Magazine article The CPA Journal

Chairman Levitt Attacks Earnings Management

Magazine article The CPA Journal

Chairman Levitt Attacks Earnings Management

Article excerpt

At a speech on September 28, 1998-marking the creation of the Center for Law and Business at New York University under the leadership of William T. Allen, chair of the Independence Standards Board-SEC chairman Arthur Levitt, Jr., declared an all-out war on earnings management. Levitt characterized the process as a "game among market participants," which, if not addressed, will have "adverse consequences for America's financial reporting system." Levitt fears that "we are witnessing an erosion in the quality of earnings, and therefore the quality of financial reporting."

Keeping with Levitt's approach to seek private-sector solutions to problems, he went on to say that the erosion of earnings is "a financial community problem. It can't be solved by a government mandate; it demands a financial community response."

Levitt presented five ways in which companies use trickery and illusions to obscure financial volatility.

Big Bath Restructuring Charges. Companies overstate the costs associated with a restructuring, enabling them to clean up their balance sheets and create a reserve for a rainy day.

Creative Acquisition Accounting. The SEC is seeing acquiring companies classify a portion of the purchase price as "in-process research and development" which is immediately written off, thereby reducing the amortization of the purchase price to future earnings.

Miscellaneous "Cookie Jar" Reserves. This is an old practice that goes back to creation. Management creates comfortable or liberally interpreted reserves in good times that are then used to smooth out earnings in not-so-good times.

Abuse of Materiality. Levitt noted companies are making unsupported adjustments which help smooth earnings or achieve an earnings estimate, but which are not challenged by auditiors or allowed to be recorded because the they are not material. He suggests that adjustments may have to be looked at relative to earnings forecasts rather than in absolute terms.

Revenue Recognition. Some companies are recognizing revenue prematurely. This is also an age-old practice that, for whatever reason, standard setters have been reluctant to address.

Levitt proposed a joint effort to deal with the issues: technical rule changes by regulators and standard setters, enhanced oversight of financial reporting process, and a cultural change on the part of corporate management. …

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