In September 1998, former Securities and Exchange Commission Chairman Arthur Levitt addressed the problem of managed earnings in a speech titled, "The Numbers Game." In the speech, he railed against American managers consistently manipulating financial statements, and called for stricter regulations on earnings reports.
Levitt remained committed to honest financial reporting until his departure last summer, launching an all-out crusade against earnings management, and founding the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audits. Unfortunately, rather than a reduction in dubious reporting practices, companies have taken the speech as a "how to" seminar, and the problem has become an epidemic.
With the recent selection of Harvey Pitt as the new SEC Chairman, financial reporting vigilance is likely to continue. Pitt, a former Washington lawyer securities lawyer, is now Wall Street's top regulator.
"During his testimony, Mr. Pitt gave investors a clear picture of his vision for the securities industry," said Stuart Kaswell, Securities Industry Association senior vice president and general counsel, referring to Pitt's appearance before the Senate Banking Committee last July. "He demonstrated true insight on the challenges facing the capital markets, and indicated a clear focus on investor protection."Tricks of the trade
Ideally, earnings statements reflect a firm's profit from its core operations. However, as companies compete to impress investors by meeting or beating analysts' projections, they post earnings statements that are often misleading.
During the last few quarters, companies have struggled to maintain a positive outlook for their investors as the once electric economy has slowed. The untouchable titans of the boom economy are feeling the strain. More importantly, they feel they have an image to maintain, and firms are finding earnings management more necessary than ever. Many companies report capital gains as earnings, and though the SEC claims that timing the collection of capital gains is an acceptable form of earnings management, most analysts find such reporting techniques to be misleading and deceptive.
Unfortunately, earnings management reaches beyond judicious collection on investments into the realm of fraud. A study of 200 publicly owned firms investigated for fraud over an 11-year period found that 50 percent were suspected of fraudulent revenue recognition. Revenue recognition was one of former Chairman Levitt's top five managed earnings problem areas, accompanied by restructuring charges, acquisition accounting, "cookie-jar reserves" and over-capitalization.
With the SEC focused on earning statements, firms eager to impress investors are finding new ways to post questionable reports. Many firms report their earnings via press releases in "Pro Forma" format because media releases are not audited by the SEC. Unless the report lies outright about the state of the company, the SEC cannot contest the claims. The Pro Forma format was originally created for firms that wanted to anticipate future cash flow problems or that were going into a merger or acquisition.
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