Financial Reporting Essay, Research Paper

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.

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.