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Earnings Management Abuse

In reading Arthur Levitt’s 1998 speech to the NYU Center for Law and Business, all members of Team C were in general agreement and felt there was almost too much truth to what was being said. Given this speech was delivered in 1998, long before the Enron and WorldCom scandals were discovered, Mr. Levitt was predicting these occurrences would begin to appear due to the pressures of meeting Wall Street and investors expectations.

Mr. Levitt’s theme of earnings management being a “game among market participants” states there is an increasing number of creative accounting irregularities that will eventually hurt individual investors as well as the entire economic market structure. Levitt highlights five of the most common accounting gimmicks being used, including but not limited to “Big Bath” restructuring charges. The speech unfortunately turned out to be a gloomy prediction that we all hoped would not come true under any circumstances, but unfortunately the corporate accounting scandals that erupted proved that the Americas Capital Markets are not invincible, but happen to be quite fragile.

The accounting methods utilized by companies have been sporadic at best, while our values and goals have seemed to cross wires. Mr. Levitt’s personal beliefs concerning our system comes through his words clearly; it is our obligation to realize who the accounting is for, what benefits it brings and that it needs to be done accurately.

Marshal, et al note that the responsibility as being honest and forthright in all communications. This involves ‘telling the whole truth’. In reading Levitt’s debate one team member thought of a recent experience with a loan officer. The loan was a routine application for a home equity loan in which the loan officer called with the details. When the papers arrived they had a bit more information, not that he hadn’t offered the important highlights but there were hidden details that should have been disclosed upfront prior to getting this far into the process. People responsible for accounting tend to act in that same manner to ‘keep up appearances’. This experience ties directly into the accounting practices being mentioned in the speech. Accountants are finding more and more ways to hide revenue peaks and valleys through restructuring costs, cookie jar reserves, and unearned revenue reporting.

There are two sides to earnings management abuse. There is the blatant abuse which is done knowingly for an end goal, and then there is ignorant abuse. An example of blatant abuse is the fictional accounting practices brought to life by Jeffrey Fastow, former CFO of Enron. These off balance sheet accounting entries were used to intentionally hide earnings losses and create additional revenue from the mutual fund managers as well as individual investors. Ultimately, this activity cost investors billions of dollars in portfolio wealth. Ignorant abuse might be attributed to misuse or misunderstanding of information. For example, if I have been recently hired into a company as the CFO, comptroller, auditor, etc I will need some learning time to ensure I utilize information correctly and account for things accurately.

“Big Bath” charges are in correlation with restructure costs. An example of “Big Bath” comes from a team member’s experience with their employer. For the past few years the company has been through the ringer financially but management is striving to ensure that the communication lines are open for investors, employees and shareholders. In the most recent posting of financial statements the CEO took the time to ensure that people understood where the company is now, where they came from and where they expect to be. He wanted to ensure that the costs seen in the financial statements truly represent the company and it’s future.

Arthur Levitt spoke to current events and the five gimmicks he outlined are at the peak of earnings management abuse. Earnings are not to be managed, they are to be reported and accounted for. In today’s society we have seen blatant examples of what Levitt warned about, however, we see those that are striving for his mission. He delivered a message and a mission to both public and private companies to clean up their act and to begin taking responsibility for their actions especially in relation to the financial statements reported to the public “[This] cannot be solved by a governmental mandate: It demands a financial community response” (Levitt). Little did we all know that three years later the largest accounting scandal would be uncovered and the root of the problem would relate exactly to Arthur Levitt’s warning of the misconstrued financial reporting methods.

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