Signs Of Backlash Against SEC's Attack On Cookie Jar Reserves And Income Smoothing

August 1999

SIGNS OF BACKLASH AGAINST SEC'S ATTACK ON COOKIE JAR RESERVES AND INCOME SMOOTHING

SEC Chair Arthur Levitt, in his well-known September 28, 1998, speech, attacked the earnings management and income smoothing practices of some public companies. He spoke of the use of "cookie jar" reserves to sock away money in good times only to be drawn upon in bad times. There is no question that some companies have used reserves to bolster earnings reports and hide the true picture of declining profitability.

Some observers are beginning to question this all-out attack on what many financial managers think is a proper and conservative tempering of operating results. An example of this is the recent testimony of Rex S. Schuette before the House Financial Institution Subcommittee. Schuette, testifying on behalf of the American Bankers Association, objected to the SEC's activities directed at banking institutions that were using reserves to manage earnings.

Schuette's remarks questioned the appropriateness of making loan loss reserves an industry issue at this point in the economic cycle. He stated that the SEC's actions, "whether intended or not, may lead to a widespread dilution of reserves."

Schuette focused on three aspects of loan loss provisions:

Reserves are vital to bank safety and soundness. Banks and banking regulators recognize that continued economic growth cannot be sustained and that the likelihood of a slowdown must be considered in evaluating the adequacy of reserves.

Accurate and timely reporting of loan losses is important. The methodologies that institutions use are well established and accepted among regulators, auditors, and banking institutions.

Clarification of rules for reserving, if necessary, should involve all the parties to the process. The SEC's actions have caused confusion. If the SEC believes it is only addressing outliers in providing for loan losses, clarification is needed.

In concluding his testimony, Schuette expressed appreciation for the SEC's efforts to open up communications with the banking community.

Financial officers of public companies have also been heard mumbling and groaning over the SEC's position. Under a number of theories--conservatism, matching revenues and costs, saving for a raining day, and the like--members of this group see it as their duty to take the rough edges off operating results. *

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