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Ever wonder why certain public companies meet or beat the earnings number predicted by Wall Street research analysts? GE, Microsoft, Apple are just a few of many corporate behemoths that tend to impress analysts and investors quarter after quarter. So how are they able to consistently able to beat these numbers, even in a slow economy? Two factors contribute to this:

1. Guidance
2. Profit Smoothing

As much as we would like to believe that the stars align for such companies, the reality is that managing earnings is more a product of skill than divine intervention.

When it comes to guidance, corporate managers tend to under-promise and hope to over-deliver. It works something like this: Company X just released its quarterly earnings report and beat the consensus earnings number. The consensus number is the average of analysts’ prediction for net earnings (also referred to as net income, net profit or the bottom line). Company X was pleased to report that due to aggressive cost cutting, they were able to beat the consensus number by one penny per share (total net earnings divided by total shares of stock outstanding). Beating the estimate is always a good thing and will often drive the stock price higher. While analysts and investors rejoice, the corporate management pats itself on the back for achieving strong results.

So how did they pull this off? At the conclusion of last quarter, Company X purposely issued very conservative earnings guidance even though there were several large sales likely to close before the end of the quarter. To play it safe, they sought to keep expectations low knowing they could easily surpass them and push the stock price higher.

As it turned out, several of the planned sales fell through. Time to bring in the heavy artillery. In this case, the heaviest of all is profit smoothing. Company X can adjust the assumptions on non-cash gains and expenses to make the earnings number beat expectations. Still too low? Why not lower the charge against a bad loan portfolio? How about changing the depreciation schedule to lower the expense taken in the near term? Through some combination of non-cash adjustments, Company X is able to generate the right earnings number. Unfortunately, once in a while no amount of profit smoothing will save a company from a bad earnings number which is what happened to GE a few quarters ago. And when that happens, look out below!

In the midst of record high oil prices, a near meltdown of the banking sector, a loss of confidence in the stock market, a mortgage crisis and rising inflation, we find ourselves feeling rather helpless. As the overall economy suffers, business activity will likely slow leaving a dearth of opportunities for most of us in the business and legal community. So what can an able bodied professional like you do to manage this crisis? Educate yourself. That’s right. Knowledge is power and taking advantage of any downtime to build up your personal balance sheet will help you understand the current situation and, hopefully, allow you to add more value when opportunities present themselves. To start you out, here is a quick guide to what any professional should know about the current economy:

Where to begin? To understand the current situation, it’s important to consider the following process:

Bad mortgages weak banking sector weak stock market high commodity prices inflation weaker stock market higher commodity prices higher inflation job losses economic collapse.

Of course, the above chain of events paints a rather bleak picture of the future and for the most part, is a worst-case-scenario assessment. Where we go from here is something I’ll leave to the economic prognosticators (who, by the way, are usually wrong). Rather, I’ll simply attempt to clarify the forces at work and you can predict what might happen next.

Mortgage crisis—Basically, too many loans were issued to individuals who at any other point in time would not have qualified for these loans. These loans were packaged and sold to other investors who were virtually unaware of the risks associated with them. These bundled loans were termed collateralized debt obligations (CDO’s) and valued based on their future expected payments. This method of valuation, often termed mark-to-market accounting, creates innumerable accounting problems but most importantly, can mislead the investor because what you see may not be what you get. So when a company such as Citigroup states $30 billion worth of these loans on their balance sheet (what you see), what you get in 2008 is more like $5 billion.

Bank failures—The traditional economic belief is that when the banks fall, so do other aspects of the economy. Banks serve as an engine for growth providing consumers and corporations with the capital needed to expand. As the banks continue to report bad news including write downs of mortgage backed assets and worse, overall liquidity problems, investors lose faith in the sector. And as investors lose faith in the sector, they lose faith in the economy. When investors lose faith in the economy, what do they do? They sell stock. If companies are expected to suffer, their stock will be worth less. So if investors sell their stock, where do they invest their money? These days, oil!
Oil crisis—Investors, and more specifically commodities speculators, have invested heavily in oil futures due to a shortage of other compelling investment opportunities. Combine this with increasing demand for oil in emerging markets and tensions in the Middle East, and you have the perfect formula for sizeable gains in black gold. Real estate values have fallen and the stock market has fallen leaving investors with few other investment opportunities. Few will dispute the fact that the surge in oil, as well as other commodities, is creating a bubble. Nonetheless, the impact of this momentum is widespread. Specifically, higher fuel costs leads to higher costs in just about everything else. And overall higher costs lead to inflation. If inflation is prolonged, it impacts not only the consumer, who buys less, but the corporation, who may earn less. And if corporations suffer, job losses will mount.

That’s it in a nutshell. Clearly there’s much more happening behind the scenes but this should be enough to get you through your next water cooler discussion. And as bad as it sounds, signs of hope are emerging. Banks are beginning to show better than expected earnings (which isn’t saying much), oil prices are coming down, speculators are facing possible restrictions on their trading activities, and the government has pledged its support for some of the largest financial institutions. So stay tuned, it may or may not get better from here but it will most definitely get more interesting.

(For valuable, understandable, and interesting courses on accounting and financial statements, corporate finance and valuation, or other business topics, in your city or online, visit www.OneDayMBA.org.)