November 1998 Issue


Authur Levitt At a speech on September 28, 1998--marking the creation of the Center for Law and Business at New York University under the leadership of William T. Allen, chair of the Independence Standards Board--SEC chairman Arthur Levitt, Jr., declared an all-out war on earnings management. Levitt characterized the process as a "game among market participants," which, if not addressed, will have "adverse consequences for America's financial reporting system." Levitt fears that "we are witnessing an erosion in the quality of earnings, and therefore the quality of financial reporting."

Keeping with Levitt's approach to seek private-sector solutions to problems, he went on to say that the erosion of earnings is "a financial community problem. It can't be solved by a government mandate; it demands a financial community response."

Levitt presented five ways in which companies use trickery and illusions to obscure financial volatility.

Big Bath Restructuring Charges. Companies overstate the costs associated with a restructuring, enabling them to clean up their balance sheets and create a reserve for a rainy day.

Creative Acquisition Accounting. The SEC is seeing acquiring companies classify a portion of the purchase price as "in-process research and development" which is immediately written off, thereby reducing the amortization of the purchase price to future earnings.

Miscellaneous "Cookie Jar" Reserves. This is an old practice that goes back to creation. Management creates comfortable or liberally interpreted reserves in good times that are then used to smooth out earnings in not-so-good times.

Abuse of Materiality. Levitt noted companies are making unsupported adjustments which help smooth earnings or achieve an earnings estimate, but which are not challenged by auditiors or allowed to be recorded because the they are not material. He suggests that adjustments may have to be looked at relative to earnings forecasts rather than in absolute terms.

Revenue Recognition. Some companies are recognizing revenue prematurely. This is also an age-old practice that, for whatever reason, standard setters have been reluctant to address.

Levitt proposed a joint effort to deal with the issues: technical rule changes by regulators and standard setters, enhanced oversight of financial reporting process, and a cultural change on the part of corporate management. Included in the program is a challenge to the AICPA to provide guidance to auditors when auditing purchased R&D, restructuring charges, and revenue recognition.

The AICPA issued a news release in response to Levitt's address that announced initiatives to better equip auditors in dealing with earnings management. This includes a toolkit for auditing revenue recognition, a reexamination of the audit risk model by the Auditing Standards Board, and the development of a publication intended for members of audit committees.

A key aspect of Levitt's plan is the establishment of a "blue-ribbon" panel under the sponsorship of the New York Stock Exchange and the National Association of Securities Dealers to make recommendations "intended to empower audit committees and function as the ultimate guardian of investor interests and corporate accountability."

The SEC will be issuing Staff Accounting Bulletins that will require additional disclosures for loss accruals and accounting assumptions and give further guidance on revenue recognition. Levitt also charged the Public Oversight Board of the SEC Practice section to form a group "to review the way audits are performed and assess the impact of recent trends on the public interest."

On the day of Levitt's address, Business Week's cover story was on corporate earnings and "Who Can You Trust?" Parts of the article dealt with "Earnings Hocus-Pocus," the very subject of Levitt's speech; "Where Were the Accountants?" which dealt with the problems auditors face regarding companies that push the envelope in earnings recognition; and "Wall Street's Spin Game," which exposed the pressures on analysts and questioned whether they can be trusted to tell it as they really see it.

Which came first and does it matter--the Levitt speech or the Business Week cover? They clearly tell much of the same story and perhaps represent a mutually arrived at position. More importantly, the SEC has declared war on what it views as a significant deterioration in earnings quality, which is the very cornerstone of the success and value of U.S. securities markets. The complete text of Levitt's speech will appear in the December issue of The CPA Journal. *

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