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. Levitts 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-1930s 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 CEOs 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 olbag 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 focuss 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 companys 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 90s, 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 WorldComs 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 …