ACCOUNTING HOCUS-POCUS

This case is an excerpt from a presentation given by former Chairman Arthur Levitt, Securities and Exchange Commission, the ‘‘Numbers Game,'' to New York University Center for Law and Business, September 28, 1998.

Accounting Hocus-Pocus

Our accounting principles weren't meant to be a straitjacket. Accountants are wise enough to know they cannot anticipate every business structure or every new and innovative transaction, so they develop principles that allow for flexibility to adapt to changing circumstances. That's why the highest standards of objectivity, integrity and judgment can't be the exception. They must be the rule. Flexibility in accounting allows it to keep pace with business innovations. Abuses such as earnings management occur when people exploit this pliancy. Trickery is employed to obscure actual financial volatility. This, in turn, masks the true consequences of management's decisions. These practices aren't limited to smaller companies struggling to gain investor interest. It's also happening in companies whose products we know and admire.

So what are these illusions? Five of the more popular ones I want to discuss today are ‘‘big bath'' restructuring charges, creative acquisition accounting, ‘‘cookie jar reserves,'' ‘‘immaterial'' misapplications of accounting principles and the premature recognition of revenue. ‘‘Big-Bath'' Charges

Let me first deal with ‘‘Big Bath'' restructuring charges.

Companies remain competitive by regularly assessing the efficiency and profitability of their operations. Problems arise, however, when we see large charges associated with companies restructuring. These charges help companies ‘‘clean up'' their balance sheet-giving them a so-called ‘‘big bath.''

Why are companies tempted to overstate these charges? When earnings take a major hit, the theory goes Wall Street will look beyond a one-time loss and focus only on future earnings.

And if these charges are conservatively estimated with a little extra cushioning, that so-called conservative estimate is miraculously reborn as income when estimates change or future earnings fall short.

When a company decides to restructure, management and employees, investors and creditors, customers and suppliers all want to understand the expected effects. We need, of course, to ensure that financial reporting provides this information. But this should not lead to flushing all the associated costs-and maybe a little extra-through the financial statements.

Creative Acquisition Accounting

Let me turn now to the second gimmick.

In recent years, whole industries have been remade through consolidations, acquisitions and spinoffs. Some acquirers, particularly those using stock as an acquisition currency, have used this environment as an opportunity to engage in another form of ‘‘creative accounting.'' I call it ‘‘merger magic.''

I am not talking tonight about the pooling versus purchase problem. Some companies have no choice but to use purchase accounting-which can result in lower future earnings. But that's a result some companies are unwilling to tolerate.

So what do they do? They classify an ever-growing portion of the acquisition price as ‘‘in-process''

Research and Development, so-you guessed it-the amount can be written off in a ‘‘one-time'' charge-removing any future earnings drag. Equally troubling is the creation of large liabilities for future operating expenses to protect future earnings-all under the mask of an acquisition.

Miscellaneous ‘‘Cookie Jar Reserves''

A third illusion played by some companies is using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses or warranty costs. In doing so, they stash accruals in cookie jars during the good times and reach into them when needed in the bad times.

I'm reminded of one U.S. company who took a large one-time loss to earnings to reimburse franchisees for equipment. That equipment, however, which included literally the kitchen sink, had yet to be bought. And, at the same time, they announced that future earnings would grow an impressive 15 percent per year.

‘‘Materiality''

Let me turn now to the fourth gimmick-the abuse of materiality-a word that captures the attention of both attorneys and accountants. Materiality is another way we build flexibility into financial reporting. Using the logic of diminishing returns, some items may be so insignificant that they are not worth measuring and reporting with exact precision.

But some companies misuse the concept of materiality. They intentionally record errors within a defined percentage ceiling. They then try to excuse that fib by arguing that the effect on the bottom line is too small to matter. If that's the case, why do they work so hard to create these errors? Maybe because the effect can matter, especially if it picks up that last penny of the consensus estimate.

When either management or the outside auditors are questioned about these clear violations of GAAP, they answer sheepishly....‘‘It doesn't matter. It's immaterial.''

In markets where missing an earnings projection by a penny can result in a loss of millions of dollarsin market capitalization, I have a hard time accepting that some of these so-called non-events simply don't matter.

Revenue Recognition

Lastly, companies try to boost earnings by manipulating the recognition of revenue. Think about a bottle of fine wine. You wouldn't pop the cork on that bottle before it was ready. But some companies are doing this with their revenue-recognizing it before a sale is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale.

Required

a. ‘‘Big Bath''-Comment on how a ‘‘Big Bath'' would have enabled WorldCom to cover up its fraud.

b. Why would writing off ‘‘in-process'' Research and Development be similar to a ‘‘Big Bath''?

c. How could a company use ‘‘allowance for doubtful accounts'' as ‘‘Cookie Jar Reserves''?

d. Speculate on how a company could use ‘‘Materiality'' or disregard or partially disregard a specific accounting standard.