262 I Unit 4: Ethics and Company Culture
So it is with this case. Was that fine line between gathering information legally and gaining tippee status crossed? We will not know the· answer for some time. However, there are now a total of fourteen under indictment in this case and there is already a great deal of tossing nnder the bus from five of those who seek to enter pleas early in exchange for testimony and leniency. One lawyer has already stated publicly that his cli ent intends to “cooperate fully” with prosecutors (translate: sing like a canary).438 Preet Bharara, the U.S. Attorney for the Southern District of New York who is overseeing the prosecution of the case has said, “I urge you to come knocking on our door before we come knocking ,on yours.”439
There is a prescience and wisdom in those words. When we are gauging behavior by
the -strict legal standards, we do come close to the edge of illegality. Rather than waiting for the knock, perhaps some introspection is in order. That’s where ethics come in. Toes right at the line, only worrying about mens rea and actus reus, and proudly proceeding with the phrase, “Prove it” often do win the day in court. But, in the process we chip away at the transparency and forthrightness efficient markets require for long-term prog ress. Yes, you could do that. Yes, everyone does that and it is standard industry practice. But, “Should it be?” is the question that requires an answer if we would like to avoid having fraud become a routine market correction.
Discussion Questions
L Walk through each of the examples given and list the advantages gained by their “common” conduct For those examples for which there is an outcome, describe the costs.
Are you at a disadvantage competitively if you do not engage in the same behaviors as those in your industry?
Reading 4.19
Can you give examples of negative conse quences for companies that adopted industry practices?
“What response do you offer to the argument that if everyone is behaving this way it will be difficult for you to be caught?
A Primer on Accounting Issues and Ethics and Earnings Management44 0 ·
When Arthur Levitt was the chairman of the Securities Exchange Commission (SEC), the federal agency responsible for regulating accurate disclosures in companies’ financial reports, he gave a speech at New York University (NYU) that became known as the “Numbers Grune” speech. He spoke about compa’nies and their efforts to use earnings management, a process in which they use accounting rules and financial manipulations to meet goals or make their earnings seem smooth. Mr. Levitt said, “Too many corporate managers, auditors, and analysts are participants in the game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation Managing may be giv
ing way to manipulation; integrity may be losing out to illusion.”441
Earnings management has been business practice for so long, so often, and by so many that many businesspeople no longer see it as an ethical issue, but an accepted business prac-
438 Susan Pulliam, “Five Cooperatlng Witnesses Propel Federal Probe,” Wall Street Journal, November 6, 2009, p. A6.
439 New York Times, November 8, 2009, BU2, in “The Chatter feature.
440Adapted from an article by Marianne M. Jennings in Corporate Finance Review 3, no. 5: 39–41 {March/April 1999). Reprinted from Corporate Finance Review by R!A. 395 Hudson Street, New York, NY 10014.
441 Arthur Levitt, Chairman, Securities and Exchange Commission, “The Numbers Game,” speech, NYU Center for Law and Business, New York, September 28, 1998.
Section D: The Industry Practices and Legal Factors I 263
tice. Fortune magazine has even offered a feature piece on the «how to’s” and the importance of doing it It remains an unassailable proposition, based on the financial research, that a firm’s stock price attains a quality of stability through earnings management. However, the financial issues in the decision to manage earnings are but one block in the decision tree. In focusing on that one block, firms are losing sight of the impact such activities have on employees, employees’ conduct, and eventually on the company and its shareholders.
Issues on financial reporting and earnings management are at the heart of market transparency and trust. Understanding the issue of earnings management is important as you begin to study the cases involving companies that used this process, perhaps to an extreme. “What is earnings management? How is it done? How effective is it? How do accountants and managers perceive it from an ethical perspective?
The Tactics in Earnings Management
Earnings management consists of actions by managers used to increase or decrease current reported earnings so as to create a favorable picture for either short-term or long-term economic profitability. Sometimes managers want to make earnings as low as possible so that the next quarter, particularly if they are new managers, the numbers look terrific and it seems as if it is all due to their new management decisions. Earnings management consists of activities by managers to meet or exceed earnings projections in order to inctease the company’s stock value. ‘”
You can pick up just about any company’s annual report and see how important con sistent and increasing earnings are. Tenneco’s 1994 annual report provides this explana tion in the management discussion section, “All of our strategic actions are guided by and measured against this goal of delivering consistently high increases in earnings over the long term.” Eli Lilly noted it had thirty-three years of earnings without a break. Bank of America’s annual report notes, “Increasing earnings per share was our most important objective for the year.” .
The methods for managing earnings are varied and limited only by manager creativity within the fluid accounting rules. The common physical techniques that have been around since commerce began are as follows:
Write down inventory.
Write up inventory product development for profit target. Record supplies or next year’s expenses ahead of schedule. Delay invoices.
Sell excess assets. Defer expenditures.
However, in his NYU speech, Chairman Levitt noted five more transactional and ‘sophisticated methods _for earnings management.
Large-charge restructuring
Creative acquisition accounting
Cookie jar reserves
Materiality
Revenue recognition
Yet another accounting issue, not noted by Mr. Levitt, percolates throughout the financial collapses and misstatements of companies.
EBITDA (earnings before interest taxes, depreciation, and amortization) and non-GAAP (GAAP is an acronym for generally accepted accounting principles) financial reporting.
264 \ Unit 4: Ethics and Company Culture
In the following sections, you can find an explanation of each of these accounting issues that present both ethical and legal questions and provide the squishy areas too many companies have used to ultimately mislead investors, creditors, and the markets about their true financial status.
Large-Charge Restructuring
This type of earnings management helps clean up the balance sheet (often referred to as the “big bath”). A company acquiring another company takes large expenses for the acquisition because during the next quarter its new and effective management and con trol, without those added expenses, makes things look so much better. Often referred to as spring-loading, this technique was part of Tyco’s acquisition accounting. The strategy here is to toss in as many expenses as possible in the quarter of the acquisition. Even bills not due and charges not accrued are plowed in with the idea of showing a real dog of a performer at the time of the acquisition. Management looks positively brilliant by the next quarter, when the expenses are minimal Indeed, the next quarter, with its low expenses, may afford the opportunity for some cookie jar reserves (see below) to be set aside for future dry periods of revenues or increased expenses.
Creative Acquisition Accounting
This method, also employed by WorldCom and Tyco and other companies that went on buying binges in the 1990s, is an acceleration of expenses as well. The acquisition price is designated as «in-process” research. The tendency for managers is to overstate the restructuring charges and toss the extra charges, over and above actnal charges, into reserves, sometimes referred to as the cookie jar.442 For example, a company makes an acquisition and books $2 billion for restructuring charges. Its earnings picture for that year is painted to look quite awful.443 However, the actual costs of the restructuring are spread out over the time it takes for the company to restructure, which is actually two to three years, and some of the charges booked may not ever be incurred.444 The charges taken are often called soft charges, or anticipated costs, and can include items such as training, new hires, computer consulting, and so forth. It is possible that those services may be necessary, but it is literally a guess as to whether they will be needed and an even bigger guess as to how much they will cost. However, the hit to earnings has already been taken all at once, with the resulting rosier picture of earnings growth in subsequent years. Also, although not entirely properly so, managers have been known to use these in a future year of not-so-great earnings to create a smoother pattern of earnings and earn ings growth for investors.445 Indeed, the reserves have been used to simply meet previ ously announced earnings targets.446 So, taking the example further, if the actnal charges are $1.5 billion, then the company has $500 million in reserves to feed into earnings in order to demonstrate growth in earnings where there may not be actual growth or to create the appearance of a smooth and upward trend.
For example, in an acquisition, there will be costs associated with merging computer
systems. When one airline buys another, the two reservations systems must be merged. Some mergers of computer systems have been done with relative ease and little in the way of either labor costs or consulting fees. However, the acquiring airline has taken a
442Geoffrey Colvin, “Scandal Outrage, Part 111,” Fortune, October 28, 2002, p. 56.
443 “Arms’ Stress on ‘Operating Earnings’ Muddies Efforts to Value Stocks,” Wall Street Journal, August 21, 2001,
pp. Al, AB.
444Caro1 J. Loomis, ULies, Damned Lies and Managed Earnings: The Crackdown \s Here,” Fortune, August 2, 1999,
pp. 75, 84,
445 /d., pp. 74, 84.
446Louis Uchitelle, “Corporate Profits Are Tasty, but Artificially Flavored,” New York Times, March 28, 1999, p. BU4.
Section D: The Industry Practices and Legal Factors I 265
charge, anticipating a large cost ofthis merger. Its numbers look low for the quarter and year of the charge. The next quarter and year, however, look dramatically improved. The acquiring air(ine gains value because of this performance and likely double-digit growth in earnings. The market responds with increased share value. That increased value is not grounded in real performance, changing markets, or superior skill, foresight, and indus try on the part of the airline. Rather, the simple manipulation of the timing on reporting expenses yields results. The hit to earnings in one fell swoop means the financial reports do not reflect 11\e airline’s expenses and evolving challenges. The hit to earnings may not be real, and certaiuly we cannot know whether the anticipated costs and expenses actu ally occur. Again, future earnings look better and the door is open again for cookie jar reserves.
Cookie Jar Reserves
Th s technique uses unrealistic assumptions to estimate sales returns, lo_an losses, or war ranty costs. These losses are stashed away because, as the argument goes, this is an expense that cannot be tied to one specific quarter or year (and there has been much in the way of interpretation as to what types of expenses fit into this category). Companies then allocate these reserves as they deem appropriate for purposes of smoothing out earnings. They dip into the reserves when earnings are good to take the hit and then also use the reserves when earnings are low to explain aw y performance issues. The dis cretionary dip is the key element of the cookie jar. You dip in as needed.
Materiality
Companies avoid recording certain items because, they reason, they are too small to worry about. They are, as the accounting profession calls them, immaterial. The problem is that hundreds of immaterial items can and do add up to make material amounts on a single :financial statement. Also, these decisions on whether items are material versus immaterial, and to report or not to report certain things, seem to create a psychology in managers that finds them always avoiding reporting bad news or trying to find ways around disclosure. An example comes from Sunbeam, Inc., a maker of home appliances such as electric blankets, the Oster line of blenders, mixers, can openers, and electric skil lets. Sunbeam carried a rather large inventory of parts it needed for the repair of these appliances when they came back while under warranty. Sunbeam used a warehouse owned by EPI Printers to store the parts, which were then shipped out as needed. Sun beam proposed selling the parts to EPI for $11,000,000 and then booking an $8,000,000 profit. However, EPI was not game for the transaction becaus.e its appraisal of the parts came in at only $2,000,000. To overcome the EPI objection, Sunbeam let EPI enter into an agreement to agree at the end of 1997. The “agreement to agree” would have EPI buy the parts for’$11,000,000, which Sunbeam would then book as a sale with the resulting profit. However, the agreement to agree allowed EPI to back out of the deal in January 1998. The deal was booked, the revenue recognized, Sunbeam’s share price went up, and all was well. And all without EPI ever spending a dime.
Arthur Andersen served as the outside auditor for Sunbeam during this time, and its managirig partner, Phillip E. Harlow, did raise some questions about the EPI deal and didn’t particularly care for the Sunbeam executives’ responses. Mr. Harlow asked the executives to restate earnings reflecting changes he deemed necessary. Management refused, but Mr. Harlow and Arthur Andersen certified the Sunbeam financials anyway. Mr. Harlow reasoned that he did not see the change as “material,” something that Sunbeam executives were required to restate prior to his certification. For example, under: accounting rules, the “agreement to agree” with EPI, although nothing more than a sham transaction, was not “material” with regard to its amount in relation to
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I
Sunbeam’s level of income. However, Mr. Harlow had defined materiality only in the sense of percentage of income. Although the amount was immaterial, the transaction itself spoke volumes about management integrity as well as the struggle within Sunbeam to meet earnings projections. Both of those pieces of information are material to investors and creditors. The nondisclosure of the sham transaction meant that the true financial, strategic, and ethical situation in Sunbeam was not revealed through the financial state ments intended to give a full and accurate picture of where a company stands.
Further, if one added together the total number of items that were deemed immaterial
individually in the Sunbeam •ituation, the amount of those items (items that the SEC eventually challenged as improper accounting) totaled 16 percent of Sunbeam’s profits for 1997.
There is no question that Sunbeam, Mr. Harlow, and Andersen were correct in their handling on the Sunbeam issues, if we measure from a strict application of accounting rules. As the certification reads, Sunbeam’s financial statements “present fairly, in all material respects, the financial position of, in conformity with generally accepted accounting principles.”
In fact, Mr. Harlow hired PricewaterhouseCoopers to go over Sunbeam’s books and his (Harlow’s) judgment calls, and those auditors from another firm agreed indepen dently that Mr. Harlow certified “materially accurate financial statements.”447 However, the real issues in materiality are not the technical application of accounting rules. Rather, the issues surround the question of intent in using the materiality trump card.
The amounts involved in many of the noted Sunbeam. improprieties were not “mate rial” in a percentage-of-income sense. The problem is that an individual auditor’s defini tion of materiality is the cornerstone of a certified audit All an auditor does is certify that the financial statements “conform with generally accepted accounting principles.”
There is no definition of materiality for the accounting profession. Research shows that most auditors use a rule of thumb of 5 to 10 percent as a threshold level of disclosure, such as 5 percent of net income or 10 percent of assets or vice versa.448 They may also use a fixed dollar amount or an index of time and trouble in relation to the amount in question.449
However, it is clear just from the amount of regulatory action, shareholder litigation, and judicial definitions that the standard for materiality employed by auditors is not the same as the standard other groups would use in deciding which information should be disclosed. Called the expectations gap, this phenomenon means that auditor certification and executive disclosure are at odds from the expectations of investors and creditors. They expect more disclosure even as the technical application of accounting rules allows for less disclosure.
As a company establishes its ethical standards for materiality and disclosure, it should adopt the following questions as a framework for resolution:
What historically has happened in cases in which these types of items are not disclosed? In our company? In other companies?
What are the financial implications if this item is not disclosed now? v\That are our motivations for not disclosing this item?450
447 Andersen has settled the suit brought against it by shareholders for $110 million. Floyd Norris, “S.E.C. Accuses Former Sunbeam Official of Fraud,” New York Tfmes, May 16, 2001, pp. A1, C2.
448 Marianne M. Jennings, Phnip M. Reckers, and Danie\ c.· Kneer, “A Source of Insecurity: A Discussion and an Empir
ical Examination of Standards of Disclosure and Levels of Materiality in Financlal Statements.ff 10 J. Corp. L 639 (1985). .
449 Jeffries, “Materiality as Defined by the Courts,” 51 CPA J. 13 (1981).
4501n thinking about this question, the words of outgoing SEC Chairman Arthur Levitt are instructive: “ln markets where missing an earnings projection by a penny can result in a loss of millions of dollars in market capitalization, I have a hard time accepting that some of these so-called nonevents simpfy don’t matter.” Id.
Section D: The Industry Practices and legal Factors I 267
What are our motivations for booking this item in this way? What are our motivations for not booking this item?
How do we expect this issue to be res lved?
Are our expectations consistent with the actions we are taking vis-.\-vis disclosure?
If I were a shareholder on the outside, would this be the kind of information I would want to know?
Revenue Recognition
These are the operational tools of earnings management, noted earlier in this discussion. Some examples include channel stuffing, or shipping inventory before orders are placed. Sales are recognized as final and booked as revenue before delivery or final acceptance, sometimes without the buyer even knowing. The financial reporting issues at Krispy Kreme Donuts resulted from this ploy of reflecting sales of franchise items to franchises without those franchises actually having ordered those items.
The other tools related to revenue recognition can be broken down into categories. Operations earnings management would involve delaying or accelerating research and development expenses (R&D), maintenance costs, or the booking of sales (channel stuff ing). Finance earnings management is the early retirement of debt. Investment earnings management consists of sales of securities or fixed’ assets. Accountings earnings manage ment could include the selection of accounting methods (straight-line vs. accelerated depreciation), inventory valuation (last in first out [LIFO], or first in first out [FIFO]), and the use of reserves (the cookie jar).
EBITDA and Non-GAAP Financial Reporting
Earnings management does hit those roadblocks of the application of accounting rules and their interpretation. So, rather than risk the wrath of the SEC and the litigation of shareholders and creditors, managers began using a different sort of financial statement. Sanjay Kumar, the former CEO of Computer Associates, once said that “standard accounting rules [are] not the beSt way to measure Computer Associate’s results because it had changed to a new business model offering its clients more flexibility.”451
The “pro forma” financial statement, with all the assumptions and favorable earnings management techniques, was born. Also known as non-GAAP measures, this is account ing that does not comply with “Generally Accepted Accounting Principles,” the rules established by the American Institute of Certified Public Accountants (AICPA), devel oped through its work with the SEC, scholars, and practitioners as they debate that elu sive question of “Are these financials fair?”
Non-GAAP measures of financial performance can be . enormously helpful and insightful in assessing the true financial condition and performance of a company. How ever, non-GAAP measures can also. be used in a way that obfuscates or even conceals the true financial condition and performance of a company.
The Types of Non-GAAP Measurements and Their Use
EBIT (earnings before interest and taxes) and EB!TDA (earnings before interest taxes, depreciation, and amortization) are not as much accounting tools as :financial analysis tools. They were developed because of concerns on the part of those who evaluated financial performance and worth that the rigidity of GAAP necessarily resulted in the omission of information that was relevant for determining the true value of a company and the richness of its earnings. EBIT and EBITDA were means of factoring out the oranges so that the apples of real earnings growth in a company could be determined.
451 Alex Berenson, “Computer Associates Officials Stand by Thelr Accounting Methods,” NeW York Times, May 1, 2001, p. C1, C7.
268 I Unit 4: Ethics and Company Culture
Although the dot-corns and other firms of the new economy are often viewed as those that popularized EBITDA as the measure of valuation for companies, its origins actually go back to the time of Michael Milken and the junk bond era of the 1980s. The takeovers of fhe Milken era, with their characteristics of very little cash, were actually accomplished through the magic of the EBITDA measurement. If an acquirer could reflect an EBITDA of just $100 millio per year, that amount was sufficient to attract investors for purposes of acquisition of up to a $1 billion company. Milken, in effect, leveraged EBITDA num bers to structure takeovers.452 However, the EBITDA figures that Milken used did not include the long-term capital expenditures and principal repayments that were, in effect, assumed to be postponed and postponable, thus allowing a portrayal of a company that could see itself through to a state of profitability. Factoring out expenses such as the cost
o.f equipment replacement meant that earnings growth was reflected at a substantially
higher rate. Investors were thus lulled into a sense of exponential earnings growth at
I the acquired company, not realizing the balloon type of investment that would be required when equipment replacement became inevitable.
I EBITDA, for some companies, is perhaps the only forthright way to actually reflect the
I value of a company. A company dependent onc;”quipment, with its resulting replacement costs, has its earnings growth and value distorted through the use of EBITDA because investors should have the cost of replaceme:qt reflected in the numbers. Depreciation is the means whereby that cost is reflected in GAAP measurements. If an equipment-heavy company, such as a manufacturer, has the same EBITDA as a service company, with only minimal equipment investment because of its focus on human resources, then EBITDA is a misleading measure. For example, Sunbeam the small appliance manufacturer, clearly a company in which replacement of manufacturing equipment is a significant cost, was a proponent and user of EBITDA. Firms in different industries cannot be compared accu rately using only EBITDA numbers because the nature of their business attaches signifi cance to those numbers. GAAP measures that include depreciation provide a better means for cross-comparison, with the financial statement user able to note the deprecia tion component and make independent judgments about the quality of earnings.
The use of these non-GAAP measures in creating pro forma numbers is also particularly useful to investors and analysts when a company changes an accounting practice. For exam ple, when a company switches its inventory evaluation method from UFO to FIFO, the ability to present to financial statement users the contrast between what the company’s per formance would have been under the previous accounting practices versus the new methods hows users the real performance versus performance that includes the new methodology.
‘The original intent in pro forma numbers was a desire on the part of the accounting profession to offer more information and a better view of the financial health of a com pany. That intent was particularly justified in those cases in which a company has under gone a change in accounting practice that affects income in perhaps a substantial way, but would actually have little impact if prior treatments had continued. The booking of options as an expense is an example. The change in the rule is important, but investors and users of financial statements will want to know what income would have looked like under the old methodology so that they are better able to track trends in real perfor mance. However, these original good intentions in the use of pro forma reports changed. Pro forma became the accepted metric with the pro forma results often manipulated with the idea of meeting earnings expectations, or the practice of earnings management.
Warren Buffett described resorting to non-GAAP methods as a means of “manufacturing desired ‘earnings.”‘453 However, among academicians and analysts there
45 2Herb Greenberg, “Alphabet Dupe: Why EBITDA Falls Short,” Fortune, J ly 10,2000, p. 240.
453 Uchitelle, “Corporate Profits Are Tasty, but Artificially Flavored,” p. BU4.
Section D: The Industry Practices and Legal Factors I 269
was substantial disagreement about whether EBITDA and other non-GAAP measures were meaningful forms of valuation.454 In 2000, prior to the dot-com bubble bursting, Moody’s analyst Pamela Stump created a furor by releasing her twenty-four-page exami nation of EBITDA in which she concluded that its use was excessive and that it was no substitute for full and complete financial an alysis.455 Former SEC Chief Accountant Lynn Turner was more harsh in his assessment of the pervasive use of EBITDA, calling such usage a means oflulling the “investing public into a trance with imaginary numbers, just as if they had gone to the movies. Little did they know that the theater was burning the entire time.”456 An example of EBITDA in action can be found in the WorldCom case (see Case 4.27).
As early as 1973, the SEC had issued its cautionary advice on the use of pro forma
financial statements.457 Nonetheless, the use of non-GAAP measures continued and expanded, and the accounting profession offered its imprimatur and certification for pro forma releases. By 2001, 57 percent of publicly traded companies used pro forma numbers along with GAAP numbers in their financial reports, whereas 43 percent used only GAAP num bers.458 For the years 1997 to 1999, Adelphia, the company that col lapsed in 2002 and has had two of its officers convicted and sentenced, included on the cover of its annual report charts that reflected its EBITDA growth. Geoffrey Colvin of Fortune has said that EBITDA stands for “Earnings Because I Tricked the Dumb Auditor.”
Following the passage of Sarbanes-Oxley the SEC defined both EBIT and EBITDA as
non-GAAP measures of financial performance.459 Although both can be offered in finan cial reports, the SEC requires a joint appearance of the two measures of financial perfor mance.460 The critical portion of those new rules is that the non-GAAP measures must be accompanied by GAAP measures.461 These new regulations and appropriate uses of non-GAAP measures are so complex that the SEC has been forced to post responses to the thirty-three most frequently asked questions (FAQs) it has received on non-GAAP
financial measures.462
454 1d. ln his 2000 annual report to shareholders, Mr. Buffett wrote, “References to EBITDA make us shudder.rt Elizabeth McDonald, “The EBITDA Folly,” Forbes, March 17, 2003, http://www.forbes.com.
455 Greenberg, “Alphabet bupe,” 240.
456MacDona!d,”The EBITDA Fol!y,” supra note 93 at p. 3.
457 Securities and Exchange Commission, Accounting Series Release No. 142, Release No. 33-5337, March 15 (Washington, DC: Securities and Exchange Commission, 1973); and Securities and Exchange Commission, Cautionary Advice regarding the Use of “Pro Forma” Financial Information, Release No. 33-8039 (Washington, DC: Securities and
Exchange Commission, n.d.J. ,
458 Thomas J. Phillips Jr., Mlchael S. Luehlfing, and Cynthia Waller Vallario, “Hazy Reporting,” Journal of Accountancy
(August 2002), http:/lwww.aicpa.org/pubs/jofa/aug2002/phillips. (original publicatfon URL).
459 15 C.F.R. § 244.1101Ca)(1). The rule provides, “A non-GAAP financial measure is a numerical measure of a regis trant’s historical or future financial performance, financial position or cash flows that: {i) excludes amounts, or is subject to adjustments that have the effect of excluding ar:nounts, that are included in the most directly comparable measure calculated and presented in accordance with GAA.P ln the statement of income, balance sheet or statement of cash flows (or equivalent statements) of the isSUer or (il) Includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable measure so calculated and presented.” Non-GAAP measures do not include ratios.
460 SEC Release No. 34-47226, conditions for Use of Non-GAAP Financial Measures,” ·17 C.F.R. §§ 228, 229, 244, and 259 (Washington, DC: Securities and Exchange Commission, n.d.J.
461 Running parallel to the SEC changes is a project by the Financial Accounting Standards Board (FASS) called Finan cial Reporting by Business Enterprises. The purpose of the project is to focus on how key performance measures are presented and the calculation of those measures. The project will also address the general issues of whether current accounting standards and their rigidity prevent the release of full and accurate portrayals of the financial health of a
company.
462 The FAQs on non-GAAP measures can be found at the Securities and Exchange Commission website, http://www. sec.gov/divisions/corpfin/faqs/nongaapfag.
270 I Unit 4: Ethics and Company Culture
Some of those FAQs have producetl’ the following clear rule interpretations from the
SEC:
Companies should never use a riOn-GAAP financial measure in an attempt to smooth earnings. All public disclosures are covered by RegulatiOn G (the new rule that requires the presentation of GAAP and non-GAAP measures together).
The fact that analysts find the non-GAAP measures useful is not sufficient justification for their presentation.
Non-GAAP measures make sense in certain circumstances, when their use is actually necessary to provide the financial statement user with a full and fair picture of the com pany’s financial health.
A Follow-Up to Levitt: Ethical Issues in Financial Reporting, Earnings
Management, and Accounting
How Effective Is Earnings Management?
Earnings management is effective in increasing shareholder value. A consistent pattern of earnings increases results in higher price-to-earnings ratios. That ratio is larger the lon ger the series of consistent earnings. Firms that break patterns of consistent earnings experience an average 14 percent decline in stock returns for the year in which the earn ings pattern is broken. However, the discovery of earnings manipulation at a company results in a stock price drop of 9 percent. In short, there appears to be a net upside for engaging in earnings management.
In addition to the shareholder value argument, there are other drivers that make earn ings management such a treacherous area for managers and employees. Executive and even employee compensation contracts may provide dramatic in’centives for managing earnings. Bausch & Lomb, Sears, and Cendant are all examples of companies whose managers manipulated earnings because of incentive systems and goals that brought the managers personal benefits. Incentives for earnings ,management can also come from sources other than compensation incentives for executives. Covenants in debt contracts, pending proxy contests, pending union negotiations, pending external financing propo sals, and pending matters in political or regulatory processes can all be motivational fac tors for earnings management. Many managers use earnings management as a strategic tool to have an impact on pending matters.
The Ethics of Earnings Management
The question that fails to arise in the context of management decisions on managing earnings is whether the practices are ethical. Managers and accountants comply with the technical rules, but technical compliance may not result in financial statements that are a full and fair picture of how the company is doing financially. In a system depen dent upon reliable (known as transparent) financial information, the practice of earnings management conceals relevant information. Research shows that firms that engage in earnings management are more likely to have boards with no independence and eventu ally higher costs of capital.
The new approach to accounting rules and earnings management focuses on the ethi cal notion of balance: If you were the investor instead of the manager, what information about earnings management would you want disclosed? If you were on the outside look ing in, how would you feel about the decision to book extra expenses this year in order to even out earnings in a year not so stellar? In short, when all the complications of LIFO, FIFO, EBITDA, and spring-loading are discussed, we are left with the simple notions of ethical analysis provided in Unit 1, from the categorical imperative to the