Financial Reporting Essay

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.

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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.

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 Exceed
Expectations” 20 Oct. 1999.


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