As John Maynard Keynes so eloquently stated, "Recessions catch what the auditors miss". This time around the recession also caught an auditor (Arthur Andersen). If coming out of a spectacular stock market bubble is akin to a nasty hangover, then the current accounting debacle is akin to realizing, in your haze, that you have awakened in a strange place, then realizing that somebody has stolen your wallet, and finally, finding your wallet, only to discover that all of your money is missing.

The experience has led the investment community to take a closer look at accounting fundamentals, which took a back seat to several other phenomena occurring in the markets in the late 1990s.

What Happened?

The investment community’s (Wall Street analysts, professional investment managers, the media, and the investing public) obsession with the earnings per share (EPS) number became stronger as the 90s progressed. It is so convenient to boil down the health of a complex organization into one EPS figure. It is great for sound bites on CNBC and helps simplify things for less sophisticated investors. However, EPS rarely, if ever, provides an entirely accurate picture of a company. Surely, the EPS figure and its valuation cousin, the price to earnings ratio (P/E), are useful to the extent that EPS accurately reflects real cash flows. But, as Enron made so clear, the reflection can be a mirage.

The EPS obsession affected professional investors as well. Consider, for example, a telecom fund manager in the late 1990s with the "problem" of investing increasing daily fund inflows into a rising market. The manager sees that WorldCom, for example, has beaten the consensus EPS number by $.01 and would like to spend a few hours or days to analyze the numbers before investing more funds in the company. Too late! WorldCom's stock immediately rises 10% and continues to rise over the next several days. Meanwhile, our "poor" fund manager is under-performing the benchmark as the increasing fund inflows sit in cash while the analysis is performed. This, of course, all works in reverse if the quarterly EPS number is (gasp!) $.01 shy of consensus estimates.

Company management was not blind to this phenomenon. Management teams experience pressures every day from competitors (not only in the traditional sense but, also, in terms of competing for Wall Street’s attention), shareholders, analysts, and employees that own stock and/or options. And, of course, management also owns significant amounts of stock and/or options. These pressures can lead to a more short-term focus as opposed to the long-term value creation that every management team should be striving for.

Although every public company is susceptible to these pressures, it seems that many of the companies involved in the recent accounting scandals have at least one other thing in common: an aggressive corporate culture. Management provides aggressive financial guidance for Wall Street and, in turn, sets aggressive targets for its employees. Big rewards go to the employees that succeed in hitting these targets and failure is not an option. The incentive to "cut corners" then spreads firm wide.

Finally, the auditing system itself was operating in an environment riddled with inherent conflicts of interest. First, the auditors were being paid by the corporations they were auditing. Second, growing ancillary services such as consulting had, in some cases, relegated the basic auditing function to a loss leader when trying to win business from corporations. Additionally, auditors and the Financial Accounting Standards Board (FASB) have generally placed more emphasis on following the "letter of the law" when determining the accuracy of a company’s financials as opposed to emphasizing accounting that enables a clearer insight into a company’s true economic health.

Where Are We Now?

Well, accounting fundamentals are back in vogue again, and investors are demanding transparency. But the subjectivity of accounting can present a murky picture.

Consider the following example: How much are the following two hypothetical companies in the same industry worth, all else being equal?

Arbitrarily assigning a price to earnings multiple of 15 to each company results in a much higher value (2x) for Company B. This seems relatively straightforward: Company B makes more money and, therefore, is worth more than Company A. One might even argue that Company B should be assigned a higher multiple because it has higher margins than Company A.

What if I were to tell you that hypothetical companies A and B are actually the same company using two different inventory valuation methods for their inputs to production during an inflationary period? Company A uses the LIFO (Last-in-First-Out) method, while Company B uses the FIFO (First-in-First-Out) method of accounting for inventories. Or, maybe the company uses LIFO in scenario "B" as well but has slowed down inventory buildup and begins to use "older" and "less costly" supplies. This translates to a lower cost of goods sold and higher profitability on the income statement. Does the decision to use a different inventory valuation method change the value of a company?1 Of course not.

In our example, a company's choice of inventory valuation has an effect on its financial statements. This was probably the first thing you learned in Accounting 101, along with the fact that a company must disclose its methodology in the footnotes to its financial statements. You may also recall the effects of the selected methodology on the balance sheet (and financial ratios); namely Company A’s inventories would be understated (as compared to market or replacement costs) when it uses LIFO in an inflationary environment. And, as illustrated above, the methodology selected can affect accounting earnings. It does not, however, affect the real cash flow of the company.

Companies must make assumptions in several areas of accounting, such as the expected return on their pension fund, the useful life of an asset, or when to recognize revenue, to name just a few. However, absent fraud, none of these accounting practices will change the real value of a company. So, to summarize what we all should have learned in Accounting 101: (1) Get behind the numbers, (2) Get behind the numbers, and (3) Do not make fun of your accounting professor’s glasses.

We would argue that a more precise valuation of a company could be achieved through an analysis of the present value of future free cash flow (FCF).

As an insurance professional, you clearly appreciate that the value of any asset is the present value of future cash flows. A 30-year AAA-rated municipal bond, for example, is currently priced at a 4.84% yield to maturity. And, for illustrative purposes, let us assume that a AAA municipal bond is risk free. So, this means the market is placing approximately a 21x free cash flow multiple on a long duration "risk free" asset. We can use this as a "stepping-off point" to valuing an equity security. Clearly, equities are riskier, so we can expect a lower multiple of FCF (i.e., higher discount rate), all else being equal. However, there is an expected growth component to most equities, which implies a higher multiple of FCF (i.e., lower discount rate).2

The point here is that we only care about accounting to the extent that it enables us as investors to arrive at the real cash flows of a company. Generally speaking, if we don’t have complete trust in the accounting numbers that we use to arrive at a company’s true cash flow, we as investors will require a higher risk premium (lower multiple) for the company in question. This reality has been painfully clear thus far in 2002.

What should your manager be doing now?

Long before Enron was in the news, Brown Brothers Harriman had prided itself on performing independent, in-depth research including rigorous financial statement analysis. However, shortly after Enron declared bankruptcy, our portfolio management and research teams undertook an accounting review of our favorite companies. We thought the environment warranted such an exercise and, if nothing else, it was an indication of our respect for market sentiment.

We reviewed the financials of our favorite names with several yellow and red flags in mind — flags such as off-balance sheet items, highly acquisitive history, and optimistic pension return assumptions, to name a few. Our intentions were to jettison those positions with red flags and to look deeper into any positions in which we identified yellow flags. Upon completing the analysis of any yellow flag situation, we would be either extremely comfortable with our conclusions or we would sell the stock.

We are pleased to report that our model portfolios did not own any Enron, Global Crossing, or Adelphia. The model portfolios did own WorldCom at one point, but it was sold in 2000, long before any accounting worries. Our focus on accounting issues has allowed us to avoid many other torpedoes as well. It has also enabled us to buy into oversold stocks that may be victims of the "throwing the baby out with the bath water" syndrome. Similarly, it has prevented us from jettisoning positions into panic selling days due to "accounting worries" because we have done the homework and are comfortable with a certain company’s policies.

Looking Forward

Much has taken place in the accounting world since the Enron debacle. There is no need to rehash here what you have read in the newspapers and see on TV every day. It has been a painful experience for many investors. Although neither the revelations nor the volatility may be over, there are some reasons to be optimistic. The government has stepped up with several initiatives, not least of which is the SEC requirement that the CEOs and CFOs of the top 945 companies by revenue certify their financial statements. The prospect of potential personal liability should act as a strong deterrent going forward. The market itself and what it does to a company’s stock when there is even a whiff of malfeasance is another strong deterrent. And, not coincidentally, companies are increasingly providing more disclosure in their financial reports. Increased disclosure and greater confidence in companies’ reported numbers are both positives for the capital markets and our economy. Investors’ ability to confidently arrive at true cash flow numbers for our corporations will help keep the cost of capital down and help spur investment over the long run. Now, we just need something to kick-start this economy.