Restating the Obvious

Why new CEOs love bad news.

Thursday, IBM reported its results for the second quarter, the first full quarter in the reign of newly installed CEO Sam Palmisano. And they weren’t pretty. IBM earned a paltry $56 million, or just three cents a share, down from $2.04 billion, or $1.17 a share in the 2001 second quarter. Now, Big Blue’s business certainly wasn’t as robust as it was last year, but it wasn’t that bad. No, the steep plunge in reported earnings can be blamed largely on a $2.1 billion pretax charge. The charge, which Palmisano had signaled he would take back in June, covers the costs of thousands of job cuts, a loss on the sale of IBM’s hard-disk drive operations to Hitachi, and a restructuring of its microelectronic business.

IBM stock actually rose on the news. That’s because such charges against earnings, the writing down of assets, and the restatement of results have become something of a rite of passage for newly installed CEOs like Palmisano, who succeeded Louis Gerstner in March. Jeffrey Immelt, who took over at General Electric last September, took a similarly large charge against earnings—$1.015 billion—in his first full quarter on the job, shaving 30 percent off the earnings number. And Richard Notebaert, the buttoned-down former Ameritech executive who is trying to salvage scandal-ridden Qwest, is reportedly considering restating results to show that up to $1 billion in revenues notched by the telecommunications company in 2001—about 5 percent of the company’s total—wasn’t entirely halal.

In many instances such charges are required by accounting regulations or by law. But executives have some discretion about when and how charges are taken. And for newbies in the executive suite, there are several virtues in using legitimate accounting to make earnings appear worse. Given the current suspicious climate, there are likely to be more such charges and restatements.

This dynamic has long been seen in politics. When the Clinton administration took office, budget officials announced that the budget deficit they inherited was far higher than they had been led to believe by the Bush administration. More recently, James McGreevey, the new Democratic governor of New Jersey, has blamed his Republican predecessors for downplaying the severity of that state’s budget shortfall.

For some CEOs, especially those replacing bosses who were pushed out, cutting down the numbers is a way of affixing the blame for the current—and likely future—mess on the prior administration. And while taking charges and restating results may have adverse short-term consequences, coming clean curries favor with both investors and regulators.

For CEOs who ascend to the top spot from within the ranks, taking charges during their first quarter in control serves a somewhat different managerial and psychological purpose. After all, Palmisano and Immelt were part of the respective anciens régimes and hence complicit in whatever problems are now tarnishing the books.

But new CEOs typically get a free pass on actions taken in the first quarter and expect less forbearance as time goes on. So by taking big charges early, they can act preemptively against issues that might surface a few quarters or a year from now.

Tamping down earnings in the current quarter also sets up what people on Wall Street like to call “favorable comps.” A year from now, it will be far easier for both IBM and GE to post results that are better than this year’s comparable quarter. IBM will doubtless crush the 3-cent-per-share number it reported in the 2002 second quarter. Taking charges is a little like going out on the track before the race starts and lowering the hurdles. You might run at the same speed, but you’ll look far more impressive doing it. For while those who comb through the results might recall that earlier numbers were deflated by the charges, most people will simply focus on the headline numbers showing dramatic improvement.

Finally, while it is always dangerous to mix literary theory with corporate accounting, there may be a subconscious motive too. In his seminal book The Anxiety of Influence, the critic Harold Bloom argued that poets subconsciously aim to topple their poet father figures. Just so in management. It is difficult to succeed a legend, and there were probably no two more celebrated executives in the ‘90s than Jack Welch at GE and Louis Gerstner at IBM. What these charges do, in effect, is pull down the numbers—and hence the reputations—created by Welch and Gerstner.

For much of the 1990s, the suspicion was that companies were using legitimate accounting techniques to make earnings appear better than they actually were. In this chastened environment, newly installed CEOs may be using some of those same techniques to make earnings look worse.