Abusive Earnings Management and Early Warning Signs

By Lorraine Magrath and Leonard G. Weld

In Brief

Fraudulent Accounting Leads to Staggering Losses

Over the last three years, SEC investigations have uncovered earnings management practices that have pushed the boundaries of GAAP, even to the point of out-right fraud. In some instances, independent auditors were blamed for not catching or correcting accounting irregularities. In others, it is clear that management intended to deceive outside auditors and audit committees. Regardless of fault, when earnings management and fraudulent accounting schemes are uncovered, the monetary losses can be staggering.

Enron’s stock fell from its high of $90.75 to $0.68 after the SEC began investigating Enron’s accounting practices. After the collapse in the market value of its stock, Enron was forced to seek bankruptcy protection, resulting in the largest bankruptcy in U.S. history. A recent Financial Executives International (FEI) report indicates that the stock market lost more than $34 billion during the three-day period during which the three most egregious cases of abusive earnings management in 2000 (Lucent Technologies, Cendant, and MicroStrategy) surfaced.

While SEC documents indicate that the accounting irregularities at Lucent, Cendant, and MicroStrategy were primarily “abusive” earnings management schemes or outright fraud, all three companies began their abusive and fraudulent practices by engaging in earnings management schemes designed primarily to “smooth” earnings to meet internally or externally imposed earnings forecasts and analysts’ expectations. Earnings management practices can be designed either to assist managers in fulfilling their obligations to stakeholders or to deceive investors. The SEC’s concept of “abusive” earnings management suggests analytical approaches to uncovering such practices. In addition, the accounting profession has taken steps to educate accountants about earnings management practices and their effects and consequences. (See the Sidebar for further readings on abusive earnings management.)

Good Business Practice or “Abusive” Earnings Management?

In his 1998 “Numbers Game” speech, former SEC Chairman Arthur Levitt expressed his concern that too many corporate managers, auditors, and analysts let the desire to meet earnings expectations override good business practices. He called for a fundamental cultural change on the part of corporate management and the entire financial community.

The need to precisely define “earnings management” arises because the SEC and accounting profession acknowledge that some earnings management techniques are not fraudulent. Many accountants, analysts, and investors believe that good business practice requires managers to manage earnings. For example, in an article on the reaction to Chairman Levitt’s remarks, The CPA Journal (1999) noted that Chairman Levitt “attacked the earnings management and income smoothing practices of some public companies” and noted that some questioned “this all-out attack on what many financial managers think is a proper and conservative tempering of operating results.”

Companies have long used earnings management techniques to “smooth” earnings, a process that is typically rewarded in the stock market. For example, a 1994 Wall Street Journal article detailed the many ways in which General Electric smoothed earnings, including the careful timing of capital gains and the use of restructuring charges and reserves. In response to the article, General Electric reportedly received calls from other corporations questioning why such common practices were “front-page” news.

Managers engage in income smoothing activities because they know that volatile earnings streams typically lead to lower market valuations. Many successful management teams believe that the strategic timing of investments, sales, expenditures, and financing decisions is an important and necessary strategy for managers committed to maximizing shareholder value.

Levitt’s speech indicated that the SEC would target companies that engaged in “practices that appear to manage earnings,” without clearly distinguishing between earnings managed in the ordinary course of business and earnings fraudulently managed in a deliberate attempt to deceive the financial community.
Chairman Levitt did, however, identify five popular examples of “accounting hocus pocus” that could be used to create illusionary earnings:

Because these forms of earnings management typically require premeditated use of sophisticated accounting techniques, the examples apparently preclude good business practices arising in the normal course of business from being “illusionary earnings” or abusive earnings management. In subsequent speeches, SEC Chief Accountant Lynn Turner clarified the issue “by indicating that misapplication of GAAP and stretching the rules to achieve desired targets are fraudulent accounting practices that would be targeted by the SEC.” In its 1999 annual report, the SEC offered further clarification when it indicated that its enforcement division focused on abusive earnings management practices which involved “the use of various forms of gimmickry to distort a company’s true financial performance in order to achieve a desired result.” In several actions brought against companies since the 1998 speech, SEC documents refer directly to managers’ attempts to meet analysts’ expectations.

Meeting Analysts’ Expectations

In general, analysts’ expectations and company predictions tend to address two high-profile components of financial performance: revenue and earnings from operations. The pressure to meet revenue expectations is particularly intense and may be the primary catalyst in leading managers to engage in earnings management practices that result in questionable or fraudulent revenue recognition practices. One FEI study indicates that improper revenue recognition practices were the cause of one-third of all voluntary or forced restatements of income filed with the SEC from 1977 to 2000. The Lucent, Cendant, and MicroStrategy restatements mentioned earlier were due primarily to improper recognition of revenues.

In one case investigated by the SEC, high-level managers shipped fruit baskets to friends and associates, and used the shipping documents to provide audit evidence to support fictitious sales (AAER 1311, 09/16/2000). Because such activities tend to involve high-level employees intent on deception, auditors frequently find such fraudulent activities difficult to uncover.

Other top managers engaging in improper revenue recognition practices may do so with the full cooperation of employees that may not understand the impropriety of their actions. For example, an SEC investigation revealed that premature revenue recognition practices were such an integral part of operations at one manufacturing company that MIS personnel wrote a program to automatically freeze the computer date while the quarter was held open. In another case, one manufacturer obtained audit evidence for sales recognized prematurely by shipping legitimate orders to its own warehouses and holding the products until customer-requested shipping dates in later periods. In many cases, managers attempt to meet quarterly expectations by prematurely or improperly recognizing revenue for sales that do not meet criteria for recognition under GAAP but would be legitimately recognized in future periods. Such premature revenue recognition can go unnoticed if company managers do not consistently engage in such practices or if the company continues to grow.

Nonetheless, because revenue expectations for future quarters are based primarily on revenues recognized in current quarters, analysts’ expectations for the quarters following those in which revenue was prematurely or improperly recognized are typically inflated. The magnitude of the inflated expectations is usually compounded by the addition of “growth” factors, rendering the new quarterly expectations difficult or impossible to achieve without further manipulations or fraudulent accounting activities. The seemingly common consequence of improper revenue recognition practices is that, once started, companies must continue earnings management activities in order to meet ever-increasing internal sales targets and analysts’ expectations. Frequently, the earnings manipulations or fraudulent activities involving revenue generate the need for more complex and sophisticated accounting techniques to ensure analysts’ earnings expectations are met. Eventually, companies must engage in more blatant fraudulent activities by creating artificial reserves, understating reserve liabilities, using creative acquisition accounting practices, or otherwise manipulating GAAP to perpetuate myths involving company “growth.”

Detecting Earnings Management

Fraudulent accounting practices involving restructuring charges, reserves, creative acquisition accounting, and manipulation of GAAP are very difficult for outsiders to detect. Insiders responsible for earnings management are intent on hiding such activities, particularly when the earnings management practices escalate beyond improper revenue recognition. As the charges in several SEC investigations indicate, when managers engage in abusive earnings management practices they must lie to auditors, analysts, investors, and their own coworkers to cover these fraudulent activities.

SEC documents indicate that, in many cases, once the abusive earnings management practices become firmly entrenched at a company, high-level managers spend a great deal of time devising methods to ensure that the abusive practices continue. Because outsiders cannot observe management’s day-to-day activities, investors and auditors should look carefully for warning signs that abusive earnings management is present:

Cash flows. One of the most obvious warning signs that companies are engaging in improper revenue recognition is a lack of correlation between cash flow from operations and earnings. If revenue is properly recognized, cash flows should closely follow revenue recognition; that is, the business cycle will be completed and cash will be available for reinvestment when customers discharge their obligations in a timely manner. Cash flow lagging significantly behind revenues could be a sign that companies are inflating revenues by recognizing sales in inappropriate periods, making sales to non-creditworthy customers, or recording fictitious sales.

Receivables. Investors should also compare receivables and cash flow from operations with revenues and earnings. Receivables rising more quickly than revenues could be a sign that customers are experiencing financial distress. It could also be a sign that a company is engaging in abusive earnings management by recording fictitious sales or otherwise inflating revenues and accounts receivable. For example, a June 2000 Wall Street Journal article suggested that Lucent Technologies might be engaging in creative accounting practices, noting that Lucent’s receivables were rising at 49% while revenues were rising at only 20%.

Allowance for uncollectible accounts. Analyzing reserves for uncollectible accounts could also provide clues of abusive earnings management. Receivables growth not also reflected in the allowance could be a sign that managers are aware that revenues were recorded prematurely. It could also be a sign that managers have deliberately understated their reserves for uncollectible accounts or recorded fictitious revenues. Both Lucent and Cendant decreased their reserves for uncollectible accounts at times when revenues and receivables were rising.

Other reserves. Using reserves to appropriately match earnings with associated costs is a fundamental accrual accounting concept. GAAP requires that reserves be established for uncollectible accounts, warranties and guarantees, future commissions, and a host of other legitimate business purposes. These reserves are designed to ensure proper matching of revenues (or gains) and related costs. GAAP also allows, under stringent criteria, the establishment of restructuring reserves to reflect the beneficial effect of the restructuring on income in future periods. Reserves are established before circumstances requiring their use are known with certainty and, therefore, require informed judgments. High-level managers, who are in the best position to understand their customers, company, and industry, frequently control the terms and conditions by which reserve accounts are changed. Investors should carefully scrutinize all disclosure notes and other discussion materials related to reserves to determine if changes in reserve accounts are consistent with good business practices. For example, Cendant manipulated its cancellation and commission reserves downward at a time when revenues were increasing. Lucent manipulated its pension reserves and significantly inflated earnings by changing its accounting policies. Both companies manipulated or overstated acquisition and purchase reserves.

Acquisition reserves. Investors and auditors should carefully review the circumstances surrounding acquisitions. Escalating abusive earnings management practices often provide incentives for companies to seek business combinations that can be used to strengthen their “cookie jar.” If there is no apparent business purpose for a business combination, investors and auditors should carefully analyze the transaction. If restructuring charges or reserves set aside for disposals are created, investors and auditors should question the legitimacy of the business combination or acquisition. For example, SEC documents indicate that Cendant management intentionally overstated merger and purchase reserves, which were subsequently reversed directly into operating expenses and revenues.

Consistent earnings. Finally, investors and auditors should carefully examine the accounting practices of companies that consistently and precisely meet analysts’ expectations, particularly growth expectations. Analysts’ expectations are based in part on information obtained from company management; therefore, companies strive to meet analysts’ expectations to protect their reputations as well as the market value of their stock. Although many companies employ legitimate means to meet or exceed analysts’ expectations, other companies may engage in abusive earnings management practices to cover failures resulting from overly optimistic predictions, economic downturns, or business setbacks. For example, Cendant manipulated its financial reports to ensure that revenues and expenses were consistently reported at approximately the same percentages each quarter. While all businesses strive for smooth earnings, consistencies such as those reported by Cendant should trigger closer analysis of financial reports.

Professional Guidance

Since the SEC identified abusive earnings management as a primary target of its enforcement actions, the accounting profession and SEC have taken steps to improve the quality of financial reporting. The SEC has issued Staff Accounting Bulletins that 1) discuss the appropriateness and application of materiality in financial reporting, 2) discuss the appropriateness of and disclosure for acquisition-related reserves, and 3) reiterate existing GAAP with respect to revenue recognition. The accounting profession has participated in the discussion over how auditors, audits, and audit committees can be more effective in uncovering abusive earnings management practices.

The efforts of the SEC and the accounting profession are focused on informing auditors and accountants of existing GAAP and auditing procedures, not creating new accounting or auditing standards. Accounting irregularities, earnings management, and fraud occur when managers and accountants attempt to manipulate GAAP and obfuscate financial reports. Additional accounting regulations and standards may not be the solution to ending abusive earnings management and fraudulent accounting practices. Instead, auditors and investors should be vigilant in their attempts to uncover earnings management abuses and fraudulent accounting schemes by understanding the difference between good management and deceptive business practices.

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Lorraine Magrath, PhD, is an assistant professor at Troy State University, Troy, Ala. Leonard G. Weld, PhD, is a professor of accounting and head of the department of accounting and finance at the Harley Langdale, Jr., College of Business Administration, Valdosta State University, Valdosta, Ga.

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