After the Fall

The experts weigh in on how to prevent future Enrons.

Hill: I think FASB could do some things that would get us a little closer, but you’re never going to have a standardized number that everyone is going to accept.

I think everyone would agree that there are times when it’s not only legitimate to adjust GAAP earnings, but desirable. The problem is that you use earnings for different things.

The SEC’s cautionary advice [on the use of pro forma financial information in earnings releases] that came out recently was a big step forward on this issue. The advisory said you had to provide some sort of trail from how you got from GAAP to the pro forma earnings.

Willens: But doesn’t that bother you, the fact that virtually no one is using GAAP net income for analytical purposes? That everyone is using their own formulas?

Hill: That’s what analysis is all about.

Griep: This is a very big issue on the equity-analytic side of our business, and with the index business as well. I know they’ve proposed a definition of operating earnings to try to bring standardization to that aspect, and it’s the one that we would use internally for valuation purposes.

Hill: But you can’t do that. The problem is, everyone agrees that the extraordinary items as defined by FASB should be excluded from the GAAP net earnings. But the sticky wickets are the footnotes, the restructuring charges, the asset-sale gains and losses, the acquisition charges, litigation, inventory write-downs. All these kinds of things can come in a lot of different shapes and flavors.

Rethinking Rating Triggers

Let’s turn to another post-Enron issue: rating triggers. The rating agencies are going to take a closer look at those, but S&P seemed to suggest that a lot of change wasn’t necessary.

Griep: Enron was a catalyst for us to undertake a review of what the actual exposure was of, in particular, lower-investment-grade companies — those rated in the triple-B, single-A range — to contingent commitments that involved significant debt repayment or collateral pledge. While it’s been played up in the media as a focus on credit-rating triggers, the questionnaire we put together actually focuses on rating, equity-price, and other kinds of operating-performance triggers that are built into borrowing arrangements and counterparty arrangements. The problem of how to factor these triggers into the rating process is a challenging one, and one that we’re still reviewing.

The alternative methodologies are to factor it directly into the rating, in the form of reduced financial flexibility; or, secondarily, just signal the presence of this contingent risk in a way that’s incremental to the rating. But we’re going through a process of differentiating the degree to which these triggers represent risks.

You know, rating agencies are in a difficult position. Our goal is to opine on creditworthiness, not create it. So where we have a company that is rated triple B minus and has substantial triggers, if they were to fall to noninvestment grade, the debate internally is the extent to which we lower that rating. It becomes self-fulfilling. Is there another way to signal that risk?

Discuss

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