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You can get ripped off easier by a dude with a pen than you can by a dude with a gun.

—Bo Diddley

The Numbers Game

Even Graham would have been startled by the extent to which companies and their accountants pushed the limits of propriety in the past few years. Compensated heavily through stock options, top executives realized that they could become fabulously rich merely by increasing their company’s earnings for just a few years running.1 Hundreds of companies violated the spirit, if not the letter, of accounting principles—turning their financial reports into gibberish, tarting up ugly results with cosmetic fixes, cloaking expenses, or manufacturing earnings out of thin air. Let’s look at some of these unsavory practices.

As If!

Perhaps the most widespread bit of accounting hocus-pocus was the “pro forma” earnings fad. There’s an old saying on Wall Street that every bad idea starts out as a good idea, and pro forma earnings presentation is no different. The original point was to provide a truer picture of the long-term growth of earnings by adjusting for short-term deviations from the trend or for supposedly “nonrecurring” events. A pro forma press release might, for instance, show what a company would have earned over the past year if another firm it just acquired had been part of the family for the entire 12 months.

But, as the Naughty 1990s advanced, companies just couldn’t leave well enough alone. Just look at these examples of pro forma flim-flam:

For the quarter ended September 30, 1999, InfoSpace, Inc. presented its pro forma earnings as if it had not paid $159.9 million in preferred-stock dividends.

For the quarter ended October 31, 2001, BEA Systems, Inc. presented its pro forma earnings as if it had not paid $193 million in payroll taxes on stock options exercised by its employees.

For the quarter ended March 31, 2001, JDS Uniphase Corp. presented its pro forma earnings as if it had not paid $4 million in payroll taxes, had not lost $7 million investing in lousy stocks, and had not incurred $2.5 billion in charges related to mergers and goodwill.

In short, pro forma earnings enable companies to show how well they might have done if they hadn’t done as badly as they did.2 As an intelligent investor, the only thing you should do with pro forma earnings is ignore them.

Hungry for Recognition

In 2000, Qwest Communications International Inc., the telecommunications giant, looked strong. Its shares dropped less than 5% even as the stock market lost more than 9% that year.

But Qwest’s financial reports held an odd little revelation. In late 1999, Qwest decided to recognize the revenues from its telephone directories as soon as the phone books were published—even though, as anyone who has ever taken out a Yellow Pages advertisement knows, many businesses pay for those ads in monthly installments. Abracadabra! That piddly-sounding “change in accounting principle” pumped up 1999 net income by $240 million after taxes—a fifth of all the money Qwest earned that year.

Like a little chunk of ice crowning a submerged iceberg, aggressive revenue recognition is often a sign of dangers that run deep and loom large—and so it was at Qwest. By early 2003, after reviewing its previous financial statements, the company announced that it had prematurely recognized profits on equipment sales, improperly recorded the costs of services provided by outsiders, inappropriately booked costs as if they were capital assets rather than expenses, and unjustifiably treated the exchange of assets as if they were outright sales. All told, Qwest’s revenues for 2000 and 2001 had been overstated by $2.2 billion—including $80 million from the earlier “change in accounting principle,” which was now reversed.3

Capital Offenses

In the late 1990s, Global Crossing Ltd. had unlimited ambitions. The Bermuda-based company was building what it called the “first integrated global fiber optic network” over more than 100,000 miles of cables, largely laid across the floor of the world’s oceans. After wiring the world, Global