Business and Different Financial Issues
Corporate managers have a professional responsibility to ensure the integrity and faithful representation of their company’s financial statements. Outside auditors are responsible for expressing an independent opinion on financial statements to determine if they are presented fairly and in accordance with GAAP. These professional roles are the cornerstone of the U.S. financial system, which protect public interest and investor confidence. Over the past 50 years however, the pressure on corporate management to meet analysts’ short-term earning projections, showing continued growth, has increased dramatically. The markets have punished companies harshly for missing earnings projections, even by a small amount. This pressure led to the management practices commonly referred to as “earnings management” and “earnings smoothing”. These developments have had an adverse effect on the quality of earnings and financial statements. As SEC Chairman Arthur Levitt described, this process is a “game among market participants” (The Numbers Game, pg. 1). The integrity of financial statements fell in priority for corporate management. They were willing to take risks and push the accounting rules to their limits to achieve their desired financial results. Auditors also contributed to this problem by not standing up to their clients who were implementing such questionable accounting practices and misrepresenting their financial statements. The standard setters, regulators, and politicians were pressured and lobbied by industries not to impose stricter standards on corporations. As a consequence of these developments, there came a series of financial collapses and accounting scandals in the U.S., such as Enron, Sunbeam, Waste Management, and Arthur Andersen – and billions of investment dollars were lost.
One reason behind the “earnings management” mindset is that top management had personal financial incentives to increase the value of their companies’ stocks. Managers’ compensation packages included thousands, and in some cases millions, of stock options. In order to increase the value of these stock options, top management had to meet or exceed analysts’ earnings expectations for their companies. As a result, personal greed and market pressures led management to adopt aggressive accounting practices and techniques to help them craft preferred short-term financial results. Accounting principles provide managers with the flexibility to use their judgment, which in turn creates an opportunity for misuse and abuse in the application of accounting standards. Corporate management employed five popular earnings management techniques: “big bath” restructuring charges, creative acquisition accounting, “cookie jar” reserves, materiality, and revenue recognition. For example, Sunbeam CEO, Mr. Dunlap, recorded an excessive restructuring write-off and created “cookie jar” reserves in 1996, the year he became CEO. This technique made the following year’s results appear superior and created an illusion of a company turnaround. Moreover, Sunbeam also improperly recognized millions of dollars in sales revenue for paper transactions through the “channel stuffing” technique. Waste Management Company meanwhile, manipulated depreciation expense numbers to overstate their earnings.
How it works
This priority on short-term financial gains over long-term results led many corporate managers to create financial devastation, and even total collapse, for their companies. These managers misrepresented the real financial picture, misleading investors in the process. Eventually, investors lost confidence in capital markets, putting the entire financial system in jeopardy. The integrity, credibility, and transparency of financial statements and a focus on long-term financial goals should be a top priority for managers. The whole financial community is responsible for restoring financial stability and success in the United States. Auditors should maintain independence and uphold professional and ethical standards. Meanwhile, private standard setters must continue to improve accounting standards and regulators must reinforce standards to implement them.