The Earnings Management Mousetrap

The assault on managed earnings, led by the SEC, is winning applause from investor advocates, academics and even many finance pros. But companies are still doing what they can to smooth out earnings — very cautiously.

Managing earnings is taboo but far from extinct. In 1998, then-SEC chairman Arthur Levitt dropped a bomb on its practice in a speech that characterized earnings management as a dangerous game played by finance executives, analysts and auditors. According to Levitt, "This is the pattern earnings management creates: Companies try to meet or beat Wall Street earnings projections in order to grow market capitalization and increase the value of stock options. Their

ability to do this depends on achieving the earnings expectations of analysts. And analysts seek constant guidance from companies to frame those expectations. Auditors, who want to retain their clients, are under pressure not to stand in the way. Managing may be giving way to manipulation; integrity may be losing out to illusion."

Since Levitt's speech, enforcement actions over financial disclosure have increased from 75 in 1998 to 100 in 2000. The SEC has issued three staff accounting bulletins to tell finance executives what is now expected of them (see Read All About It to the right), and it organized a Financial Fraud Task Force in 2000. Now most auditors and finance executives have pulled back from admitting to anything that looks like managed earnings. It's hard to find a finance pro or auditor today who will defend — at least in public — any steps taken to counter volatility or smooth out reported earnings. In fact, most don't want to talk about the subject; it's not something they want their names associated with.

Clarence Otis Jr. welcomes the push to squeeze out managed earnings. The senior vice president and CFO of Orlando, Fla.-based Darden Restaurants Inc., the parent company of Red Lobster and Olive Garden, says the SEC is "providing clarity, which we need. It's requiring finance staffs and auditors to communicate better. Accounting will never be an exact science, but making it more exact is helpful."

"I'm no accountant, but I know that you can't use reserves or other accounting techniques to smooth earnings anymore," observes Louis M. Thompson Jr., president and CEO of the National Investor Relations Institute in Vienna, Va. "You manage the company for the long-term value of its shareholders; you don't manage the financial reporting process."

Finance executives are respecting the show of SEC muscle, but nobody thinks earnings management has entirely disappeared. The penalty for not managing earnings is still severe. "The market can be merciless to your stock if you fall short of earnings targets, so we watched our progress carefully and passed the word to our people in the field to push harder if we saw that we were likely to come up short," Ramon Yi says about his former job as corporate treasurer of Fresenius Medical Care North America in Lexington, Mass.

Thompson and others acknowledge that finance executives are caught in a dilemma. A powerful bloc of shareholders, led by mutual fund managers, demand that their short-term earnings expectations be met — or else. But the establishment that enforces ethical accounting principles has declared equally vehemently that companies shall not manage earnings to meet short-term expectations. Either way, a business could be dead. What executives have to manage, Thompson says, is expectations, not earnings.

Darden Restaurants is a public company, and Otis is no stranger to shareholder pressure. His solution to the earnings management dilemma is to "make sure investors' expectations are based on reasonable assumptions. If they are not, you need to do a better job of communicating the underlying realities of your business. If their expectations are reasonable and you miss the target, that's just a fact of life that you have to explain — and you should have to explain it, not cover it over."

"Don't just talk numbers," advises Thompson. "Talk about human capital, distribution reach and brand identification. Over time, that will divert attention away from short-term financial performance. Research indicates that 65 percent of investment decisions are driven by nonfinancial factors," he notes, but many finance pros focus on numbers because that's where they are most comfortable.

SEC's Shorter List

Under direct attack from Levitt and the SEC are such long-used earnings management abuses as "the big bath" — loading a lot of charges into one big hit, especially in a restructuring, to avoid future goodwill amortization and pave the way for rosier future earnings — and "the cookie jar," padding reserves for a rainy day. The SEC is also cracking down on discretion in revenue recognition decisions, notes Wayne Kolins, national director of assurance for BDO Seidman LLP, an accounting and consulting firm in New York City (see The Revenue Recognition Challenge).

The critical line is the one between earnings management and financial statement fraud, observes D. Larry Crumbley, KPMG-endowed professor of accounting at Louisiana State University, Baton Rouge, and the editor of The Journal of Forensic Accounting. "It's the difference between a lightning bug and lightning. Earnings management will get you a fat bonus; financial statement fraud will get you free room and board at Leavenworth," he quips.

What's tricky is that the "landscape is changing so rapidly, and yesterday's earnings management might be today's financial statement fraud," Crumbley observes. "It's like politics. J.F.K. could get away with almost anything, but Bill Clinton discovered he's not living in the same kind of world."

For years, companies have been using accruals to avoid exceptionally high or low quarters and create the impression of smoother, more stable growth. But sophisticated investors are demanding an end to such techniques and pushing them closer to financial statement fraud, Crumbley notes. Management used to have more leeway in deciding what to capitalize and what to expense. Now that discretion is under attack.

Likewise, securities analysts in the past applauded companies for taking substantial restructuring charges for asset write-downs and accrual of liabilities, thereby setting up future earnings growth, Kolins notes. Now rules put strict limits on these charges. Controllers have to be completely familiar with the rules, or they will find themselves in conflict with their auditors. "You cannot be comfortable by being overly conservative," he adds.

Kolins points out that Amazon.com announced significant layoffs in January, but the online bookseller could not take the severance charge in December because the rules now say that can happen only if those being laid off are informed before the end of the reporting period. Amazon didn't break the news to employees before the Christmas season, which is its peak period; therefore, it could not record the charge until after year-end, Kolins explains.

These more-demanding rules make auditing companies both harder and easier, Kolins reflects. "There are more rules to learn, but once you learn the rules there's less room for disagreement. Bright lines can simplify audits."

Assessment From the Trenches

Not every finance pro laces up his Goody Two-shoes to comment on managed earnings. "Earnings management will always be practiced to the extent that accounting rules permit it," declares Mark G. Thompson, vice president and CFO of MarketTools Inc., an application service provider (ASP) in Mill Valley, Calif. "It's a sign of adept management if you can control operating events and know where you stand financially as the end of a quarter or fiscal year draws near," he says. Although MarketTools is private, Mark Thompson practices earnings management unapologetically. For example, how aggressive he is about booking deferred earnings depends on whether the quarter is running ahead of or behind the business plan. He's encouraged to take such actions by his board and outside investors, he says.