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					The Best Paper EVER
         by
   David Breeden
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   Amanda Stuart




                      1
On September 28, 1998, Chairman of the U.S. Securities and Exchange Commission Arthur
Levitt sounded the call to arms in the financial community. Levitt asked for, immediate and
coordinated action to assure credibility and transparency of financial reporting. Levitt’s speech
emphasized the importance of clear financial reporting to those gathered at New York
University. Reporting which has bowed to the pressures and tricks of earnings management.
Levitt specifically addresses five of the most popular tricks used by firms to smooth earnings.
Secondly, Levitt outlines an eight part action plan to recover the integrity of financial reporting
in the U.S. market place.

What are the basic objectives of financial reporting? Generally accepted accounting principles
provide information that identifies, measures, and communicates financial information about
economic entities to reasonably knowledgeable users. Information that is a source of decision
making for a wide array of users, most importantly, by investors and creditors. Investors and
creditors who are responsible for effective allocation of capital in our economy. If financial
reporting becomes obscure and indecipherable, society loses the benefits of effective capital
allocation. Nothing illustrates the importance of transparent information better than the
pre-1930’s era of anything goes accounting. An era that left a chasm of misinformation in the
market. A chasm that was a contributing factor to the market collapse of 1929 and the years of
economic depression. An entire society suffered the repercussions of misinformation. Families,
and retirees depend on the credibility of financial reporting for their futures and livelihoods.
Levitt describes financial reporting as, a bond between the company and the investor which if
damaged can have disastrous, long-lasting consequences.

The pressure to achieve consensus estimates has never been so intense. The market demands
consistency and punishes those who come up short. Eric Benhamou, former CEO of 3COM
Corporation, learned this hard lesson over a few short weeks in 1996. Benhamou and
shareholders lost $7 billion in market value when 3COM failed to achieve expectations. The
pressures are a tangled web of expectations, and conflicts of interest which Levitt describes as
almost self-perpetuating. With pressures mounting, the answer from U.S. managers has been
earnings management with a mix of managed expectations. March of 1997 Fortune magazine
reported that for an unprecedented sixteen consecutive quarters, more S&P 500 companies have
beat the consensus earnings estimate than missed them. The sign of a quickly growing economy
and a measure of the importance the market has placed on consensus earnings estimates. The
singular emphasis on earnings growth by investors has opened the door to earnings management
solutions. Solutions that are further being reinforced to managers by market forces and
compensation plans. Primarily, managers jobs depend on their ability to build stockholder equity,
and ever more importantly their own compensation.

A growing number of CEO’s are receiving greater percentages of their compensation as stock
options. A very personal incentive for executive achievement of consensus earnings estimates.


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Companies are not the only ones to feel the squeeze. Analysts are being pressured by large
institutional investors and companies seeking to manage expectations. Everyone is seeking the
win. Auditors are being accused of being out to lunch, with the clients. Many accounting firms
are coming under scrutiny as some of their clients are being investigated by the SEC for
irregularities in their practice of accounting. Cendant and Sunbeam both left accounting giant
Arthur Anderson holding a big ol’bag full of unreported accounting irregularities. Auditors from
BDO Seidman addressed issues of GAAP with Thing New Ideas company. The Changes were
made and BDO was replace for no specific reason. Herb Greenberg calls the episode, A reminder
that the company being audited also pays the auditors’ bill. The Kind of conflict of interests that
leads us to question the idea of how independent the auditors are. All of these pressures allow
questionable accounting practices to obfuscate the reporting process.

These one time write-offs become virtually insignificant footnotes to the financial reporting
process. Extraordinary charges that are becoming unusually common. Kodak has taken six
extraordinary charges since 1991 and Coca-Cola has taken four in two years. The financial
community has to wonder how unusual these charges are. Creative acquisition accounting is
what Levitt calls Merger Magic. With the increasing number of mergers in the 90’s, companies
have created another one time charge to avoid future earnings drags. The in-process research and
development charge allows companies to minimize the premium paid on the acquisition of a
company. A premium that would otherwise be capitalized as goodwill: and depreciated over a
number of years. Depreciation expenses that have an impact on future earnings. This one time
charge allowed WorldCom to minimize the capitalization of goodwill and avoid $100 million a
year in depreciation expenses for many years. A charge hiding in this complex note on
WorldCom’s 1996 annual financial statement.

    1. Results for 1996 include a $2.14 billion charge for in-process research and development
       related to the MFS merger. The charge is based upon a valuation analysis of the
       technologies of MFS worldwide information system, the internet network expansion
       system of UUNET, and certain other identified research and development projects
       purchased in the MFS merger. The expense includes $1.6 billion associated with
       UUNET and $0.54 billion related to MFS.
    2. Additionally, 1996 results include other after-tax charges of $121 million for employee
       severance, employee compensation charges, alignment charges, and costs to exit
       unfavorable telecommunications contracts and $343.5 million after-tax write-down of
       operating assets within the company’s non-core businesses. On a pre-tax basis, these
       charges totaled $600.1 million.


The dollar amounts are staggering and the future implications far reaching. Since this approach
was introduced by IBM in 1995 these charges have become commonplace for acquisition
accounting. A popularity, largely due to the level of room allowed in research and development
estimations.

The Third earnings manipulation tool discussed by Levitt is what he calls Miscellaneous Cookie
Jar Reserves. The technique involves liability and other accrual accounts specifically sensitive to


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accounting assumptions and estimates. These accounts can include sales returns, loan losses,
warranty costs, allowance for doubtful accounts, expectations of goods to be returned and a host
of others. Under the auspices of conservatism, these accounts can be used to store accruals of
future income. Restructuring liabilities created by Big Bath’ charges also provides these Cookie
jar reserve effect. Jack Ciesielski, who manages money and writes the Analyst’s Accounting
Observer, calls these accounts the accounting equivalent of turning lead into gold… a virtual
honeypot for making rainy-day adjustments. Various adjustments and entries that can produce
almost any desired results in the pursuit of consistency.

The statement of financial accounting concepts No. 2 (FASB, May 1980), defines materiality as:
The magnitude of an omission or misstatement of accounting information that, in light of
surrounding circumstances, makes it probable that the judgement of a reasonable person relying
on the information would have been changed or influenced by the omission or misstatement.

Finally, Levitt briefly touches on the complex issue of the manipulation occuring in revenue
recognition. Modern contracts, refunding, delaying of sales, up front and initiation fees all add to
the complications in some industries to follow specific rules of revenue recognition. With plenty
of holes in revenue recognition the door is open for tweaking. Microsoft is a good example of the
problems facing today’s companies. Concerned with proper revenue recognition, Microsoft
started a practice in the software industry that allows companies to recognize revenue over a
period of time. This recognition allows for better matching of revenues to future expenses
generated by the sale of the software. Expenses such as upgrades and technical support are
related to the revenue generated by the sale of the software but are incurred at a later date. The
complexities of modern business transactions have left modern standards of accountancy years
behind. Gimmicks, that all must be addressed by the financial community.

The task of returning integrity to U.S. financial reporting is of paramount importance. The
interests of our financial system are at stake. Arthur Levitt and the SEC stand ready to take
appropriate action if that interest is not protected. But, a private sector response that… obviates
the need for public sector dictates seems the wisest choice. A nine part plan that involves the
entire financial community is proposed by Levitt.




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                                     Bibliography
Bibliography

Levitt, Arthur. Quality Information: The Lifeblood of Our Markets. Speech, 18 Oct. 1999.

Fox, Justin, Searching for Nonfiction in Financial Statements, Fortune 23 Dec. 1996.

Adams, Jane B. Remarks. Speech, 9 Dec. 1998.

Ciesielski, Jack, More Second Guessing. Barrons.

Johnson, Norman S. Recent Developments at the SEC. Speech. 20 August 1999.

Tran, Khanh. Excite At Home Posts Quarterly Loss Due to Charges but Meets Estimates 20 Oct.
1999.




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