We don’t need no stinkin’ Congressional hearings. This whole accounting mess can be cleared up by simply defining the word materiality.
Have you ever tried driving your car by only looking in the rearview mirror? That is exactly what it is like being an investor. You study the past to reveal hints of the twists and turns of the road ahead. Oh yeah, and it’s foggy in front of you and your passenger seat is filled with analysts and industry sources and newspaper reporters and talking heads yelling often conflicting advice on where to turn.
The best information on a company comes from the company itself, in the form of quarterly disclosures, which investors use to figure out ongoing business trends vs. one-time events. But management guided by accountants hides behind the vague meaning of “materiality,” or what actually has to be disclosed.
The margin of materiality was first used to cover honest mistakes by accountants. As in: “Oh, we missed counting a few widgets, but it’s not a material enough amount to bother correcting.” But what is considered material? No one knows. In the past, the Securities and Exchange Commission has gone by the scientific definition of materiality as something that someone somewhere might consider important.
In 1998, the Financial Accounting Standards Board got more specific. Something was material when it was big enough that “the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement,” it said. Accountants use a rule of thumb that something larger than 5% or 10% is material. But 5% to 10% of what? Revenue? Assets? Profits?
As an investor, whenever I asked a CEO for more details on the last quarter, a further breakdown of revenues, prices, or who’s buying a hot new product, I was usually told the details were not material, meaning they were less than 10% of current revenues, even though that hot product might soon be half of the company’s business. The next favorite response was that management couldn’t tell me for “competitive reasons.”
I always felt like saying, “Look pal, I’m an owner of your company. I’m trying to make a decision whether to buy more shares, which would push up your stock price, allow you to raise cheaper capital, employ more option-hungry engineers, so you can kill your competitors, who told me about this hot product in the first place.”
But, like Enron, many companies held back disclosures by hiding behind materiality thresholds. As a $100 billion company, anything less than $10 billion at Enron was not considered material.
As an investor, flying blind, I want to know everything you can tell me. Don’t tell me it would be information overload, I have spreadsheets, I can handle it. Plus there are thousands of Wall Street analysts with not much to do who will gladly pour through these details and form an opinion.
A few weeks ago, Tyco got around to mentioning it did over 700 acquisitions totaling $7 billion in 1999-2001, $4 billion just last year, and the stock promptly halved. They may have been 700 of the greatest companies, but to paraphrase Dr. Strangelove, “The whole point is lost if you keep it a secret. Why didn’t you tell the world, eh?”
Global Crossing got snagged doing capacity swaps on the last day of the quarter, which boosted reported revenues, but not much else. These swaps of Indefeasible Rights of Use (IRUs) were disclosed, as they totaled almost 25% of revenues in Global Crossing’s last quarter before filing Chapter 11. But no other details were given. And the company invented an adjusted cash flow to report to investors. Guess which way it was adjusted.
OK, so Enron, Tyco, Global Crossing — maybe those guys were just a bunch of cowboys. Real companies disclose, right?
Not really. The bluest of the blue chips is IBM and it just got lost in the Sea of Materiality as well. IBM sold an optical component division to JDS Uniphase for a $300 million gain. But rather than reporting it as a one-time gain, IBM used it as an offset to lower its expenses, so it magically flew under the radar. IBM’s revenues in the last quarter were $22 billion, so $300 million is noise. But after-tax profits were $1.3 billion, which investors assumed represented an ongoing trend. Three hundred million dollars in hidden expense reductions means profits were legally overstated by up to 20%. By management refusing to ratchet down the materiality dial, investors were duped. Is this the Lou Gerstner legacy?
As an “average prudent investor,” to borrow the SEC’s lingo, I hereby declare that for me to be reasonably informed the materiality threshold should be 1%. While SEC chief Harvey Pitt now wants more oversight for accountants, all we need to do is recommend companies use 1% materiality. And make it voluntary.
When a company releases earnings, it should be required to include its materiality threshold. Want to stay at 10%? Fine, just tell me. Oh, your stock may trade at a lower earnings multiple, though, since no one can trust your earnings. Want to claim a 1% materiality threshold? Great, but you better back it up with all sorts of details on how revenues break down, prices, large customers and so on.
General Electric’s stock is down 30% from its May 2001 peak, because investors are worried that the House That Jack Built is increasingly a giant hedge fund with unknown risks. GE Capital, after all, is 40% of its business. In response to investor concerns, CEO Jeffrey Immelt now plans to provide sales and earnings details on 14 financial business units. That feels like a 3% disclosure. Every company in the S&P 500 should follow suit.
Don’t have that much detail at hand about your own company? I’d get your numbers-crunchers on it real quick. If you don’t want to disclose information, stay private, and try borrowing money from your local bank.
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