Escaping the quarterly EPS trap.

• Author: DONOGHUE, DANIEL J.

The key is to give Wall Street the cash flow information it needs. Here are the five most important actions companies can take.

WHY DO STOCK PRIECS swing wildly over pennies of quarterly earnings per share? A company's value is not based on historical earnings but rather its future cash flow, adjusted for both risk and the time-value of money. Rarely does a quarterly earnings report connote enough new information about future cash flow to justify millions, or perhaps billions, of dollars in revaluation of an enterprise.

In fact, reported earnings provide only limited cash flow information. Today's accrual accounting methodology measures "profitability" over short, arbitrary time periods (i.e., one quarter or one year). Over the very long term, accrual earnings and net cash flow converge, but as a snapshot of any particular reporting period, the differences are vast.

Investors and analysts are prisoners of this established accounting convention. In turn, CEOs seeking to improve their share prices feel compelled to manage their business to maximize near-term earnings per share (EPS).

Consider the potential impact of the Financial Accounting Standards Board's (FASB) proposed changes to the accounting rules for mergers and acquisitions. By eliminating pooling, companies will be required to take a potentially significant charge to earnings resulting from the acquired goodwill under purchase accounting. Earnings will be hit, but cash flow will remain completely unaffected. Nonetheless, many corporate executives have stated that they will abandon deals that make sense from a business perspective purely for these accounting reasons.

Pulling earnings out of a hat

The Securities and Exchange Commission believes public companies will go so far as to manipulate reported earnings, to please Wall Street, through a variety of accounting gimmicks. Chairman Arthur Levitt has launched a series of initiatives to curtail suspected practices. Announced targets are:

* Inconsistent and misleading practices regarding revenue recognition.

* Large, one-time restructurings and write-offs that enhance future profitability.

* Balance sheet reserves that can be used to propup future earnings.

* Accounting opportunities in business combinations such as in-process research and development write-offs.

* Discretionary use of materiality thresholds to manipulate reported results.

However, re-engineering the accounting for accrual income is not the answer. Instead, the SEC...