Financial Reporting

.. 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 companys 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 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.

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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 Analysts 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 reaonable person relying on the information would have been changed or influenced by the omission or misstatement. Todays management has started to ignore this fundamental principle. Materiality is being defined as a range of a few percentage points. Companies defend immaterial omissions by referring to percentage ceilings that draw a line on materiality. “The amount falls under our ceiling and is therefore immaterial.” The materiality gimmick is one more method companies are using to stretch a nickel into a dime. Simply put, “In 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 non-events simply dont matter,” says Levitt.

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 todays 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. Levitt has made it very clear that the SEC is prepared to start forcing change.

A line Levitt hopes will not be necessary to cross. The SEC will begin to issue guidance on a wide array of issues concerning the credibility and transparency of financial reporting. Guidance that must be acted on to “Obviate” the need for large scale SEC involvement. The SEC will also act more proactively in two of its traditional roles of information regulation and enforcement. First, the SEC will begin requiring companies to provide additional disclosure details on changes in accounting assumptions.

Supplemental beginning and ending balances and adjustments of sensitive restructuring liabilities and other loss accruals will also be required. Secondly, the SEC is unleashing the dogs on companies using any practices that appear to be managing earnings. The gauntlet has been thrown, and it is up to the financial community to accept the challenge. FASB and other standard setting bodies have fallen behind a rapidly changing and evolving economic environment. FASB and the AICPA are being coercively encouraged to clean up auditing and disclosure practices.

The pressure is on and standard setting bodies are scrambling to close the holes in GAAP. FASB has established committees to investigate a number of concerns and is diligently working toward solutions that “obviate.” Auditors and the public accounting industry received a good scolding from Levitt. Glaring failures in the auditing process at Sunbeam, Waste Management Inc., and Cendant have put the whole industry at risk of public solutions. The auditors have failed to be the “watch dog” of investors. It is time to clean up your industry. Criticism by the entire financial community has questioned the auditors, qualifications, methods and their ability to police themselves.

Finally Levitt challenges corporate management, and investors to begin a cultural change. Change that resists the pressures to follow the leader in accounting chicanery. Investors are encouraged to set financial standards of integrity and transparency and punish those who depend on illusion and deception. “American markets enjoy the confidence of the world. How many half-truths, and how much sleight-of-hand, will it take to tarnish that faith?” With the shift away form company run pension plans everyone has become their own personal financial planners. What hangs in the balance is the future of us all. 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. Fox, Justin. “Learning to Play the Earnings Game (And Wallstreet will Love You).” Fortune 31 Mar. 1997 Greenberg, Herb, “The Auditors are Always Last to Know,” Fortune Investor 17 Aug. 1998.

Melcher, Richard, “Where are the Accountants.” Business Week 5 Oct. 1998. Melcher, Richard and Sparks, Debra “Earnings Hocus Pocus” Business Week 5 Oct. 1998. Bartlett, Sarah, “Corporate Earnings: Who Can You Trust” Business Week 5 Oct. 1998.

Turner, Lynn E. “Continuing High Traditions” Speech, 5 Nov. 1998. Turner, Lynn E. “Remarks” Speech, 10 Feb.

1999. Aeppel, Timothy “Eatons Earnings Increase but Miss Analysts Forecasts” 20 Oct. 1999. Tran, Khanh “Excite At Home Posts Quarterly Loss Due to Charges but Meets Estimates” 20 Oct. 1999. Bank, David “Microsoft Earnings Exceed Expectations” 20 Oct. 1999.