OnSeptember 28, 1998, Chairman of the U.
S. Securities and Exchange CommissionArthur Levitt sounded the call to arms in the financial community. Levitt askedfor, “immediate and coordinated action. . . to assure credibility andtransparency” of financial reporting.
Levitt’s speech emphasized theimportance of clear financial reporting to those gathered at New YorkUniversity. Reporting which has bowed to the pressures and tricks of earningsmanagement. Levitt specifically addresses five of the most popular tricks usedby firms to smooth earnings. Secondly, Levitt outlines an eight part action planto recover the integrity of financial reporting in the U. S.
market place. Whatare the basic objectives of financial reporting? Generally accepted accountingprinciples provide information that identifies, measures, and communicatesfinancial information about economic entities to reasonably knowledgeable users. Information that is a source of decision making for a wide array of users, mostimportantly, by investors and creditors. Investors and creditors who areresponsible for effective allocation of capital in our economy. If financialreporting becomes obscure and indecipherable, society loses the benefits ofeffective capital allocation.
Nothing illustrates the importance of transparentinformation better than the pre-1930’s era of anything goes accounting. An erathat left a chasm of misinformation in the market. A chasm that was acontributing factor to the market collapse of 1929 and the years of economicdepression. An entire society suffered the repercussions of misinformation.
Families, and retirees depend on the credibility of financial reporting fortheir futures and livelihoods. Levitt describes financial reporting as, a bondbetween the company and the investor which if damaged can have disastrous,long-lasting consequences. Once again, the bond is being tested. Tested by afinancial community fixated on consensus earnings estimates. The pressure toachieve consensus estimates has never been so intense. The market demandsconsistency and punishes those who come up short.
Eric Benhamou, former CEO of3COM Corporation, learned this hard lesson over a few short weeks in 1996. Benhamou and shareholders lost $7 billion in market value when 3COM failed toachieve expectations. The pressures are a tangled web of expectations, andconflicts of interest which Levitt describes as “almostself-perpetuating. ” With pressures mounting, the answer from U.
S. managershas been earnings management with a mix of managed expectations. March of 1997Fortune magazine reported that for an unprecedented sixteen consecutivequarters, more S&P 500 companies have beat the consensus earnings estimatethan missed them. The sign of a quickly growing economy and a measure of theimportance the market has placed on consensus earnings estimates. The singularemphasis on earnings growth by investors has opened the door to earningsmanagement solutions. Solutions that are further being reinforced to managers bymarket forces and compensation plans.
Primarily, managers jobs depend on theirability to build stockholder equity, and ever more importantly their owncompensation. A growing number of CEO’s are recieving greater percentages oftheir compensation as stock options. A very personal incentive for executiveachievement of consensus earnings estimates. Companies are not the only ones tofeel the squeeze.
Analysts are being pressured by large institutional investorsand companies seeking to manage expectations. Everyone is seeking the win. Auditors are being accused of being out to lunch, with the clients. Manyaccounting firms are coming under scrutiny as some of their clients are beinginvestigated by the SEC for irregularities in their practice of accounting.
Cendant and Sunbeam both left accounting giant Arthur Anderson holding a bigol’bag full of unreported accounting irregularities. Auditors from BDO Seidmanaddressed issues of GAAP with Thing New Ideas company. The Changes were made andBDO was replace for no specific reason. Herb Greenberg calls the episode,”A reminder that the company being audited also pays the auditors’bill.
” The Kind of conflict of interests that leads us to question the ideaof how independent the auditors are. All of these pressures allow questionableaccounting practices to obfuscate the reporting process. Generally acceptedaccounting principles are intended to be a guide, not a procedure. They havebeen developed with intended flexibility so as not to hinder the advancement ofnew and innovative business practice. Flexibility that has left plenty of roomfor companies to stretch the boundaries of GAAP.
Levitt focus’s on five of themost widespread techniques used to deliver added flexibility. “BigBath” restructuring charges, creative acquisition accounting, “CookieJar” reserves, “Immaterial” misapplications of accountingprinciples and the premature recognition of revenues. These practices do notspecifically violate the “letter of the law,” but are gimmicks thatignore the spirit and intentions of GAAP. Gimmicks, according to Levitt, thatare “an erosion in the quality of earnings and therefore the quality offinancial reporting.
” No longer is this just a problem perceived in smallcorporations struggling for recognition. Throughout the financial community,companies big and small are using these tools to smooth earnings and maximizemarket capitalization. The “Big Bath” restructuring charge is thewiping away of years of future expenses and charging them in the current period. A practice that paves the way to easy future earnings growth by allowing futureexpenses to be absorbed by restructuring liabilities. Large one time chargesthat will be ignored by analysts and the financial community through a littleconvincing and notation. In note fifteen of the Coca-Cola company’s 1998annual report shows seven nonrecurring items from the past three years.
Fours ofthese charges are restructuring charges, most significantly in 1996 in thisnote. In 1996, we recorded provisions of approximately $276 million in selling,administrative and general expenses related to our plans for strengthening ourworld wide system. Of this $276 million, approximately $130 million related tostreamlining our operations, primarily in Greater Europe and Latin America. These one time write-offs become virtually insignificant footnotes to thefinancial reporting process. Extraordinary charges that are becoming unusuallycommon. Kodak has taken six extraordinary charges since 1991 and Coca-Cola hastaken four in two years.
The financial community has to wonder how”unusual” these charges are. Creative acquisition accounting is whatLevitt calls “Merger Magic. ” With the increasing number of mergers inthe 90’s, companies have created another one time charge to avoid futureearnings drags. The “in-process” research and development chargeallows companies to minimize the premium paid on the acquisition of a company. Apremium that would otherwise be capitalized as “goodwill: and depreciatedover a number of years. Depreciation expenses that have an impact on futureearnings.
This one time charge allowed WorldCom to minimize the capitalizationof “goodwill” and avoid $100 million a year in depreciation expensesfor many years. A charge hiding in this complex note on WorldCom’s 1996 annualfinancial statement. (1) Results for 1996 include a $2. 14 billion charge forin-process research and development related to the MFS merger.
The charge isbased upon a valuation analysis of the technologies of MFS worldwide informationsystem, the internet network expansion system of UUNET, and certain otheridentified research and development projects purchased in the MFS merger. Theexpense includes $1. 6 billion associated with UUNET and $0. 54 billion related toMFS. (2) Additionally, 1996 results include other after-tax charges of $121million for employee severance, employee compensation charges, alignmentcharges, and costs to exit unfavorable telecommunications contracts and $343.
5million after-tax write-down of operating assets within the company’s non-corebusinesses. On a pre-tax basis, these charges totaled $600. 1 million. The dollaramounts are staggering and the future implications far reaching. Since thisapproach was introduced by IBM in 1995 these charges have become commonplace foracquisition accounting. A popularity, largely due to the level of room allowedin research and development estimations.
The Third earnings manipulation tooldiscussed by Levitt is what he calls “Miscellaneous Cookie JarReserves. ” The technique involves liability and other accrual accountsspecifically sensitive to accounting assumptions and estimates. These accountscan include sales returns, loan losses, warranty costs, allowance for doubtfulaccounts, expectations of goods to be returned and a host of others. Under theauspices of conservatism, these accounts can be used to store accruals of futureincome. Restructuring liabilities created by “Big Bath’ charges alsoprovides these “Cookie jar reserve” effect. Jack Ciesielski, whomanages money and writes the Analyst’s Accounting Observer, calls theseaccounts the “accounting equivalent of turning lead into gold.
. . a virtualhoneypot for making rainy-day adjustments. ” Various adjustments and entriesthat can produce almost any desired results in the pursuit of consistency.
Thestatement of financial accounting concepts No. 2 (FASB, May 1980), defines”materiality” as: The magnitude of an omission or misstatement ofaccounting information that, in light of surrounding circumstances, makes itprobable that the judgement of a reaonable person relying on the informationwould have been changed or influenced by the omission or misstatement. Today’smanagement has started to ignore this fundamental principle. Materiality isbeing defined as a range of a few percentage points.
Companies defend immaterialomissions by referring to percentage ceilings that draw a line on materiality. “The amount falls under our ceiling and is therefore immaterial. ” Themateriality gimmick is one more method companies are using to stretch a nickelinto a dime. Simply put, “In markets where missing an earnings projectionby a penny can result in a loss of millions of dollars in market capitalization,I have a hard time accepting that some of these so-called non-events simplydon’t matter,” says Levitt. Finally, Levitt briefly touches on thecomplex issue of the manipulation occuring in revenue recognition. Moderncontracts, refunding, delaying of sales, up front and initiation fees all add tothe complications in some industries to follow specific rules of revenuerecognition.
With plenty of holes in revenue recognition the door is open fortweaking. Microsoft is a good example of the problems facing today’scompanies. Concerned with proper revenue recognition, Microsoft started apractice in the software industry that allows companies to recognize revenueover a period of time. This recognition allows for better matching of revenuesto future expenses generated by the sale of the software. Expenses such asupgrades and technical support are related to the revenue generated by the saleof the software but are incurred at a later date.
The complexities of modernbusiness transactions have left modern standards of accountancy years behind. Gimmicks, that all must be addressed by the financial community. The task ofreturning integrity to U. S. financial reporting is of paramount importance. Theinterests of our financial system are at stake.
Arthur Levitt and the SEC”stand ready to take appropriate action if that interest is not protected. But, a private sector response that. . . obviates the need for public sectordictates seems the wisest choice. ” A nine part plan that involves theentire financial community is proposed by Levitt.
Levitt has made it very clearthat the SEC is prepared to start forcing change. A line Levitt hopes will notbe necessary to cross. The SEC will begin to issue guidance on a wide array ofissues concerning the credibility and transparency of financial reporting. Guidance that must be acted on to “Obviate” the need for large scaleSEC involvement. The SEC will also act more proactively in two of itstraditional roles of information regulation and enforcement. First, the SEC willbegin requiring companies to provide additional disclosure details on changes inaccounting assumptions.
Supplemental beginning and ending balances andadjustments of sensitive restructuring liabilities and other loss accruals willalso be required. Secondly, the SEC is unleashing the dogs on companies usingany practices that appear to be managing earnings. The gauntlet has been thrown,and it is up to the financial community to accept the challenge. FASB and otherstandard setting bodies have fallen behind a rapidly changing and evolvingeconomic environment.
FASB and the AICPA are being coercively encouraged toclean up auditing and disclosure practices. The pressure is on and standardsetting bodies are scrambling to close the holes in GAAP. FASB has establishedcommittees to investigate a number of concerns and is diligently working towardsolutions that “obviate. ” Auditors and the public accounting industryreceived a good scolding from Levitt.
Glaring failures in the auditing processat Sunbeam, Waste Management Inc. , and Cendant have put the whole industry atrisk of public solutions. The auditors have failed to be the “watchdog” of investors. It is time to clean up your industry. Criticism by theentire financial community has questioned the auditors, qualifications, methodsand their ability to police themselves.
Finally Levitt challenges corporatemanagement, and investors to begin a cultural change. Change that resists thepressures to follow the leader in accounting chicanery. Investors are encouragedto set financial standards of integrity and transparency and punish those whodepend on illusion and deception. “American markets enjoy the confidence ofthe world.
How many half-truths, and how much sleight-of-hand, will it take totarnish that faith?” With the shift away form company run pension planseveryone has become their own personal financial planners. What hangs in thebalance is the future of us all. BibliographyLevitt, Arthur. “Quality Information: The Lifeblood of OurMarkets.
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