Are Companies Using
Restructuring Costs To Fudge the Figures?
During the first day of your introductory finance
course your professor most likely told you that
maximizing earnings was not a good objective of the firm
and that you should maximize the value of the firm. The
reasoning behind it was that accounting earnings can be
legally manipulated upward, and that they ignore the risk
of the company’s cash flows. Here is an example of
the former where restructuring is used to fudge the
earnings figures, and the market’s reaction to such
an event.
Quotation 1
"Wall Street cheered when AT&T Corp.
announced drastic cutbacks of 40,000 employees and a
$4 billion restructuring charge on Jan. 2.
AT&T’s stock surged $2.625 a share to
$67.375 on the company’s vow to get into
fighting trim before splitting into three parts
starting later this year."
Comments: The fact that AT&T’s
stock price went up indicates that "the
market" believes that the restructuring has
created value to shareholders equal to about $2.625.
Of course, you cannot tell the precise added valued
from this number alone, as the market could have
already discounted part of the benefits in earlier
days and/or there was additional news on the same day
that was also incorporated in the price.
Quotation 2
"AT&T is only the latest corporate
giant to draw attention to how repeated restructuring
can muddy a company’s earnings picture. The same
sort of confusion has been sown at dozens of others,
from General Signal Corp. to McCormick & Co. to
International Business Machines Corp."
"Critics say that restructuring may
distort companies earnings history, packing losses
into a single quarter in a way that makes past and
future earnings look better. . . Here’s how this
kind of charge can boost earnings. Say company XYZ
reports rising profits of $1 million in Year One and
$1.2 million in Year Two. In Year Three, XYZ takes a
restructuring charge of $5 million for cost of
closing a few businesses. The charge turned Year
Three’s net into a loss of $3.5 million-but XYZ
says profit would have been $1.5 million before the
charge. The next year, Year Four the upward trend
resumes as XYZ reports profits of $1.8 million. But
the results are helped because $2 million of the
company’s Year Four expenses - say, for
severance payments and plant closings - can be
counted against the charge already taken in Year
Three."
Comment: The quote is a good illustration
of how fudging might work.
Quotation 3
". . . such charges have the effect of
‘deluding the investor into thinking that things
are better than they are,’" according
to Walter Schuetze, the former chief accountant of
the SEC.
Comments: There are probably still a few
individual investors who take reported earnings at
face value. They should take a finance course or
subscribe to this service! Valuing corporate assets
are quite complicated even without such fudging.
Sophisticated firms typically use some form of
discounted cash-flow models or EVA (Economic Value
Added) to estimate the value that might be created
when a certain corporate action is taken.
Source: WSJ,
1/30/96, p. A1
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