Second Place Massachusetts Society of CPAs
Student Manuscript!

 Splish, Splash: Management's All Wet
By Sandra Viera
Bridgewater State College

Why is the Securities and Exchange Commission (SEC) Chairman, Arthur Levitt, Jr., anguished with the financial community? In his September 1998 speech at New York University, he voiced grave concern on various reporting practices used by public companies to manage earnings. In addition, concerns with the future of the US capital market were uttered by many. Levitt characterized it is as a "game among market participants" which, "if not addressed soon, will have adverse consequences for America's financial reporting system" (Levitt, 1). Earnings management refers to an intentional structuring of reporting or production/investment decisions around the bottom line impact (Ayres, 4). Income smoothing is being deemed necessary to survive in a society that places intense pressure on meeting market expectations. Chairman Levitt fears that, "motivation to meet Wall Street earnings expectations may be overriding common sense business practices" and the "erosion in the quality of earnings would result in the lack of quality financial reporting" (Levitt, 2).

Why does management find it necessary to manipulate financial statements to their liking? By meeting Wall Street's expectations they achieve both market capitalization growth and stock value increase. Other motivations cited were minimization of the risk of possible debt, dividend covenant violations, and maximization of management bonuses (Ayres, 4). Pressures from both analysts and investors place a tremendous amount of burden on management to iron out the wrinkles. The iron used is the flexibility in accounting principles.

Levitt warns that bad financial reports could eventually hurt the U.S. stock market, referring to Asian and Russian markets as examples. "If a company fails to provide meaningful disclosure to investors about where it has been, where it is going, a damaging pattern ensues" (Levitt, 2). One of the reasons U.S. capital markets have been cited as the best in the world is the high quality and integrity of the financial reporting system in the United States (Turner, 11). Financial statements that have been smoothed are thought to be less informative to investors, creditors, and other financial users. Frances Ayres concludes that "…by acting to smooth earnings the manager may create a new problem - investors' impressions that earnings have been manipulated can lower their perception of the quality of earnings, leading to lower market values and potential future problems in capital markets" (Ayres, 6). The key reason for our market's success is that it provides investors with transparent, timely, and reliable financial statements. Reduction or elimination of any of these elements would prove extremely destructive.

Levitt addressed the most common gimmicks designed by companies to make earnings reflect the desires of management rather than their actual performance. The SEC is mainly concerned with the five most popular tricks being employed: "big bath" restructuring charges, creative acquisition accounting, cookie jar reserves, immaterial misapplications of accounting principles, and premature revenue recognition. The SEC is in the process of developing an action plan to address the various problems in accounting practices to restore confidence in the capital market.

One of the gimmicks being scrutinized is what is referred to as the "big bath" charges. To hinder earnings from rising too high in one year, management will frequently offset these gains with restructuring charges as to expand the gain into future years. These charges are used to help companies "clean up" their balance sheets by overstating restructuring charges with the prospect that Wall Street will look beyond a one-time loss and focus on future earnings (Levitt, 4). One company currently partaking in this scheme is General Electric (GE). In 1993, GE smoothed a gain from the sale of its aerospace business by "anticipating some specific 1994 expenses such as asset write-offs, lease terminations and severance benefits" to assist in the reporting of future profits (Smith, 322). Dennis Dammerman, the finance chief of GE, maintains that "the use of such charges is one way it pursues both short-term and long-term goals; without such gains, he adds, some of the spending wouldn't have been planned or would have been timed differently" (Smith, 323). Some companies were also found to have delayed the sales of assets with unrealized losses in periods were profits were too high in order to boost future earnings.

Levitt also cited concerns with a practice that's grown in popularity in recent years. "Creative acquisition accounting" classifies a portion of an acquisition price of a company as in-process research and development and writes it off in a one-time charge (Levitt, 4). Management's objective is to expense the charge in one period as to avoid having to recognize goodwill, which would result in lower future earnings. Questions began to arise when several companies were found to have recorded larger portions of in-process research and development when the companies purchased had shown little or no research and development expenditures ("SEC Chief…", 5). The same scheme is employed to create large liabilities for future operating expenses to protect future earnings. The SEC staff has issued a letter to the AICPA SEC Regulations Committee requesting assistance in developing the best practices in this very judgmental area (Turner, 3).

In December 1998, the SEC caught W.R. Grace executives with their hands in the "cookie jar". Grace was charged with employing a "cookie jar" strategy that stashed as much as $20 million of excess profits (Bailey, D1). According to the SEC the company was stashing the profits to declare them in future years.

"Cookie Jar Reserves" refers to the practice of using unrealistic assumptions to estimate liabilities such as sales returns, warranties, and loan losses (Levitt, 4). By overestimating liabilities in one period a company can reserve the excess profits for future years. When the excess profits are needed, a change in accounting estimate is recorded and according to APB No. 20, Accounting Changes, a change in estimate must be handled currently and prospectively. Management justifies its actions with the concept of conservatism. The concept of conservatism maintains that when in doubt choose the solution that will be least likely to overstate assets and income (Kieso, 51). However, companies are abusing the concept when no doubt actually exists, clearly a violation of generally accepted accounting principles (GAAP). The outcome results in stashing accruals in cookie jars during the good times and reaching into them when needed in the bad times (Levitt, 4).

Engagement in the mistreatment of the concept of materiality is also practiced to smooth earnings. Materiality abuse is the intentional recording of errors within a defined percentage ceiling arguing that it is not material (Levitt, 4). However, Levitt has a differing opinion stating that, "In markets where missing an earnings projection by 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 simply don't matter" (Levitt, 5). The Financial Accounting Standards Board (FASB) concludes that materiality is "both a qualitative and quantitative concept" and "certain events or transactions are material because of the nature of the item regardless of the dollar amounts involved" (Delaney, 9). Therefore, both quantitative and qualitative factors should be considered when determining materiality. A situation may arise where quantitatively an event is immaterial and does not require disclosure. However, qualitatively it is capable of influencing or changing the judgment of a reasonable person, which would require disclosure.

Another area being used for manipulation is recognition of revenue. Revenue is being recognized prior to the completion of the sale, prior to delivery of the product to the customer, and when customers still retain the options to terminate, void, or delay the sale; resulting in an increase in sales and the perception of higher net income. An extension in fiscal year is also being employed to maximize sales. Fiscal years are extended beyond 365 days to record extra sales that the company knows don't conform to what a customer ordered ("SEC chief…", 5).

The FASB has begun and will continue to address revenue recognition issues in various industries it feels need further clarification and guidance. However, the SEC staff believes that "…appropriate requirements already exist in accounting literature and findings of the Commission in previous enforcement cases. Specifically, FASB Statement 48, SOP 97-2, Software Revenue Recognition, Concepts Statement No. 5, Recognition and Measurement In Financial Statements of Business Enterprises, and No. 6, Elements of Financial Statements, and Accounting and Auditing Enforcement Release ("AAER") No. 108…" (Turner, 6). Concepts Statement No. 5 explicitly requires that an entity "…substantially accomplish what it must do to be entitled to the benefits represented by the revenues" (Delany, 828). Clearly, companies participating in these types of activities are not complying with this concept and ultimately violating GAAP, as in the case of Leslie Fay Companies.

In 1993, Leslie Fay Companies, a women's apparel firm, announced overstatements of $131million in their profits due to accounting irregularities. What the SEC later discovered was that these accounting irregularities were partially due to a prevalent industry practice referred to as pre-billing. Pre-billing is the practice of including in the sales of one quarter shipments that will not occur until the first few days of the following quarter (i.e. recording sales in one quarter that pertains to the following quarter) (AICPA, 13). While it may be a prevalent industry practice, it does not conform with GAAP. According to Concept Statement No. 5, the sales from the following quarter have not yet been earned and therefore should not be recorded.

In light of the benefits provided by earnings management, there are still some truly honest companies that refuse to participate. Peter Lewis, chairman of Progressive a Cleveland auto insurer, refuses to guide analysts about Progressive's quarterly earnings. He also won't lift a finger to smooth out earnings zigs and zags (McGough, C1). Mr. Lewis states that, "It is not honest to manage earnings. Besides, when companies manage their earnings, they mar their own business intelligence: The accounting stuff that's required to smooth things out causes management to mislead itself" (McGough, C1). The financial community can only hope that others share in Mr. Lewis' belief.

In his speech, Levitt presented his action plan which included, "…changes in technical rules by regulators and standard setters to improve the transparency of financial statements, enhanced oversight of the financial reporting process by those entrusted to act as the shareholders guardian, and a fundamental cultural change by corporate management as well as the financial community" to address the nine problem areas (Levitt, 5). His nine-point program would help to restore integrity in financial statements. First, to improve accounting framework the SEC staff will be requiring well-detailed disclosures about the impact of changes in accounting assumptions. The inclusion of beginning and ending account balances as well as the adjustments being required would also enhance understandability of financial statements. By comprehending the changes investors and creditors can better determine the future effects on earnings. Secondly, clarification of auditing rules for research and development purchases are being requested from the American Institute of Certified Public Accountants (AICPA). Levitt believes that, "it's time for the accounting profession to better qualify for auditor's what's acceptable and what's not" (Levitt, 5). The third step addresses the issue surrounding materiality; the SEC staff was asked to emphasize the need for considering qualitative factors, not just quantitative because not all relevant factors that impact an investors decision can be measured quantitatively. Fourth, the SEC staff will invoke guidance on revenue recognition. Fifth, private sector standard setters were asked to provide further assistance where current standards and guidance were inadequate. Sixth, the SEC will begin targeting public companies that appear to manage earnings (Levitt, 6).

To improve outside auditing, Levitt proposed that the Public Oversight Board form a group of all the major constituencies to review the way audits are performed and assess the impact of recent trends on the public interest. The "blue-ribbon" panel, sponsored by the New York Stock Exchange and the National Association of Securities Dealers, will be establishing recommendations that empower audit committees and function as the ultimate guardian of investor interests and corporate accountability. Lastly, Levitt encourages the financial community to "re-examine our current environment" and "embrace nothing less than a cultural change" (Levitt, 7).

In conclusion, our market and economy relies upon the reliability of financial statements provided by management; it is their responsibility to provide the most reliable, transparent information. By manipulating earnings they are tampering not only with the financial statements but also with the financial system itself. The prosperity of the market depends on investors and their perception of positive indicators for future earnings and growth. If the trust in financial reports is lost, a panic will ensue, inevitably causing a collapse in our financial system. Everyone will be affected by the consequences of earnings management; therefore, we are all obligated to support and assist in the implementation of Chairman Levitt's action plan, to provide that neither the quality nor the integrity of our financial statements are affected. Chairman Levitt stated that, "For the sake of our markets; for the sake of a globalized economy which depends so much on the reliability of America's financial system; for the sake of investors; and for the sake of a larger commitment not only to each other, but to ourselves, I ask that we join together to reinforce the values that have guided our capital markets to unparalleled supremacy" (Levitt, 8).

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McGough, Robert. "Executive Critical of Managed Earnings; Doesn't Mind if the Street Criticizes Him." Wall Street Journal, April 23, 1999, eastern ed.: C1.

Smith, Randall, Steven Lipin, and Amal Kumar Naj. "Managing Profits: How General Electric Damps Fluctuations in its Annual Earnings," Wall Street Journal, (1994),: 321-326.

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Last Modified: April 6, 2004