Paul Rosenfield, CPA
On September 28, 1998, Chairman Arthur Levitt of the Securities and Exchange Commission (SEC) referred to a "widespread, but too little-challenged custom: earnings management." He referred to the practice as a game of nods and winks, accounting being perverted, cutting corners, and wishful thinking ... winning the day over faithful representation. He stated his fear that "we are witnessing an erosion in the quality of earnings, and therefore the quality of financial reporting. Managing may be giving way to manipulation; integrity may be losing out to illusion.... in the gray area between legitimacy and outright fraud"[174]
The SEC defines "earnings management" as "distorting the application of generally accepted accounting principles."[175] Levitt said that "Flexibility in accounting allows it to keep pace with business innovations. Abuses such as earnings management occur when people exploit this pliancy." He said that the practice "reflect[s] the desires of management rather than the underlying financial performance of the company." He said earnings may be managed by "gimmicks."[176] Those gimmicks distort the application of generally accepted accounting principles (GAAP) to serve the desires of management, for example, by (1) reporting higher overall earnings than the underlying financial performance of the reporting entity justifies, (2) reporting earnings in periods other than when they occur to obtain a desired result, and (3) stabilizing reported earnings. (Levitt said, "Trickery is employed to obscure actual financial volatility.")[177]
One force driving this phenomenon is the feeling among managers that they have to make their estimates, that reported quarterly or annual earnings that are less than the reporting entity or analysts had predicted spells doom. Levitt stated: "I recently read of one major U.S. Company that failed to meet its so-called numbers by one penny, and lost more than six percent of its stock value in one day.... [And] [A]uditors, who want to retain their clients, are under pressure not to stand in the way."[178]
Levitt listed these ways to distort the application of GAAP to manage earnings:
"Big bath" restructuring charges (see item 2 below).
Creative acquisition accounting, in which an ever-growing portion of the acquisition price is classified as in-process research and development, which can be written off in a one-time charge rather than included in goodwill to be charged ratably against income. The SEC sent a letter on September 9, 1999, to the American Institute of Certified Public Accountants (AICPA), which it publicized on its Web site,
www.sec.gov, asking the AICPA to describe best practice in the area and giving some guidance. The AICPA is now working on the project; meanwhile, the SEC's letter apparently has had the effect of reducing the practice."Cookie jar reserves," in which unrealistic assumptions are used to estimate liabilities for items such as sales returns, loan losses, or warranty costs. Companies reach into the cookie jars and report income when needed in bad times. The SEC issued proposed rule S7-03-00 dealing with this matter on January 27, 2000.
"Immaterial" misapplications of accounting principles (see item 1 below).
Premature reporting of revenue (see item 3 below).
The SEC has dealt with those techniques by enforcement actions. In addition, it has issued the following Staff Accounting Bulletins on three of them:
In Staff Accounting Bulletin No. 99, issued on August 12, 1999, the SEC staff stated its view that no misstatement is immaterial if its purpose is to manage earnings (see Section 3.2(c)).
In Staff Accounting Bulletin No. 100, issued on November 24, 1999, the SEC staff stated its views on reporting on charges that typically result from consolidation or relocation of operations or the disposition or abandonment of operations or productive assets (see Section 9.4(b)).
In Staff Accounting Bulletin No. 101, issued on December 3, 1999, the SEC staff stated its views on issues in reporting of revenue, in part because of revenue reporting issues encountered by registrants that came to the Commission's attention, including issues related to earnings management (see Section 17.3(h)).
Chapter 5 discusses recent egregious examples of earnings management (and of hiding debt, etc.) by distorting the application of GAAP, by Enron, WorldCom, and a number of other reporting entities.
EARNINGS MANAGEMENT BY THE FAULTY DESIGN OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES[179]
As discussed in Section 6.1, the SEC (and most others) has assumed that GAAP itself acts as a bar to earnings management, defining it in terms of the application of GAAP. Schipper likewise contends that "... GAAP, auditors, audit committees, and legal rules—constrain reporting. In addition, economic conditions influence accruals. Some components of earnings are therefore not susceptible to management...."[180] Healy and Wahlen state that "Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers."[181]
However, the SEC has been considering the view that distorting the application of GAAP is the smaller of the two causes of earnings management, and that the larger cause is the faulty design of GAAP itself.
The faulty design of GAAP may permit earnings to be managed, for example, by permitting reporting entities to report income that they have not earned. For example, consider this statement by Johnson and Petrone, two Financial Accounting Standards Board (FASB) staff members, about a formerly acceptable method of accounting for business combinations: "[The pooling-of-interests method of reporting after a business combination] essentially is a means ... to report higher earnings without having to earn them.... "[182] However, the desire to report income as high as possible, as real and as well known as it is, is tempered by fears of attracting increased demands from suppliers of inputs, such as stockholders and employees, and from the government. In contrast, the issuers of financial reports have no such reservations about another way to manage earnings that is facilitated by the faulty design of GAAP, to avoid significant fluctuations from period to period in reported income. Their desire for stability of income reporting exceeds their desire for higher reported income. Their acceptance of income tax allocation, for example, demonstrates that. Stability of income reporting is the fundamental goal of traditional financial reporting. Heath reported that "One former FASB member told me recently that 95 percent of the comments the Board receives from financial statement preparers fall into one of three categories: Don't make any changes, don't move so fast, and don't make income volatile—don't let it fluctuate."[183] Wyatt, a former member of the FASB, states that "... the artificial smoothing of real world volatility [is] a common feature of FASB standards.... "[184]
A view of Chief Accountant Turner of the SEC, that "No accounting system [other than ours] provides comparable transparency to a reporting entity's underlying economic events and transactions,"[185] is a commendable objective. It conforms with this observation by the FASB: "An analogy with cartography [map making] has been used to convey some of the characteristics of financial reporting...."[186] However, our GAAP as currently designed fails for two reasons to provide such transparency. Because the reasons are pervasive, the failure is systemic. First, application of current GAAP results in failure to report on a major portion of the underlying economic events that meet the FASB's qualitative criteria for reporting on events in its Concepts Statement No. 2. Second, application of current GAAP introduces noise into the system that hopelessly clouds the portrayal of the effects of the events it does permit reporting entities to report on and thereby prevents achievement of transparency in reporting on them. It does all that for the single purpose of managing earnings.
Because of the realization convention, the events current GAAP permits reporting entities to report on are mainly confined to changes in quantities of assets and liabilities. Those are underlying events that affect reporting entities, of course. But they are not the only underlying events that affect reporting entities. As the FASB states, "... all entities are [also] affected by price changes, interest rate changes, technological changes ... and similar events.... "[187] The FASB goes on to state that "To compare ... performance by comparing only realized gains [gains reported when quantities change] implies a definition of performance that many people would regard as incomplete and, therefore, as an unreliable representation."[188] Consider the exchange by a reporting entity of 10 shares of a widely traded stock worth $150 a share for $1,500. That does not affect the reporting entity much if at all. But a prior change in its price from $100 to $150 a share while held did affect the reporting entity, as anyone who holds such stock can testify (are investors indifferent about increases in the current selling prices of their stocks?). The FASB concludes that "Information based on current prices should be recognized if it is sufficiently relevant and reliable to justify the costs involved and more relevant than alternative information."[189]
The FASB does not, however, conform with those praiseworthy observations it makes. In 1978, the FASB stated in the foreword to its "Objectives" that it "... recognizes that in certain respects current generally accepted accounting principles may be inconsistent with those that may derive from the objectives and concepts set forth in [its Concepts] Statement[s] ... In due course, the Board expects to reexamine its pronouncements, pronouncements of predecessor standard-setting bodies, and existing financial reporting practice in the light of newly enunciated objectives and concepts." But in the ensuing 25 years to this writing, it has not evaluated the current broad principles by applying the objectives and concepts, and there is no sign that it will do so in the foreseeable future. (In fact, in its Concepts Statement No. 7, paragraph 16, issued in 2000, the Board stated that it "... does not intend to revisit existing accounting standards and practice solely as result of issuing this Statement.") Kripke noted "...the [FASB]'s failure to attempt to make progress...by applying its own qualitative characteristics...."[190] The American Accounting Association characterizes the result: "The most general criticism to be leveled at financial statements in their present form is that they are seriously incomplete.... One respect in which financial statements are now incomplete is that, because they are substantially transaction-based, they fail to recognize some value changes occurring during a period that aren't associated with a transaction."[191]
Systematic and rational allocation causes the noise current GAAP introduces. The adoption in the 1930s of the definition of accounting as a process of allocation[192] and the retention of that definition to this day demonstrates that allocation is endemic to financial reporting. Allocation infects most of financial reporting, including, for example, depreciation, and reporting on inventories, investments, income taxes, pensions, goodwill and other intangibles, and liabilities. Allocation seems necessary because of the events whose effects are not reported on, because, in the absence of allocation, not reporting on those effects would result in reporting all assets and liabilities while they are held or owed at their original amounts, an obviously unsatisfactory result.
Allocation uses smooth ("systematic") formulas, such as the straight-line and doubledeclining-balance formulas for depreciation and the compound interest formula for reporting on liabilities, each selected at the beginning of the period of allocation, supposedly to represent the effects of underlying economic events that are expected to occur in the future. We financial reporters cannot be that prescient about events that may occur in the future, after we select the formulas. And events do not occur as regularly as the formulas imply.
Moreover, allocation does not even represent the effects of underlying economic events. It merely takes amounts from the financial reporting territory, such as costs, enters them in the financial reporting map, and massages them there. As Hendriksen and van Breda state: "... annual [depreciation] is simply a fraction of the total ... cost.... [and] has no necessary relation to ... occurrences within the year.... [it] has no real world connotations.[193]" The AICPA said the same: "Definitions are unacceptable which imply that depreciation for the year is a measurement ... of anything that actually occurs within the year."[194] (Also see Thomas[195] and Section 19.8.)
If financial reporting reported on the effects of the economic events it fails to report on, allocation would be unnecessary. But reporting on those effects would result in reported income being less stable than it is under current GAAP. The issuers want more stable income reporting, so they prevent GAAP from resulting in reporting on those effects. As Zeff states: "... [there is] intense political lobbying against proposals that special interests find to be obnoxious even though the proposed reforms are seen as serving the interests of financial statement users."[196] The issuers usually disguise their desire and power to prevent introduction of more volatility in income reporting. Ihlanfeldt, an issuer, provides an undisguised example in the following narrow area: "... field- testing...sponsored by the Financial Executives Research Foundation...confirmed that application of the FASB's tentative conclusions would have introduced a high degree of volatility into companies' annual pension expense.... This resulted in the Board making changes in the final standard that helped to reduce volatility.... they did listen—but it was not without considerable prodding."[197]
We defend allocation mainly on the basis of realization and objectivity. Both are smoke screens to cover up the real goal of those who support it, to stabilize reported income. The smooth formulas allocation uses have that result. Hatfield, a leader of the profession in the early twentieth century, stated that "... depreciation is only part of a broader scheme whose purpose is to equalize charges between different years."[198] Sterling said that "The very purpose of measurement is to discover variations in empirical phenomena. By contrast, it seems that the purpose of allocation is to make the empirical phenomena appear to be smooth regardless of the actual variations."[199] Lee said that "... allocations [are] designed to produce smoothed income flows."[200] And Devine said that "... depreciation is clearly a device for smoothing irregular capital budgeting outlays."[201] We use allocation for managing earnings, as former Chief Accountant Schuetze of the SEC, said, for "... smoothing the hills and valleys of change."[202]
The power of realization and allocation to stabilize income reporting, embodied in the current design of GAAP, dwarfs the power individual issuers have to stabilize income reporting by distorting the application of GAAP. Those concepts are the main engines of earnings management today, and they should therefore be eliminated.
FASB, Statement of Concepts No. 1, "Objectives of Financial Reporting by Business Enterprises".
Arthur, Levitt, Speech at New York Center for Law and Business, September 28, 1998.
Securities and Exchange Commission, "Fact Sheet", p. 2.
[174] 1Speech at New York Center for Law and Business, September 28, 1998.
[175] 2Securities and Exchange Commission, "Fact Sheet," p. 2.
[176] 3Speech at New York Center for Law and Business, September 28, 1998.
[177] 4Id.
[178] 5Id.
[179] 6This section is taken from Paul Rosenfield, "What Drives Earnings Management? It Is GAAP Itself," Journal of Accountancy, October 2000.
[180] 7Katherine Schipper, "Commentary on Earnings Management," Accounting Horizons, December 1989, p. 98.
[181] 8Paul M. Healy and James M. Wahlen, "A Review of the Earnings Management Literature and Its Implications for Standard Setting," Accounting Horizons, December 1999, p. 368.
[182] 9L. Todd Johnson and Kimberley R. Petrone, "Why Not Eliminate Goodwill?" FASB Status Report, November 17, 1999, p. 12.
[183] 10Loyd C. Heath, "How About Some Constructive Input to the FASB?" Financial Executive, September/October 1990, p. 57.
[184] 11Arthur R. Wyatt, "Professionalism in Standard-Setting," The CPA Journal, July 1988, p. 25.
[185] 12Lynn Turner, Letter to P. Rosenfield, October 27, 1999.
[186] 13FASB, Statement of Concepts No. 2, "Qualitative Characteristics of Accounting Information," par. 24.
[187] 14FASB, Statement of Concepts No. 6, "Elements of Financial Statements," par. 218.
[188] 15Statement of Concepts No. 2, par. 118.
[189] 16FASB, Statement of Concepts No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises."
[190] 17Homer Kripke, "Reflections on the FASB's Conceptual Framework for Accounting and on Auditing," Journal of Accounting, Auditing & Finance, Winter 1989, p. 25.
[191] 18American Accounting Association, "Report of the American Accounting Association Committee on Accounting and Auditing Measurement, 1989–90," Accounting Horizons, September 1991, p. 83.
[192] 19American Accounting Association, "A Tentative Statement of Accounting Principles Affecting Corporate Reports," The Accounting Review, June 1936.
[193] 20Eldon S. Hendriksen and Michael F. van Breda, Accounting Theory, Fifth Edition (Boston: Richard D. Irwin, Inc., 1992), pp. 527, 528.
[194] 21American Institute of Certified Public Accountants (American Institute of Accountants until 1957), "Review and Résumé," Accounting Terminology Bulletin No. 1, p. 24.
[195] 22Arthur L. Thomas, "The FASB and the Allocation Fallacy," Journal of Accountancy, November 1975.
[196] 23Stephen Addam Zeff, "A Perspective on the U.S. Public/Private-Sector Approach to Standard Setting and Financial Reporting," Inaugural Lecture, State University of Limburg, June 3, 1994, p. 26.
[197] 24William J. Ihlanfeldt, "The Rule-Making Process: A Time for Change," in Previts, Standard Setting, p. 28.
[198] 25Henry Rand Hatfield, Modern Accounting (New York: D. Appleton and Company, 1916), p. 134.
[199] 26Robert R. Sterling, Toward a Science of Accounting (Houston: Scholars Book Co., 1979), p. 226.
[200] 27T. A. Lee, "The Simplicity and Complexity of Accounting," in Sterling, Simplified, p. 45.
[201] 28Carl Thomas Devine, Essays in Accounting Theory, Volume II (American Accounting Association, 1985), p. 79n.
[202] 29Walter Schuetze, "Keep It Simple," Accounting Horizons, June 1991, p. 113.