1999-IBM's Accounting Method Faces Scrutiny

Does an accounting strategy make the world's largest computer maker look more efficient than it really is?

On first blush, this year's results at IBM suggest it has become a tightly run ship. With revenue growing just 12% to $63.4 billion for the nine months to Sept. 30, operating income rose a heady 53% to $8.9 billion. A major factor: Reported operating expenses fell by more than $1 billion.

Louis Gertsner, IBM's chief executive, cited "strong expense management" as helping to fuel third-quarter gains -- and as a reason to expect better results to come. IBM's shares, which fell $1.6875 to $106.1875 at 4 p.m. on the New York Stock Exchange Tuesday, have nearly recovered from the drubbing they received after the earnings announcement last month, when revenue failed to meet analysts' expectations.

But some accounting specialists and analysts, scrutinizing the footnotes, now are raising questions about IBM's unusual treatment of one-time gains. At issue: IBM booked about $4 billion in such gains from the sale of its Global Network business to AT&T Corp. during its second and third quarters. The gains were included in selling, general and administrative expenses, or SG&A.

Translation: Reported costs were lowered. And reported operating income was raised.

The issue is important on Wall Street. This is because operating income --which excludes taxes, interest and other items that have little to do with success in making and selling products or services -- is often more important to investors than net income, and widely regarded as an indicator of how well management is running the shop.

In a new report, accounting watchdog Howard Schilit says IBM should be "roundly criticized for its policy of bundling one-time gains and other nonoperating activities into operating income." SG&A expenses, he says, should be "just that" -- and shouldn't include one-time charges or gains that don't reflect operating performance. Mr. Schilit's reports on such matters have a close following among money managers.

An IBM spokesman says it has been putting one-time gains and charges into SG&A since about 1994 and categorizes such items as "general" expenses.

IBM, Armonk, N.Y., has disclosed the dollar value and impact on earnings per share of the charges in the text accompanying its earnings releases, the spokesman said. The gains in both the second and third quarters were partially offset by unrelated charges, such as write-downs of other assets also included in the SG&A line.

Instead of the $8.9 billion IBM reported in operating income for the first nine months, Mr. Schilit estimates it would have reported $6.5 billion without the AT&T gains and other one-time items reflected in the SG&A line. In the third quarter, he estimates the boost to operating income was $758 million.

The IBM spokesman declined to comment on the analysis.

IBM's practice of defraying operating expenses with gains makes it difficult for investors and analysts to quickly work out the company's true performance, said Gary Helmig, an analyst with SoundView Technology Group. But he says it doesn't matter to the bottom line -- and thus, isn't that important.

But that isn't necessarily the bottom line with federal regulators. According to Securities and Exchange Commission regulations, companies should include gains from material asset sales in a line-item called "non-operating income" that sits below operating income, says Paul Kepple, a senior accounting fellow at the SEC. The $4 billion gain IBM booked "would seem to be material," and thus should "generally" be treated as a nonoperating item, Mr. Kepple adds.

Meanwhile, the Financial Accounting Standards Board, the body to which the SEC delegates accounting standards, doesn't offer guidance about the proper place to record such gains as asset sales, according to Robert J. Laux, a FASB industry fellow. But Mr. Laux says companies generally break out such items below the operating income line.

Mr. Helmig says after IBM released its third-quarter results last month, he suggested to company officials they break out the figure so it would show operating income minus the one-time gains and charges. He says he received no response. The IBM spokesman declined to comment.

The gains and offsetting charges are explained in footnotes and management discussion sections of IBM filings with the SEC. But Mr. Schilit, who runs the Center for Financial Research and Analysis, a Rockville, Md., accounting-research organization, says without a discrete line item for such one-time items, investors could have a hard time evaluating IBM's financial performance. Mr. Schilit calls IBM's practice "pretty unusual" and says it doesn't conform to what most other companies do.

IBM's practice "muddies the water," Mr. Schilit says, and causes investors to "lose confidence when we look at the company's operating income in future periods."

He predicts some investors might be more skeptical when reading future IBM earning releases, asking themselves: "Is that really the company's operating income?"