Corporate Finance

Back to the Future

What the SEC should really do about earnings management.
Stephen BarrSeptember 1, 1999

Securities and Exchange Commission chairman Arthur Levitt has been railing against earnings management for a year now, but a close look at his proposed remedies suggests he is mistaking the symptoms for the disease. Levitt, to be sure, has been beating up on executives and board directors for “accounting gimmicks” that some, at least, deploy to smooth earnings. But the fact is, such tricks aren’t the crux of the problem.

Granted, Levitt, in launching his campaign last September, spoke of the “game of nods and winks” that goes on among corporate leaders and investment analysts, and expressed concern that “the zeal to satisfy consensus earnings estimates…may be winning the day over faithful representation.” But the solution he unveiled, a nine-point action plan to enhance integrity in financial reporting, puts the onus on corporations for the fix. His plan consists largely of devising new accounting guidelines, bolstering SEC enforcement activities, and improving the oversight role of the audit committee and auditors.

Although he cited the market’s unforgiving response to companies that miss analyst estimates by as little as a penny a share, he offered only the mildest rebuke: “To Wall Street, I say: Look beyond the latest quarter. Punish those who rely on deception, rather than on the practice of openness and transparency.” The plan stopped well short of proposing any concrete ideas for bringing that about – other than to suggest that analysts obey Levitt’s command to be more like Warren Buffett and take a longer view.

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Gripes one finance executive who prefers anonymity: “I haven’t heard anything that deals with the other side of the street.” And CFOs are not the only ones to notice the apparent shortcomings. “What’s missing is what Wall Street ought to do,” says former Secretary of Commerce Barbara Franklin, who is now president of her own consulting firm, in Washington, D.C., and who serves on four boards, chairing the audit panel of two of them. “Levitt won’t solve anything by attacking only one side of the problem. There’s only so much management and board members can do.” Even some analysts contend that the direction of the SEC crusade has, at least implicitly, absolved Wall Street of any responsibility for this nefarious nods-and- winks game. Because there is more focus “on the peripheral issues of accounting practices, the investment community has no motivation to get involved,” says Steve Percoco, a housing industry analyst at Lark Research Inc., in Rahway, New Jersey.

The SEC’s chief accountant, Lynn Turner, has heard the complaints that the commission’s campaign has not focused on Wall Street’s role in earnings management, and he has asked for suggestions of what to do. “We have yet to receive responses from anyone,” Turner says.

But if Levitt were serious about curbing earnings management, he might best heed the call of those who say it’s time to overhaul financial reporting, including none other than former SEC commissioner Steven Wallman. The blue-sky solution, these futurists contend, is a “real-time” reporting system in which analysts and investors have direct, networked access to key performance measures on a continuous basis.

Such pleas, in the past, have been issued in the spirit of modernizing an antiquated system with accounting rules that reflect old-line bricks-and-mortar enterprises. But the truth is, such modernization may be the most effective – in reality, the only effective – means of ending earnings management by, over time, making the quarterly earnings release irrelevant.

Reforming the system along these lines would, in a sense, entail deregulating financial reporting, and Levitt is not known as a firm believer in market-oriented solutions to regulatory problems. But the SEC chairman was appointed (and reappointed) to his job by a President fond of “third-way” approaches to public policy. And Levitt himself has at least paid lip service to the notion that more regulation isn’t always best.

The Wrong Focus

This is not to say that Levitt’s campaign has had no effect. According to the “National Charge Clock” (an online, running tally of corporate accounting charges), write-offs of purchased research and development – a practice Levitt identified as an area of concern – are down significantly in 1999. Last year, the SEC outlined stricter standards for determining how much companies could write off. Through March, the number of charges for in-process R&D was down 40 percent, with the dollar amount of those charges down 16 percent.

“It seems as if the word is out and the jaw- boning by the SEC has had an impact,” says Jack Ciesielski, who publishes The Analyst’s Accounting Observer newsletter and maintains the Charge Clock.

However, Ciesielski is baffled that the number and dollar amounts of restructuring charges have continued to soar despite the SEC’s warning that it would scrutinize write-offs and reserves more closely. He insinuates that companies worried about their future earnings may be looking to “immunize” themselves against investor disappointment. Granted, the long-promised SEC Staff Accounting Bulletin on reserves, as well as the ones on revenue recognition and materiality, might make a difference when they are finally released.

So, too, might the proposals to reform audit committees by the blue-ribbon panel Levitt convened last year. But the fate of those recommendations is still unclear, and corporate-governance experts say that their effect will fall short of the remedy Levitt seeks. CFOs agree. “I value the importance of audit committees, and I think we ought to be looking at how to make them better,” says John Wulff, CFO of Union Carbide Corp., the $5.7 billion chemicals company based in Danbury, Connecticut. “But there is almost an overfocus in that one area, and not enough emphasis on other issues.”

Like many, Wulff suspects that the root cause of last year’s spectacular accounting disasters at Cendant Corp., Sunbeam Corp., and Livent Inc. had less to do with faulty accounting rules and practices than with executives succumbing to the pressure to meet earnings estimates. (See “Guilty as Charged,” April, for an in-depth analysis of the accounting legerdemain perpetrated at California Micro Devices in the early 1990s.)

And, arguably, even after Levitt tightens a bunch of accounting rules and reminds CFOs that they are supposed to make accounting judgments without casting an eye toward the impact on earnings, he will have done nothing to mitigate the pressure that tempts companies to manage earnings in the first place.

Outdated Rules

Of course, there may be little the SEC can do to influence analysts’ behavior. Says Martin Fridson, a managing director at Merrill Lynch & Co. and the author of several books on financial-statement analysis: “I’m not defending the idea of setting up a number that can be easily contrived and punishing a company for not meeting that imaginary target by artificial means, but I don’t think it’s likely that Wall Street is going to change.”

Others blame not the analyst culture, but secretive CFOs reluctant to disclose the accounting estimates and activity in noncash balance sheet accounts that can have an impact on earnings. “Earnings management always goes on,” says accounting expert Ciesielski. “We just can’t tell how they’re doing it.”

Yet CFOs like Steve Key of Textron Inc., a $10 billion global multi-industry company, in Providence, have tried to buck that trend, only to run afoul of regulators. Key suggests that letting companies report separate earnings-per-share numbers for core and noncore income would give a truer picture of business fundamentals. He tried something along those lines at another company, when he reported cash earnings in the annual report. But that prompted a lengthy comment letter from the SEC. “The analysts loved it,” he says, “but we never did that again.”

And then there are those who say the only way to stop earnings management is to render the quarterly earnings release obsolete. In fact, these forward-thinking accounting experts argue that most current rules and reporting practices have outlived their usefulness, especially with the emergence of new knowledge- based industries. They contend that layering on new guidelines and new disclosures only further encumbers a system whose artificiality encourages earnings management.

Instead, they envisage something completely different – a real-time financial reporting system in which analysts and investors have continuous, networked access to a wealth of disaggregated corporate data.

Says Wallman, who is chairing a Brookings Institution task force on the future of financial reporting and is also CEO of FolioTrade LLC, an Internet investment firm in McLean, Virginia: “It is not a coincidence that this ‘concern’ about earnings management has come at a time when the current accounting rules don’t fit well. But the only solutions proposed so far by the SEC involve more regulations and more iterations and interpretations of accounting rules. They’re sensible as stopgap measures. Yet the point of departure I have is that we really need to work on how to make a better system for the long-term.”

Information Mismatch

The crux of the earnings-management issue is not that accounting-savvy executives need to be watched more carefully, but that an extraordinary mismatch exists between the market’s demands for financial information and the ability of today’s Depression-era financial-reporting system to deliver it.

On the one hand, the insatiable information thirst of analysts and investors is slaked by an increasing array of instantaneous media services, ranging from Bloomberg terminals to Internet Web sites and chat rooms to various pager and phone products. On the other hand, the SEC oversees a process of quarterly and annual reporting that was developed in the 1930s, when carbon paper was a technological innovation.

“There is just such a huge gap between what the markets want and what the system can deliver,” says Michael Young, a partner at the New York law firm of Willkie Farr & Gallagher and editor of the forthcoming book Accounting Irregularities and Financial Fraud.

These days, that information void is readily filled by analyst reports and estimates, which are compiled and presented in consensus form as never before and, whether the predictions are right or wrong, have become the drivers of stock prices. “The only time an earnings release moves the market is when it’s inconsistent with expectations,” says Young, who has both investigated and defended companies accused of accounting irregularities.

Consequently, what has emerged is an environment in which investing is a new form of entertainment, seeing who hits their earnings target is a blood sport, and gamesmanship goes on each quarter around consensus estimates, analyst guidance, whisper numbers, pre-announcements, and conference calls. If CFOs aren’t managing earnings, they’re certainly spending more time than they’d like managing expectations.

In a CFO magazine survey conducted in July, 72 percent of CFOs responded that they had issued preannouncements or guidance on earnings in the previous three years. Of those that had, 68 percent explicitly indicated that they’d wanted to warn investors that earnings would fall short of the consensus estimate. One did it to “keep the market from being shocked.” Another noted fatalistically that doing so was “better than the alternative.”

To Young, these executives are struggling with a sputtering reporting system that isn’t up to feeding the information-hungry beast. “Preannouncements are the most obvious symptom of the mismatch,” Young says. “Companies feel they have no choice but to take a step in the direction of more- frequent financial reporting.”

Talk vs. Action The notion that the current financial reporting system is in need of an overhaul has been kicking around for years.

In 1991, the American Institute of Certified Public Accountants formed a special committee to look at the relevance and usefulness of business reporting, publishing a 200-page paper three years later. Known as the Jenkins Report, after Financial Accounting Standards Board chair Edmund Jenkins, who was an Arthur Andersen partner when he led the study effort, the work outlined a new reporting model that called for more disclosure of key performance measures and forward-looking information than that found in mandated financial reports.

“As performance measures are much more widely used internally, logic suggests that such information would probably be helpful to investors as well,” Jenkins avers in an interview. The wide-ranging report lent support to the SEC’s move in 1995 to provide a safe harbor for forward-looking statements. It also bolstered FASB’s work on simplifying pension disclosures and a new standard on segment reporting. But, Jenkins concedes, executives were leery that the call for more corporate disclosures was a thinly veiled effort by the AICPA to generate more audit work.

In 1997, the same skepticism greeted what was known as the Elliott Report, the work of another AICPA special committee, chaired by KPMG partner Bob Elliott. This second study went a step further to address the timeliness of disclosures. Specifically, it discussed a new reporting system in which key financial and nonfinancial data is updated and available on a real-time basis through computer links.

“To the extent that you disclose more corporate information on a more-frequent basis,” Elliott says, “it seems to me that uninformed volatility would be reduced. You’d still have volatility when exogenous events occur that change the real value of the company, but you’d have less volatility from lack of information or misinformation in the marketplace.”

Among the strongest advocates of these ideas is Wallman, who was an SEC commissioner from 1994 to 1997. In his last two years at the agency, he published a four-part commentary on the future of accounting and financial reporting in Accounting Horizons, a quarterly journal of the American Accounting Association. In that work, he laid out his argument for a new “user-customized” system, much like the one described in the Elliott Report, in which analysts and investors have direct, real-time access to a broad set of disaggregated data.

As Wallman sees it, periodic financial reporting reflects a bygone era. He argues that, at a time when the new, more-intangible drivers of value are lost in the old accounting rules, and new technology can make warehouses of data available on a networked basis, it seems counterproductive to prop up the current system.

Further, he contends, as this real-time reporting system with direct access to key value drivers comes about, the notion of periodic reporting will become outmoded. “Businesses are run on a continuous basis, not a quarterly basis,” Wallman contends. “If you didn’t have the artificiality of the quarterly reporting system, some of the artificiality of business activities, like trying to move inventory at the end of a certain quarter in order to show an uptick in revenues, wouldn’t be there.”

In turn, he explains, everything that is part of the system today – from the consensus estimates to selective disclosures to whisper numbers to preannouncements – would evaporate. “Analysts and investors would judge a stock based on a company’s performance and prospects, not on how well it manages to a certain number four times a year.”

Evolution, Not Revolution
None of this will happen over-night, though there are glimmers that things are moving in the right direction.

For one thing, in January 1998, FASB launched a special project on business reporting designed to urge companies to be more forthcoming and to disclose nonfinancial data, particularly key performance drivers, more frequently. “The objective is to identify best practices with respect to the disclosure of measures outside the traditional financial statement reporting package, with the hope that others will adopt similar disclosures,” explains Jenkins.

This project would go a long way toward encouraging what Wallman calls “the colorized approach” to financial reporting, which he defines as reporting additional categories of useful information as a supplement to the current core disclosures. “Colorized reporting is a way station to direct-access reporting,” he says.

Most companies already disclose some colorized data on industry trends and various performance metrics, often in the management- discussion part of the financial statements, or in disclosures outside the quarterly and annual releases. Retailers, for instance, disclose monthly sales, which are a strong indicator of profits. Airlines disclose their monthly load factors.

“Once you have our top line, you can run your models and get a good sense of what the results are going to be,” says Roger Polark, senior vice president and CFO of Walgreen Co., a national drugstore chain based in Deerfield, Illinois. “If things are trending one way or another, analysts would be picking up on that; we’d be having discussions with them; and we’d be less likely to have a surprise at the end of the quarter.”

Polark acknowledges that the monthly sales figures contribute to more movement in the stock than the quarterly earnings, but the more-frequent release of key financial data does not give rise to more analyst pressure to make the numbers. “I find that the release of interim information has a positive effect on how well the company is followed and its performance is understood,” he says. “Any possible surprises are adjusted for monthly.”

Although there has been some talk that FASB’s business reporting project, which will be completed next year, is merely a precursor to new disclosure standards, Jenkins insists that any recommendations will be voluntary. Says Union Carbide’s Wulff, a member of the project’s steering committee, “I think it would be a big mistake if we came out with a document that was used as a standard, because standards in the area of nonfinancial reporting would have the potential of undermining creativity and hamstringing companies.”

Barriers to Reform

But even if companies disclose more information, how feasible is the idea that outsiders can tap into disaggregated corporate data at will?

As far as technology is concerned, Wallman sees no barriers, as bandwidth expands and networked links become ubiquitous. Even today, the component pieces of a direct-access reporting model are evident in enterprise resource planning systems, just-in-time inventory systems, and electronic data interchange with customers and suppliers. “You can see in place the kinds of systems that would facilitate the move,” Wallman says.

A more significant barrier would be corporate resistance. There would be the fear that such direct access to information would tip off competitors, though these new systems could be designed to allow access to a select database of key measures, not to all planning and performance information. And there would also be the fear that executives might have to endure the agony associated with putting out an earnings press release not quarterly, but every day.

“If I sell less today than I did yesterday, will that be seen as indicative of a downturn in the business?” wonders one CFO. Wallman responds that a real-time system would reduce uncertainty and volatility. He would expect investors to view trends over the period of time that’s most relevant to a particular business, instead of in three-month cycles that themselves may be out of sync with the internal cycles of the business.

Brokerage firms would also be likely to resist such a real-time reporting system. For one thing, their analysts gain notoriety and the firms make a lot of money based on how well they can predict earnings. “The concern I’ve heard from analysts is that it would make it easier for others to do [the analysts’] job,” Wallman allows. “That’s conceivable, but their role, rather than diminished, would be enhanced by the value they could bring to understanding the data.”

For now, even Wallman is reluctant to abandon today’s financial reporting system and the accounting rules that underlie it, as flawed as they are. Rather, he would expect to see the new system built alongside the old one. And he believes that the impetus for such a change must come not through regulatory action, but from a ground swell of users and preparers who see the benefit of something better.

That doesn’t mean Arthur Levitt is off the hook. What is called for is not for the SEC to dump its earnings-management campaign, but for the chairman to temper his ferocious, puffed- chest rhetoric with talk about these “third- way” ideas. Doing so may not be easy for him, but he is in the best position to point the way.

“The SEC is the voice that still needs to be heard,” Wallman says. “Unfortunately, a regulator’s mind-set is that we must make the system work, saying there’s nothing wrong that more enforcement and more rules can’t fix. What’s really required is for somebody to say our system works well but is showing signs of wear. No one is suggesting a radical departure that should be put in place tomorrow, or that even could be. But we can start to think about a better system that over 5 or 10 years we could evolve toward.”

A tall order, yes, and long overdue.

———————————————– ——————————— A Broken System

In a survey conducted in July, we asked Fortune 500 CFOs what they think about the quarterly reporting dance with Wall Street analysts. To Michael Young, a partner at Willkie Farr & Gallagher and author of a forthcoming book on accounting irregularities and earnings management, the results are compelling evidence of a periodic financial reporting system that is not working.

“The survey speaks volumes about inefficiency and unfairness,” says Young, who reviewed the findings. “It’s pathetic that CFOs are spending so much time dealing with analysts, and potentially unfair that information is disclosed to some analysts and not to others.” As for the large number of preannouncements, he says, “they serve to highlight the need for increased frequency of financial reporting. CFOs are leaving behind the established legal framework for reporting and trying to give the markets what they want.”

How many analysts’ calls do you get in an average week?

Fewer than 5 : 32%
5 to 10 : 30%
10 to 15 : 13%
15 to 20 : 4%
More than 20 : 21%

How much of your time is spent dealing with analysts?

Less than 5% : 14%
5% to 10% : 27%
10% to 15% : 21%
15% to 20% : 18%
More than 20% : 20%
On a scale of 1 (subtle) to 5 (brazen), how explicit are analysts in asking for your assessment of consensus estimates?
1 ­ 5%
2 ­ 14%
3 ­ 19%
4 ­ 30%
5 ­ 32%

How many times in the past 3 yrs. have you disclosed data to one analyst and not to others or to the public?

Never : 73%
1 to 4 times : 23%
5 to 10 times : 2%
More than 10 times : 2%

Have you ever issued preannouncements or guidance on earnings?

Yes : 72%
No : 28%

How many times in the past 12 quarters have you surprised Wall St.?

Never : 12%
1 time : 27%
2 times : 20%
3 times : 14%
4 or more times : 27%

Were the surprises positive or negative?

Positive : 67%
Negative : 33%

Source: CFO magazine

———————————————– ——————————— Have you ever felt pressure to report earnings in a way that misrepresented the company’s true performance? Click here to take our online poll!