000 companies, Jeff Payne

                   of the University of Mississippi and Sean Robb of

                   Canada's Wilfrid Laurier University found an

                   unmistakable pattern of using accruals (i.e.,

                   judgment calls) to manage earnings upward if they

                   were below the analysts' consensus and a somewhat

                   less pronounced trend of managing them downward if

                   they were above the consensus.


                   General Electric, a company whose name invariably

                   comes up when you ask Wall Streeters about earnings

                   management, says it does what it does because the

                   stock market demands it. "We think consistency of

                   earnings and no surprises is very important for us,"

                   says Dennis Dammerman, the company's CFO. "We're a

                   very complex, diverse company that no one from the

                   outside looking in can reasonably be expected to

                   understand in complete detail; so our story to the

                   investing world is, we have a lot of diverse

                   businesses, and when you put them all together they

                   produce consistent, reliable earnings growth." And if

                   something inconsistent comes along--say, a one-time

                   gain from selling off a factory--"we have a pretty

                   consistent record of saying, 'Okay, we're going to

                   take these large gains and offset them with

                   discretionary decisions, with restructurings.'"


                   These tactics have helped GE meet or beat

                   expectations every quarter but one in the past five

                   years, and they certainly haven't hurt it among

                   investors, even skeptical ones. "They are using all

                   sorts of techniques to smooth earnings," says Howard

                   Schilit, whose Center for Financial Research and

                   Analysis keeps institutional investors posted on

                   companies whose earnings numbers may be hiding

                   business troubles. "If I wrote that to my clients,

                   there would be a big yawn."


                   Another investor favorite that produces awfully

                   smooth earnings is Coca-Cola, which in the third

                   quarter of last year took advantage of $520 million

                   in one-time gains from a settlement with the IRS and

                   the sale of some bottling operations to recognize

                   $500 million in supposedly one-time hits to earnings.

                   One of those hits, $200 million used to reduce the

                   inventories of soft drink concentrate at bottling

                   companies, was explained as a move to free up

                   bottlers' capital but was seen by some as an

                   admission that Coke had been shipping concentrate

                   early to artificially boost earnings. That hurt the

                   company's stock price for a few months, but by taking

                   the charge Coke gave itself the option of using

                   inventory buildup at its bottlers to pad profits

                   later. "When they pull it out in 1998 or 1999 to keep

                   up their 19% or 20% earnings growth, everyone will

                   have forgotten," says Roy Burry, who follows Coke for

                   Oppenheimer & Co.


                   Will everyone really forget? If financial markets are

                   in fact efficient, economic reality will in the long

                   run win out over accounting games. But the long run

                   can seem awfully far away when you've got a posse of

                   analysts breathing down your neck every three months.

                   Many corporate executives also seem to think

                   investors take earnings numbers at face value; they

                   write outraged letters to the Financial Accounting

                   Standards Board, accounting's top rule-making body,

                   whenever it proposes a change that might reduce

                   reported earnings. "They obviously don't believe in

                   efficient markets," says Neel Foster, a FASB member

                   and former treasurer of Compaq Computer. "Academic

                   evidence shows that generally, accounting changes

                   don't result in changes in stock prices. But it also

                   shows that people that make greater disclosures

                   generally have a lower cost of capital. They don't

                   believe that either."


                   Even this doesn't explain why some companies seem to

                   persist in managing earnings in the face of Wall

                   Street disbelief. Food maker H.J. Heinz grew rapidly

                   during the 1980s but has since needed repeated asset

                   sales and other special items to keep earnings

                   steady--and its stock has lagged. Last June the

                   company announced quarterly earnings of 45 cents a

                   share but failed to mention that four of those cents

                   came from the sale of a magazine and two pet food

                   brands. It was "immaterial," a company spokesman says

                   now, but it nevertheless infuriated some analysts,

                   who found out only when they received the annual

                   report a month later. It didn't help the stock price

                   either, although the stock later bounced back on

                   rumors of a major restructuring.


                   What might motivate such corporate behavior? One

                   answer is money. High-level executives like to get

                   paid a lot, and it so happens that many bonus

                   plans--including the one at Heinz--are built around

                   meeting earnings targets. The rise of

                   performance-related bonuses has taken earnings

                   tweaking to new heights, say some market watchers.

                   There's no reliable measure of such activity, but one

                   rough gauge, comparing profits reported to the

                   Internal Revenue Service by U.S. corporations with

                   profits reported to shareholders (the measure that

                   counts for bonuses) by companies on the S&P 500,

                   gives a clue. It shows some wild relative swings in

                   S&P earnings in the late 1980s and early 1990s,

                   probably a result of big corporations using one-time

                   charges to pay for restructuring costs like plant

                   closures. This write-off binge ended in 1994, which

                   could mean either that earnings quality is getting

                   better or that companies are coasting to ever higher

                   earnings now because they hid ongoing costs back



                   While there's no conclusive proof that managing

                   earnings is on the rise, it is undeniable that the

                   game is being played more aggressively than ever.

                   This isn't necessarily bad: "The good side of what a

                   lot of people call the game of managing expectations

                   is that companies realize that they have to give

                   better guidance to the market as to what their

                   prospects are," says Ed Keon, senior vice president

                   for marketing at I/B/E/S.


                   The downside of giving better guidance--apart from

                   the hours of valuable top management time that it

                   eats up--is that the investors most interested in the

                   estimates are not exactly the well-run corporation's

                   best friend. They are the momentum guys--mutual fund

                   managers and hedge fund jockeys and individual

                   investors--who jump on the bandwagon when a company's

                   earnings growth is accelerating and beating the

                   analysts' estimates, and jump off the second it

                   misses a quarter.


                   "When it stops, they sell--you cannot break this

                   algorithm," says a resigned Eric Benhamou, chief

                   executive of 3Com Corp., which lost $7 billion in

                   market value in a matter of weeks this year as it

                   became known that its earnings for the quarter ended

                   February 28 would not meet analysts' expectations.


                   The moral of the story: Unless you're a trader,

                   ignore the short-term kabuki that the companies and

                   the analysts perform for each other, but educate

                   yourself about the accounting games that companies

                   play. If enough investors did, it could mean that the

                   smartest earnings and expectations management

                   strategy of the 2000s will be--don't bother.




                   HOW THE PROS DO IT


                   Plan ahead: Time store openings or asset sales to

                   keep earnings rising smoothly. In most cases, this is

                   earnings management at its least controversial. The

                   master of it is General Electric.


                   Call it a sale: Madly ship products during the final

                   days of a weak quarter, or hold off if the quarter's

                   already in the bag. There's leeway in revenue

                   recognition too: Tech companies often book sales

                   aggressively to boost profits, but Microsoft is now

                   demonstrating the virtues of belated recognition.


                   Capitalize it: Usually it's pretty clear which costs

                   you capitalize and which you expense. But there are

                   gray areas--software R&D is one--and you can get

                   creative about the length of time an asset should be

                   depreciated. America Online was, until it stopped in

                   October, a noted aggressive capitalizer.


                   Write it off: Take a "big bath" and charge a few

                   hundred million in restructuring costs, and meeting

                   future earnings targets will be easier. Among the

                   biggest restructurers of the 1990s: IBM.


                   Use your reserves: Build them up for product returns,

                   bad loans, and insurance losses; drain them down to

                   bolster earnings when business sags. Outsiders say

                   this is one of the secrets of GE's success, but the

                   company says that's just not true.


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