COOKING THE BOOKS TO FATTEN PROFITS

Things are seldom what they seem. Skim milk masquerades as cream; High lows pass as patent leathers; Jackdaws strut in peacock feathers.

LITTLE Buttercup's wry observation in Gilbert and Sullivan's Pinafore applies with prophetic accuracy to much of today's corporate enterprise. There are dozens of legal ways in which companies can juggle their books to inflate profits. The most common objectives are to camouflage a poor earnings performance, to help lift the price of common stock, and to promote--or fend off--mergers. Many conglomerate corporations owe their recent ascendancy at least in part to such practices. The trend has spread confusion among security analysts and investors; it has fired acrimonious debate among businessmen and accountants; it has provoked concern among regulatory authorities.

Elastic Rules. In one effort to limit such legerdemain, the Securities and Exchange Commission expects within a week or two to tighten the disclosure rules for companies seeking to float securities. Companies will be required in registration statements to divulge their sales and pretax profits for each line of business that contributes more than 10% to the total. Firms that engage in only one activity will have to abide by the 10% rule in showing sales by product or service. Though the new regulations will not apply directly to annual reports, many companies have already begun revealing operating data once deemed too sensitive to publicize. Borden, Bangor Punta, W.R. Grace and National Distillers & Chemical, for example, all issued reports this year showing sales and profits for every division.

Welcome as such facts will be to investors, the new SEC rule only reaches the foothills of a Himalayan problem. Accounting practices, on which laymen rely as a warrant of truth, have grown increasingly elastic. Tax laws give companies great latitude in deciding how to treat both assets and costs that affect profits. Frequently, companies quite legally report results one way to the public and another to the tax collector. The conglomerates in particular are worried. Says Chairman Laurence Tisch Jr. of Loew's Theaters: "Accounting tricks are taking over. There's no rule on how to keep the books. You can make up your own mind."

Shifting Depreciation. An increasingly popular stratagem is for companies to reduce the rate at which they write off --that is, deduct from their taxable income--the cost of new facilities. The results can be astonishing. U.S. Steel raised last year's reported profits 59% above what they otherwise would have been, from $159 million to $253 million, largely by switching from rapid to straight-line depreciation of its huge investment in mills and other properties. The change reduced the amount that the company set aside on its books to reflect the degree by which its plant and equipment wore out in 1968. Net income increased, just as it would after a reduction in any other expense. Most other steelmakers took similar steps, partly to prevent unwanted takeovers by conglomerates.

For Trans World Airlines, depreciation changes converted what would have been an $11.5 million loss from airline operations into a $9.1 million pretax profit. TWA saved $20.6 million in current "costs" simply by spreading the depreciation of most of its planes over twelve or 14 years, instead of eleven years. Other income and credits, including $6.2 million from TWA-owned Hilton International, raised the line's reported net to $21.2 million.

B.F. Goodrich Co., fighting a takeover by Northwest Industries, increased its 1968 profit from $2.76 per share to $3.25 through two maneuvers. The company shifted to straight-line depreciation and changed its method of tabulating earnings. Higher profits, of course, would tend to lift the price of Goodrich's stock --making it more difficult for Northwest to buy control.

Wrangling with Bankers. Confusion has arisen despite--and partly because of--a seven-year effort by the American Institute of Certified Public Accountants to standardize corporate reporting. The institute prescribes rules through its 18-man Accounting Principles Board, and firms of accountants must follow them or risk being charged with unethical conduct. The SEC, which polices accounting by publicly owned companies, goes along with the board's formal "opinions."

Twice, the accounting board has retreated from attempts to require more conservative bookkeeping treatment of the 7% tax credit to which companies are entitled on purchases of machinery. The board wanted to force businessmen to spread that credit over the life of the machinery instead of taking it entirely in the year of purchase. About 80% of U.S. companies use the latter method; for some, it provides the difference between profit and loss.

After a protracted wrangle with bankers, the board last month demanded that banks include in their reported profits the losses on collectible loans as well as the gains or losses on securities transactions. Until now, banks have excluded both categories from "net operating earnings." As a consequence, says Leonard M. Savoie, executive vice president of the accountants' institute, "the operating results of an entire industry are overstated. When is a loss not a loss? When it happens to a bank."

Per-Share Perplexity. The board's most complex decision came as it struggled to divulge what Savoie calls "ersatz earnings"--per-share profits derived from fancy financial footwork. This is a sensitive matter because many investors mistakenly believe that they can gauge a stock's merit simply by checking per-share earnings. The board ruled that companies with a complicated mix of securities may no longer merely divide their net profits by the number of shares outstanding to arrive at per-share earnings. Instead, companies must reduce the net to allow for future conversion of all warrants and some (but not all) convertible debentures and convertible preferred shares. Many businessmen and accountants object to the proviso. "The interests of average stockholders aren't served at all by reporting theoretical figures as though they were actual," argues Harry F. Reiss Jr., a partner in the accounting firm of Ernst & Ernst. "The whole theory is misleading."

Following the convoluted rules, Gulf & Western Industries has just announced a 21% increase in per-share profits, to $1.92, for its latest six months. But in a footnote, G. & W. added that if all its warrants and other debt securities had been converted into common stock, per-share profits would have fallen 26%, to $1.52. The company said that its total earnings increased 22% to $42,862,000, but that this figure included a $16,300,000 profit from stocks that it sold. On the other hand, Litton Industries was forced to show its 1968 net per share as $1.83, whereas the true figure, without the mandatory computations for possible dilution, was $2.33.

No wonder ordinary investors are baffled. Even professional security analysts have some trouble figuring out how some companies have really performed. To find out, the average investor can only go to his broker, accountant or some other expert willing and able to decipher the myriad footnotes that clutter so many corporate reports. Obviously, the accountants must produce some tougher yet simpler rules for reporting. Their failure to do so has helped to promote the very thing that they hoped to discourage: a speculative fever, fired up by reports of earnings that look fatter than they really are.

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