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. Last Updated: 07/27/2016

Working Backward to Make a Profit

NEW YORK -- On Wall Street, it is called backing in. Each quarter, analysts at securities firms forecast the earnings per share of the companies they watch. Companies whose profit falls short of the consensus estimate may have their stock values fall 10 percent or more.

So some companies do whatever they have to make sure they don't miss that estimate. Instead of first figuring out their sales and subtracting expenses to calculate the profit, such companies work backward. They start with the profit investors are expecting and manipulate sales and expenses to make sure the numbers can accommodate the forecasts.

During the last decade's boom, as executive pay was increasingly based on how the company's stock performed, backing in became both more widespread and more aggressive. Just how much so is only now becoming clear.

Xerox said Friday it was reclassifying $6.4 billion in revenue from the late 1990s. That announcement followed WorldCom's report last Tuesday that it had hidden $4 billion in expenses in 2001 and this year. Since the financial collapse of Enron, scores of public companies have acknowledged overstating earnings.

For years, Wall Street has known that companies manage their earnings. Academic studies have found that actual earnings do not fall randomly around the consensus estimate, as one might expect. Instead, they tend to come in at or just above the forecast. Some companies, like General Electric, almost always seem to beat estimates by a penny or two, no matter what the economic climate.

"If GE needs to make a penny this quarter, they'll take it out of next quarter," said Jon Brorson, who oversees $65 billion in stock investments for the Northern Trust Co. in Chicago.

In itself, that is not particularly surprising or disturbing, Brorson and other professional money managers say. Managements try to give investors what they want, and companies whose earnings are predictable are prized on Wall Street.

But the current wave of financial fraud is different, professional investors say. Analysts and investors always assumed that earnings management happened on the margins, as companies pushed earnings higher or lower by a penny or two a share to mask the normal volatility of their businesses.

Now it seems that some companies took advantage of loose accounting rules to make their reported profits seem much bigger than the cash they were really generating. Others went further, committing outright fraud.

But the slope from earnings management to earnings manipulation to fraud is a slippery one. As companies like Cisco Systems and Microsoft reported year after year of booming sales and profits, many investors began to believe the surest route to riches was to buy stocks of companies with rising sales and profits.

A company that became a favorite of these new investors could have an extraordinarily quick rise in its stock. As stock option packages became more lucrative, top executives could make tens or hundreds of millions of dollars after only a year or two of good performance. Unfortunately, many of these new investors were highly fickle, and companies that disappointed them by missing earnings targets could see their shares plunge.

Meanwhile, executives at companies that had not shared in the boom became eager to share in investors' largesse by showing they too were running fast-growing businesses.

So increasingly companies took advantage of loose accounting rules. That task was made easier because many investors do not understand how much flexibility companies have to alter their results under standard accounting rules.

Now, after being scalded so many times, investors are wary of any company whose accounting appears less than pristine.

Brorson said he would like to believe that the recent announcements are the high-water mark of the post-boom accounting scandals.

"You hope," he said, "that this is the edge here."