Financial Reporting
On
September 28, 1998, Chairman of
the U.S. Securities and Exchange Commission
Arthur Levitt sounded the
call to arms in the financial community. Levitt asked
for, "immediate and
coordinated action... to assure credibility and
transparency" of financial
reporting. Levitt’s speech emphasized the
importance of clear financial
reporting to those gathered at New York
University. Reporting which has
bowed to the pressures and tricks of earnings
management. Levitt specifically
addresses five of the most popular tricks used
by firms to smooth earnings.
Secondly, Levitt outlines an eight part action plan
to recover the integrity
of financial reporting in the U.S. market place. What
are the basic
objectives of financial reporting? Generally accepted accounting
principles
provide information that identifies, measures, and communicates
financial
information about economic entities to reasonably knowledgeable
users.
Information that is a source of decision making for a wide array
of users, most
importantly, by investors and creditors. Investors and
creditors who are
responsible for effective allocation of capital in our
economy. If financial
reporting becomes obscure and indecipherable, society
loses the benefits of
effective capital allocation. Nothing illustrates the
importance of transparent
information better than the pre-1930’s era of
anything goes accounting. An era
that left a chasm of misinformation in the
market. A chasm that was a
contributing factor to the market collapse of 1929
and the years of economic
depression. An entire society suffered the
repercussions of misinformation.
Families, and retirees depend on the
credibility of financial reporting for
their futures and livelihoods. Levitt
describes financial reporting as, a bond
between the company and the investor
which if damaged can have disastrous,
long-lasting consequences. Once again,
the bond is being tested. Tested by a
financial community fixated on
consensus earnings estimates. The pressure to
achieve consensus estimates has
never been so intense. The market demands
consistency and punishes those who
come up short. Eric Benhamou, former CEO of
3COM Corporation, learned
this hard lesson over a few short weeks in 1996.
Benhamou and
shareholders lost $7 billion in market value when 3COM failed to
achieve
expectations. The pressures are a tangled web of expectations, and
conflicts
of interest which Levitt describes as "almost
self-perpetuating." With
pressures mounting, the answer from U.S. managers
has been earnings
management with a mix of managed expectations. March of 1997
Fortune
magazine reported that for an unprecedented sixteen consecutive
quarters,
more S&P 500 companies have beat the consensus earnings estimate
than
missed them. The sign of a quickly growing economy and a measure of
the
importance the market has placed on consensus earnings estimates. The
singular
emphasis on earnings growth by investors has opened the door to
earnings
management solutions. Solutions that are further being reinforced to
managers by
market forces and compensation plans. Primarily, managers jobs
depend on their
ability to build stockholder equity, and ever more
importantly their own
compensation. A growing number of CEO’s are recieving
greater percentages of
their compensation as stock options. A very personal
incentive for executive
achievement of consensus earnings estimates.
Companies are not the only ones to
feel the squeeze. Analysts are being
pressured by large institutional investors
and companies seeking to manage
expectations. Everyone is seeking the win.
Auditors are being accused of
being out to lunch, with the clients. Many
accounting firms are coming under
scrutiny as some of their clients are being
investigated by the SEC for
irregularities in their practice of accounting.
Cendant and Sunbeam both
left accounting giant Arthur Anderson holding a big
ol’bag full of unreported
accounting irregularities. Auditors from BDO Seidman
addressed issues of GAAP
with Thing New Ideas company. The Changes were made and
BDO 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 idea
of how independent the
auditors are. All of these pressures allow questionable
accounting practices
to obfuscate the reporting process. Generally accepted
accounting principles
are intended to be a guide, not a procedure. They have
been developed with
intended flexibility so as not to hinder the advancement of
new and
innovative business practice. Flexibility that has left plenty of room
for
companies to stretch the boundaries of GAAP. Levitt focus’s on five of
the
most widespread techniques used to deliver added flexibility.
"Big
Bath" restructuring charges, creative acquisition accounting,
"Cookie
Jar" reserves, "Immaterial" misapplications of
accounting
principles and the premature recognition of revenues. These
practices do not
specifically violate the "letter of the law," but are
gimmicks that
ignore the spirit and intentions of GAAP. Gimmicks, according
to Levitt, that
are "an erosion in the quality of earnings and therefore the
quality of
financial reporting." No longer is this just a problem perceived
in small
corporations struggling for recognition. Throughout the financial
community,
companies big and small are using these tools to smooth earnings
and maximize
market capitalization. The "Big Bath" restructuring charge is
the
wiping 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 future
expenses to be absorbed by restructuring liabilities. Large
one time charges
that will be ignored by analysts and the financial community
through a little
convincing and notation. In note fifteen of the Coca-Cola
company’s 1998
annual report shows seven nonrecurring items from the past
three years. Fours of
these charges are restructuring charges, most
significantly in 1996 in this
note. In 1996, we recorded provisions of
approximately $276 million in selling,
administrative and general expenses
related to our plans for strengthening our
world wide system. Of this $276
million, approximately $130 million related to
streamlining our operations,
primarily in Greater Europe and Latin America.
These one time write-offs
become virtually insignificant footnotes to the
financial reporting process.
Extraordinary charges that are becoming unusually
common. Kodak has taken six
extraordinary charges since 1991 and Coca-Cola has
taken four in two years.
The financial community has to wonder how
"unusual" these charges are.
Creative acquisition accounting is what
Levitt calls "Merger Magic." With
the increasing number of mergers in
the 90’s, companies have created another
one time charge to avoid future
earnings drags. The "in-process" research and
development charge
allows companies to minimize the premium paid on the
acquisition of a company. A
premium that would otherwise be capitalized as
"goodwill: and depreciated
over a number of years. Depreciation expenses that
have an impact on future
earnings. This one time charge allowed WorldCom to
minimize the capitalization
of "goodwill" and avoid $100 million a year in
depreciation expenses
for many years. A charge hiding in this complex note on
WorldCom’s 1996 annual
financial statement. (1) Results for 1996 include a
$2.14 billion charge for
in-process research and development related to the
MFS merger. The charge is
based upon a valuation analysis of the technologies
of MFS worldwide information
system, the internet network expansion system of
UUNET, and certain other
identified research and development projects
purchased in the MFS merger. The
expense includes $1.6 billion associated
with UUNET and $0.54 billion related to
MFS. (2) Additionally, 1996
results include other after-tax charges of $121
million for employee
severance, employee compensation charges, alignment
charges, and costs to
exit unfavorable telecommunications contracts and $343.5
million after-tax
write-down of operating assets within the company’s non-core
businesses. On a
pre-tax basis, these charges totaled $600.1 million. The dollar
amounts are
staggering and the future implications far reaching. Since this
approach was
introduced by IBM in 1995 these charges have become commonplace
for
acquisition accounting. A popularity, largely due to the level of room
allowed
in research and development estimations. The Third earnings
manipulation tool
discussed by Levitt is what he calls "Miscellaneous Cookie
Jar
Reserves." The technique involves liability and other accrual
accounts
specifically sensitive to accounting assumptions and estimates.
These accounts
can include sales returns, loan losses, warranty costs,
allowance for doubtful
accounts, expectations of goods to be returned and a
host of others. Under the
auspices of conservatism, these accounts can be
used to store accruals of future
income. Restructuring liabilities created by
"Big Bath’ charges also
provides these "Cookie jar reserve" effect. Jack
Ciesielski, who
manages money and writes the Analyst’s Accounting Observer,
calls these
accounts the "accounting equivalent of turning lead into gold...
a virtual
honeypot for making rainy-day adjustments." Various adjustments and
entries
that can produce almost any desired results in the pursuit of
consistency. The
statement of financial accounting concepts No. 2 (FASB, May
1980), defines
"materiality" as: The magnitude of an omission or misstatement
of
accounting information that, in light of surrounding circumstances, makes
it
probable that the judgement of a reaonable person relying on the
information
would have been changed or influenced by the omission or
misstatement. Today’s
management has started to ignore this fundamental
principle. Materiality is
being defined as a range of a few percentage
points. Companies defend immaterial
omissions by referring to percentage
ceilings that draw a line on materiality.
"The amount falls under our ceiling
and is therefore immaterial." The
materiality gimmick is one more method
companies are using to stretch a nickel
into a dime. Simply put, "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," says
Levitt. Finally, Levitt briefly touches on the
complex issue of the
manipulation occuring in revenue recognition. Modern
contracts, refunding,
delaying of sales, up front and initiation fees all add to
the complications
in some industries to follow specific rules of revenue
recognition. With
plenty of holes in revenue recognition the door is open for
tweaking.
Microsoft is a good example of the problems facing today’s
companies.
Concerned with proper revenue recognition, Microsoft started a
practice in
the software industry that allows companies to recognize revenue
over a
period of time. This recognition allows for better matching of revenues
to
future expenses generated by the sale of the software. Expenses such
as
upgrades and technical support are related to the revenue generated by the
sale
of the software but are incurred at a later date. The complexities of
modern
business transactions have left modern standards of accountancy years
behind.
Gimmicks, that all must be addressed by the financial community.
The task of
returning integrity to U.S. financial reporting is of paramount
importance. The
interests 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 sector
dictates seems the wisest choice." A nine part plan that
involves the
entire financial community is proposed by Levitt. Levitt has
made it very clear
that the SEC is prepared to start forcing change. A line
Levitt hopes will not
be necessary to cross. The SEC will begin to issue
guidance on a wide array of
issues concerning the credibility and
transparency of financial reporting.
Guidance that must be acted on to
"Obviate" the need for large scale
SEC involvement. The SEC will also act
more proactively in two of its
traditional roles of information regulation
and enforcement. First, the SEC will
begin requiring companies to provide
additional disclosure details on changes in
accounting assumptions.
Supplemental beginning and ending balances and
adjustments of sensitive
restructuring liabilities and other loss accruals will
also be required.
Secondly, the SEC is unleashing the dogs on companies using
any 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
other
standard setting bodies have fallen behind a rapidly changing and
evolving
economic environment. FASB and the AICPA are being coercively
encouraged to
clean up auditing and disclosure practices. The pressure is on
and standard
setting bodies are scrambling to close the holes in GAAP. FASB
has established
committees to investigate a number of concerns and is
diligently working toward
solutions that "obviate." Auditors and the public
accounting industry
received a good scolding from Levitt. Glaring failures in
the auditing process
at Sunbeam, Waste Management Inc., and Cendant have put
the whole industry at
risk of public solutions. The auditors have failed to
be the "watch
dog" of investors. It is time to clean up your industry.
Criticism by the
entire financial community has questioned the auditors,
qualifications, methods
and their ability to police themselves. Finally
Levitt challenges corporate
management, and investors to begin a cultural
change. Change that resists the
pressures to follow the leader in accounting
chicanery. Investors are encouraged
to set financial standards of integrity
and transparency and punish those who
depend on illusion and deception.
"American markets enjoy the confidence of
the world. How many half-truths,
and how much sleight-of-hand, will it take to
tarnish that faith?" With the
shift away form company run pension plans
everyone has become their own
personal financial planners. What hangs in the
balance is the future of us
all.
Bibliography
Levitt, Arthur. "Quality Information: The
Lifeblood of Our
Markets." Speech, 18 Oct. 1999. Fox, Justin, "Searching
for Nonfiction
in Financial Statements," Fortune 23 Dec. 1996. Adams, Jane
B.
"Remarks." Speech, 9 Dec. 1998. Ciesielski, Jack, "More
Second
Guessing." Barrons. Johnson, Norman S. "Recent Developments at
the
SEC." Speech. 20 August 1999. Fox, Justin. "Learning to Play
the
Earnings Game (And Wallstreet will Love You)." Fortune 31 Mar.
1997
Greenberg, Herb, "The Auditors are Always Last to Know,"
Fortune
Investor 17 Aug. 1998. Melcher, Richard, "Where are the
Accountants."
Business Week 5 Oct. 1998. Melcher, Richard and Sparks,
Debra "Earnings
Hocus Pocus" Business Week 5 Oct. 1998. Bartlett, Sarah,
"Corporate
Earnings: Who Can You Trust" Business Week 5 Oct. 1998.
Turner, Lynn E.
"Continuing High Traditions" Speech, 5 Nov. 1998. Turner,
Lynn E.
"Remarks" Speech, 10 Feb. 1999. Aeppel, Timothy
"Eaton’s
Earnings Increase but Miss Analysts’ Forecasts" 20 Oct. 1999.
Tran, Khanh
"Excite At Home Posts Quarterly Loss Due to Charges but
Meets
Estimates" 20 Oct. 1999. Bank, David "Microsoft Earnings
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Expectations" 20 Oct.
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