On September 28, 1998, Chairman of the U.S. Securities and Exchange
Commission Arthur Levitt sounded the call to arms in the financial community.
Levitt asked for, immediate and coordinated action… to assure credibility and
transparency of financial reporting. Levitt’s speech emphasized the importance
of clear financial reporting to those gathered at New York University. Reporting
which has bowed to the pressures and tricks of earnings management. Levitt
specifically addresses five of the most popular tricks used by firms to smooth
earnings. Secondly, Levitt outlines an eight part action plan to recover the
integrity of financial reporting in the U.S. market place. What are the basic
objectives of financial reporting? Generally accepted accounting principles
provide information that identifies, measures, and communicates financial
information about economic entities to reasonably knowledgeable users.
Information that is a source of decision making for a wide array of users, most
importantly, by investors and creditors. Investors and creditors who are
responsible for effective allocation of capital in our economy. If financial
reporting becomes obscure and indecipherable, society loses the benefits of
effective capital allocation. Nothing illustrates the importance of transparent
information better than the pre-1930’s era of anything goes accounting. An era
that left a chasm of misinformation in the market. A chasm that was a
contributing factor to the market collapse of 1929 and the years of economic
depression. An entire society suffered the repercussions of misinformation.
Families, and retirees depend on the credibility of financial reporting for
their futures and livelihoods.
Levitt describes financial reporting as, a bond between the company and the
investor which if damaged can have disastrous, long-lasting consequences. Once
again, the bond is being tested. Tested by a financial community fixated on
consensus earnings estimates. The pressure to achieve consensus estimates has
never been so intense. The market demands consistency and punishes those who
come up short. Eric Benhamou, former CEO of 3COM Corporation, learned this hard
lesson over a few short weeks in 1996. Benhamou and shareholders lost $7 billion
in market value when 3COM failed to achieve expectations. The pressures are a
tangled web of expectations, and conflicts of interest which Levitt describes as
almost self-perpetuating. With pressures mounting, the answer from U.S. managers
has been earnings management with a mix of managed expectations. March of 1997
Fortune magazine reported that for an unprecedented sixteen consecutive
quarters, more S&P 500 companies have beat the consensus earnings estimate than
missed them. The sign of a quickly growing economy and a measure of the
importance the market has placed on consensus earnings estimates. The singular
emphasis on earnings growth by investors has opened the door to earnings
management solutions. Solutions that are further being reinforced to managers by
market forces and compensation plans. Primarily, managers jobs depend on their
ability to build stockholder equity, and ever more importantly their own
compensation. A growing number of CEO’s are recieving greater percentages of
their compensation as stock options. A very personal incentive for executive
achievement of consensus earnings estimates.
