By James R. Duncan
In Brief
A Cluster of Contributing Factors
SEC Chairman Arthur Levitt’s attack on corporate earnings management turned up the heat on the quality of financial reporting that underpins the success of U.S. capital markets. The results so far have included an examination of the audit process for public companies, stronger guidelines for corporate audit committees, and three staff accounting bulletins (SAB) to circumscribe interpretations of materiality, guide restructuring and impairment charges, and restrict improper revenue recognition.
Studies show that, rather than having a single cause, earnings pressure results from multiple factors in a company’s environment, culture, or management and can lead to erosion in the quality of financial reporting. Increasing awareness of earnings management will promote its identification and treatment and enhance financial statement users’ trust in the accounting system.
Since SEC Chairman Arthur Levitt’s “Numbers Game” speech before the NYU Center for Law and Business in September 1998, earnings management has been the focus of regualtory attention. Levitt attacked accounting “hocus-pocus” as a serious threat to the viability of the financial reporting that underpins the U.S. capital markets. His speech contained a nine-point attack on earnings management and provided the impetus for three new Staff Accounting Bulletins (SAB; see Sidebar), a report from the Public Oversight Board’s (POB) Panel on Audit Effectiveness, and new recommendations from the Blue Ribbon Panel on Improving the Effectiveness of Corporate Audit Committees.
Levitt defined earnings management as practices by which “earnings reports reflect the desires of management rather than the underlying financial performance of the company.” Companies use various devices to influence earnings outcomes, including “big bath” charges, “cookie jar” reserves, and the abuse of materiality and revenue recognition principles. These practices tend to erode the quality of earnings and financial reporting and deceive financial statement users.
A 1998 Business Week poll reported that 12% of CFOs had managed earnings at the request of their superiors and an additional 55% of CFOs said they were asked to manage earnings but refused to do so. According to CFO Magazine (September 1999), 60% of CFOs have felt pressure to manage earnings. This pressure is often most strongly felt by those in middle management, including controllers and divisional personnel. This author’s own research (“Investigating Behavioral Antecedents of Earnings Management,” Research on Accounting Ethics, v.6) found that earnings pressure was by far the most significant factor affecting earnings management behavior.
Pressure to manage earnings does not stem from a single source. Pressure to influence reported results can arise from forces outside the company, from conditions and programs within the company, or from motivations held by individuals that choose to engage in earnings management activity.
External Forces
Analysts’ forecasts. Companies that fail to reach analysts’ estimates for multiple quarters can see their stocks drop precipitously. When Procter & Gamble warned that it would not meet analysts’ consensus forecast in the first quarter of 2000, its stock price fell 30%. When P&G issued further warnings just before the end of the second quarter of 2000, the stock price fell another 10% and P&G’s CFO was fired. As reported in CFO Magazine (December 1998), one CFO told SEC Chief Accountant Lynn Turner that when the CFO warned an analyst that the company might just miss consensus estimates, the analyst told him, “You’re a bright guy; you’ll figure out how to make it.”
Access to debt markets. Many companies depend on financial leverage in optimizing returns to stakeholders. To establish a business’s creditworthiness, debt rating agencies use much of the same information as stock analysts. A slight drop in earnings or negative expectations about future prospects could cause a decline in a company’s debt rating, increasing its cost of capital and diminishing prospects for new debt issues.
Competition. Companies in highly competitive industries may want to maintain an edge in revenues or market share. In 1998, Sensormatic Electronics, a maker of security systems, actually stopped its clocks, which stamped shipping dates and times on finished products, 15 minutes before noon on the last day of a quarter, so it could continue to make customer shipments within the quarter until it had reached its sales target. The SEC brought charges and Sensormatic settled without admitting or denying misconduct.
Contractual obligations. Many debt and lease agreements, as well as other contractual arrangements, contain covenants in which a company agrees to attain certain earnings, debt, or other ratios, or limit payments to shareholders. When a company is in danger of missing one of the covenants, the agreement may provide for immediate repayment or other specified performance. Manipulating earnings slightly can improve ratios enough to avert such dangers.
Roaring stock market. A red-hot stock market continues upward pressure on investor expectations and companies to achieve those outlooks. To support rising stock prices, firms could risk the improper recognition of revenues by recording false sales, shipping products before customers agree to buy, and recording up-front revenue from long-term contracts. Some observers say this pressure is strongest in the technology sector. According to National Economic Research Associates, in the first half of 1999 more than 50% of securities fraud lawsuits involved improper revenue recognition practices, compared to 20% for the preceding year.
New financial transactions. Emerging financial instruments (e.g., derivatives) allow room for discretion in accounting treatment. Accounting guidance specifies treating derivatives as hedges or speculative transactions, depending on facts and management intent and capability. Authoritative guidance for derivative accounting is complex, and different entities with similar derivatives might document these transactions in a wide variety of ways in order to obtain favorable outcomes. For software companies, another significant decision is when to treat large investments in software development as an asset.
Market disregard of big charges. The financial markets seem conditioned to disregard big nonoperating charges, thereby providing incentive for managers to make them as big as possible. Frequently, earnings announcements quote numbers “before one-time items.” Warren Buffett cites an R.G. Associates 1998 compilation of charges recorded for restructuring, in-process reseach and development, merger-related items, and write-downs. The list totaled more than 1,300 charges aggregating more than $72 billion.
Company Culture
Merger attractiveness. Good financial performance can enhance the attractiveness of merger target companies. Prior to the merger of HFS Incorporated and CUC International into Cendant Corporation, certain business units of CUC engaged in accounting irregularities that inflated company revenues by nearly $500 million. When the situation came to light, Cendant restated earnings and agreed to change its revenue accounting practices. Cendant’s stock price and reputation suffered in the process, and several members of its board of directors resigned.
Management compensation. Companies frequently tie executive stock option and bonus programs to earnings performance, attempting to align management’s objectives with ownership’s but also creating powerful incentives for managers to manipulate earnings to achieve compensation payouts. Some companies even increase the pressure by lending money to employees for the purchase of company stock. Last year, Conseco, Inc., an Indiana-based financial services company, guaranteed about $600 million in employee loans to purchase its stock. This practice can create pressure to meet optimistic earnings projections intended to maintain the stock price.
Short-term focus. Inevitably, some companies focus on short-term performance regardless of the future. Austerity programs are implemented, investment spending is delayed, and employees are fired to achieve a short-term earnings goal while undermining long-term performance. Occasionally, firms will defer or capitalize expenditures that should be expensed. A few years ago, America Online recorded a $385 million charge because it had inappropriately deferred marketing expenses; the charge wiped out all of AOL’s earnings to that point.
Unrealistic plans and budgets. Companies sometimes establish unrealistic annual plans and budgets to push managers to overachieve. One such company consistently establishes internal plans 20% over the previous year, regardless of economic or business factors. The idea is solid: Unless the bar is set high, managers won’t try to jump it. Setting budgets beyond the achievable, however, encourages managers to fudge the numbers to get as close as possible.
Period-end requests from superiors. A significant pressure to manage earnings often derives from corporate superiors requesting that division personnel provide additional profit to meet quarterly and year-end targets. The late-quarter phone call asking, “What else can you do?” provides a cultural incentive for managers to learn to play the earnings game.
Excessive profit followed by fear of decline. Some companies fear that a famine will follow feast years. W.R. Grace & Co. held back excess earnings from a medical subsidiary to create a $60 million reserve to smooth earnings over future, less profitable years. Grace used “materiality” to convince auditors that adjustment of the reserve was not required. Upon SEC investigation, Grace was fined, cease-and-desist orders were filed against two auditors, and civil charges were brought against the CFO.
Concealing unlawful transactions. Companies fear that disclosing unlawful transactions will damage their reputations. Companies and individuals can use earnings manipulation practices to cover up embezzlement, fraud, misappropriation, and bribery. ZZZZ Best Company, Inc., went to great lengths to create a paper trail of false transactions to cover for a lack of business. The CEO even issued a press release reporting record profits just before his schemes unraveled and the company collapsed.
Personal Factors
Personal bonuses. Company executive compensation policies are frequently weighted more heavily toward incentives than a base salary. With a few good years, individuals can establish their personal finances for retirement. The prospect of a giant bonus may provide sufficient motivation to fudge a few accounting numbers.
Promotions. Some individuals will do whatever it takes to get the next promotion. Their obsession with climbing the corporate ladder engenders behavior that will shed the best light on their actions. The combination of personal ambition and a corporate tendency to reward the “best” performers can create an incendiary situation.
Focus on team. In a company that stresses a team culture, “team players” receive the promotions and raises. Often, the financial team has the greatest opportunity to impact reported results at the last minute. Individuals striving for team success can undermine financial reporting by making the late adjustments that will achieve financial targets.
Job retention. In the 1990s, downsizing became the preferred method for cutting costs and enhancing profitability. When companies struggle to meet expectations, managers of underperforming areas risk losing their jobs. A little judicious earnings manipulation could improve the profit picture and keep a manager’s position secure.
Hero or turnaround specialist. Individuals can be motivated to manage earnings in order to be viewed as heroes or turnaround specialists. Sunbeam hired Al Dunlap to reverse their performance trends, but some have alleged that he pursued “accounting gimmicks” as part of his efforts to improve company performance. Dunlap resigned in 1998 after the start of an SEC investigation, and the company subsequently restated results for 1997 and part of 1998.
Low regard for auditors. In Rewarding Results, Kenneth Merchant indicated that managers have a low opinion of an auditor’s ability to detect earnings management. In large companies, almost nothing in an individual division is material to the overall financial statements; consequently, managers believe they can manipulate earnings in ways that an auditor will not detect. Some managers believe that even if the manipulation is detected, they can invent a satisfactory justification. In this author’s experience, likelihood of detection was the least significant factor in a manager’s decision to engage in earnings management practices.
Interaction of pressures. Earnings management can also be the product of interaction between various pressures. The external and company-culture forces may have greater effects on managers overly concerned with compensation or job security. Conversely, a company culture that respects genuine and ethical achievement is less likely to encourage managers to respond to external pressures in inappropriate ways. In any situation, factors in all three categories must be evaluated in order to understand the pressures that lead to earnings management.
Is There an Upside?
Many of the pressures that can lead to earnings management have positive aspects as well:
Some observers even declare that a certain amount of earnings management is good for companies and individual stakeholders, based on a belief that companies should make operating decisions that propel long-term performance by sometimes deferring spending or taking one-time charges that benefit the future. Actions that manipulate perceptions but have no lasting impact—actions solely directed toward controlling the decisions of financial statement users—may, however, cross the line.
The initiatives that have followed in the wake of the “Numbers Game” mark the start of addressing the problem of earnings management. Nevertheless, one cannot help but think these actions will fall short in creating the environmental, corporate, and individual cultures necessary to reverse the erosion of quality in financial reporting. If we are to fully understand the phenomenon of earnings management, we must comprehend the pressures that lead to this behavior. If financial statement users understand the existence of these pressures, they have the opportunity to adjust their decisions accordingly.
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