IBM'S INNOVATIVE EXPENSE REDUCTION

One-time gains can be transformed in even more miraculous ways than turning them into operating income. International Business Machines has found a means of moving such items into its reported costs, where they sur­reptitiously reduce expenses.

During 1999, Chairman Louis Gerstner hailed IBM’s “strong expense management” as a key to its recent earnings improvement.⁷ On the face of it, the numbers bore him out. For the full year, the world’s largest computer manufacturer reported that selling, general, and administrative expense fell to $14.7 billion from $16.7 billion in 1998, even though total revenue in­creased to $87.5 billion from $81.7 billion. Taken at face value, IBM’s num­bers indicated that Gerstner’s team had chopped SG&A spending from 20.4% to 16.8% of revenue. On closer examination, it turned out that IBM cut less fat than it appeared.

A portion of one sentence in the Management Discussion of IBM’s 1999 annual report notes that the year-over-year decrease in SG&A expense “reflects the net pre-tax benefit associated with the sale of the Global Net­work.” Analysts who doggedly followed the trail to the Notes to Consoli­dated Financial Statements discovered that the pretax gain on IBM’s sale of its Global Network business to AT&T totaled $4.057 billion. That ac­counted two times over for the year’s reduction in SG&A. Excluding the benefit of the unit’s sale, one-time event, SG&A rose as a percentage of IBM’s total revenues from 20.4% to 21.4% in 1998.

Diligent analysts could find all of this information in IBM’s annual re­port. The company did not explain, however, why it categorized a gain on an asset sale as a reduction in expenses.

The great advantage of this practice, from IBM’s viewpoint, is that it boosts operating income. A $4 billion improvement at that level is likely to boost the stock price more than the aftertax equivalent amount highlighted as a once-only occurrence. It is precisely to prevent such repackaging of re­ality that GAAP requires material gains from asset sales to appear below the line as nonoperating income. A senior accounting fellow at the Securities and Exchange Commission opined that IBM’s $4 billion gain on the Global Network “would seem to be material,”⁹ implying that it ought to be booked as a nonoperating item. Taken together with the integration of pen­sion plan investment returns into operating income in the same year (see Chapter 10), IBM’s handling of the gain on the Global Network sale belied Chairman Gerstner’s claims to have fortified profits through effective man- agement—unless he meant earnings management.