Dubious Reported Earnings

The Creation of Dubious Reported Earnings through “Creative” Accounting Procedures

A firm's income statement may be linked to a bikini – what it reveals is interesting but what it conceals is vital. National Student Marketing, one of the concept stocks, led the beauty parade in this regard. Andrew Tobias described it all in the Funny Money Game.

In its fiscal 1969 report, National Student Marketing made generous use of terms such as “deferred new product development and start-up costs.” These were moneys actually spent during 1969 but not charged against earnings in that year. “Unamortized costs of prepared sales programs” carried the ploy even further. These were advertising expenses that were not charged against earnings on the flimsy excuse that they would produce sales in the future. Subsidiary losses were easily handled: The companies were simply sold, removing their unfavorable results from the consolidated accounting statement. Actually it wasn't quite that simple, because the sales were consummated after the close of the fiscal year – but the accountants had no difficulty in arranging for the sale retroactively.

Since expenses were uncounted, why not count unearnings? N sooner said than done. These were duly noted in the sales column as unbilled receivables, on the justification that the actual billing of the sales could be expected to materialize in the future. Finally came “the $3,754,103 footnote.” Almost 44 million was added to net income in the form of earnings from companies whose acquisitions were “agreed to in principle and closed subsequent” to the end of fiscal 1969.

Dubios reported earnings. Photo by Elena

It turned out that even accepting the rest of the creative accounting, if you didn't count the earnings of companies that were not legally part of the National Student Marketing in 1969, the company barely broke even. Of course, the imprimatur of a prestigious accounting firm was affixed to the bottom of a statement assuring the public that the accounts were prepared in accordance with “generally accepted accounting principles.” (In 1972 the Securities and Exchange Commission charged National Student Marketing Corp., its auditors, two law firms, and fifteen individuals with violations of federal securities laws. Included in the SEC suit was a charge that the company had issues “materially false and misleading” financial statements. Cortess Randell,, the company's chief executive officer, served a prison sentence. A partner of the accounting firm of Peat, Marwick, Mitchell & Co., was convicted of having made false and misleading statements.

Similarly, Barry Minkow's late 1980s carpet-cleaning empire ZZZZ Best, was built on a mosaic of phony credit card holdings and fictitious contracts. These two are admittedly extreme examples, but the general problem is not uncommon. Seeming miracles can be accomplished with depreciation; the peculiarities of conglomerate accounting; the franchise accounting game; and the special features of the reports of land-sales companies, computer-leasing companies, and insurance companies. It is small wander that security analysts have trouble estimating reported future earnings.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.