Value investors depend on earnings statements to make valuations of stocks. When these statements can not be trusted, how can dependable decisions be made? In an article published a few days ago (August 2), I complained about two sets of books for many American corporations (here). I was referring to the GAAP (Generally Accepted Accounting Principles) "reported" earnings and the "operating" earnings, which have grown in recent years to be often much larger.
The inference in the previous article was that "reported" earnings might be more reliable than "operating" earnings. Now I am forced to recognize that neither set of books may be reliable. In an ft.com article (here). Francesco Guerrera and Joanna Chung write about a $50 million fine paid by General Electric for use of improper accounting methods.
From the ft.com article:
“GE bent the accounting rules beyond the breaking point,” said Robert Khuzami, director of the SEC’s division of enforcement.
Also from the article:
In a statement, GE said the accounting errors “fell short” of its standards. But the conglomerate added it was “committed to the highest standards of accounting” and had cooperated with regulators throughout the four-year probe.
In a related item from the same article (comparing to the action against GE):
The action also underlines the aggressive stance taken by Mary Schapiro, the agency’s new head, coming the day after Bank of Americaagreed to pay $33m to settle SEC allegations that it misled investors during the acquisition of Merrill Lynch.
Bill Cara suggests (here) that there should be a Grand Jury investigation. Cara writes:
A late-night deal on Sept 14, 2008, between Bank of America CEO Ken Lewis and Merrill Lynch CEO John Thain agreed to a bail-out of the Merrill Lynch shareholders for $50 billion. This was one of the worst deals in history because, as I stated at the time, how can a banker buy liabilities without knowing the extent of those liabilities. That’s not what bankers do.
There ought to be a grand jury investigation over this matter. But more than anything the public ought to understand that deals are done often because of the egos involved, but without the brains to require post-deal adjustments for contingencies that both parties in this case absolutely knew were ballooning leading up to and throughout this period.
At the end of the day, prosecutors cannot just look into the leadership of Messrs Lewis and Thain, but to all the senior officers on both sides of the deal, and to the Fed and Treasury, who were involved at the time, and who covered tracks later. I have no doubt there was criminality involved. Moreover, I know that the public as well as the shareholders of each of these companies needs absolute transparency. Without it, capital markets fail.
Wall Street veteran Larry Doyle, writing at his blog, Sense on Cents (here), feels that hedging activities at many financial institutions hold many potential problems, including future discovery of fraud perpetrated during the current and recent time frames.
It may be some time before classical valuation methods based on income statements, balance sheets and forward looking estimates can be used effectively.
Disclosure: The author and clients own GE.