Real earnings, or really creative earnings?

http://www.jewishworldreview.com | Stock prices are all about earnings, and we're finding out now which companies are most deserving of investor confidence, and even optimism. The earnings season is well under way, and while it's still early, there are few surprises so far. In fact, there's more good news than bad news on earnings.

The earnings that we are now seeing reported are of a much higher quality, and far more reflective of actual corporate performance. Many believe that last year's wave of corporate scandals resulted in pressure on corporations, from investors and regulators, to improve earnings quality.

"The scrutiny, in general, from the market, the SEC and FASB is leading to improved earnings quality," says Adrian Redlich, director of Analytic and Thematic Research at Merrill Lynch.

Robert Olstein of the Olstein Financial Alert Fund, who authors the "Quality of Earnings Report," told me, "Right now, we're in a high quality of earnings phase, (and) we've just come out of what I call the lowest quality of earnings phase of my 35-year career."

Although great strides have been made in reporting reliable earnings numbers, too many companies have yet to deal straightforwardly with their corporate pension deficits. Those companies assume an unrealistic rate of return on their pension assets. These companies will eventually need to replenish these underfunded pension assets, and the result will be a strain on earnings.

"Pension plans are the only quality of earnings issues left," Olstein says. "Assumptions of investment returns have to come down."

The pension issue aside, faith in the quality of U.S. corporate earnings has been returning. According to the Merrill Lynch Global Fund Manager Survey, the percentage of fund managers who think corporate America has the best quality of earnings in the world is back up to the same level as the second quarter of last year, before we knew the depth of the corporate corruption scandals. Previous surveys had showed that confidence in the quality of corporate America's earnings was plummeting in the wake of the scandals.

Changes are evident in corporate America's financial reporting. There has been an overdue effort to be far more transparent. We're seeing fewer and smaller write-offs, fewer items reported as pro-forma, fewer employee stock options being issued, and more companies reporting options as an expense.

The failure of many companies to count stock options as an expense skews the earnings picture. Merrill Lynch estimates that earnings for the market in 2001 and 2002 would have been somewhere from 8 percent to 10 percent lower if employee stock options were counted as an expense. Fortunately, many companies are beginning to make the switch. According to a new report from Bear Stearns, since July of 2002 more than 300 companies have begun to count options as an expense - a move that will dramatically improve the quality of their earnings. And while many more companies need to follow suit in order for the impact to be truly dramatic, the trend is encouraging.

Whether or not this quarter's earnings prove to be as strong as many of us are hoping, there is evidence that the quality of those earnings has improved considerably from just a year ago. And while more needs to be done to ensure the reliability of the numbers being reported, we can take heart that progress is definitely under way. And rising investor confidence is based not only on reality, but real performance.

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