Recognizing the signs: internal auditors can help organizations avoid the risks associated with inappropriate earnings management by understanding the symptoms and sharing their knowledge - Risk Watch - Column

Internal Auditor, April, 2003 by Richard J. Kokoszka

FINANCIAL MARKETS REWARD companies with steadily growing income streams. However, when operating results are disappointing or uneven from quarter to quarter, the pressure on chief financial officers and controllers to fabricate or "smooth" earnings can be intense. The plethora of recent financial frauds in the United States bears witness to the harm that can come when financial executives give in to such temptation.

Studies consistently show that more frauds are uncovered by employee tip-offs than by any other means. Internal auditors can help their organizations manage the potentially catastrophic risk of fraudulent financial reporting by understanding the most common methods of earnings management and by sharing this knowledge with employees -- who occupy positions where they might see, but not necessarily recognize, the symptoms.

COOKIE JAR RESERVES

"Cookie jar" reserves -- sometimes labeled general reserves, rainy day reserves, or contingency reserves -- enable companies to beat earnings estimates by a controlled amount no matter how the business actually performs. In periods of strong financial performance, cookie jar reserves enable companies to reduce earnings by overstating reserves, overaccruing expenses, and using one-time write-offs. In periods of weak financial performance, cookie jar reserves can be used to increase earnings by reversing accruals and reserves to reduce current period expenses. This accounting strategy obviously misleads investors.

The most prominent example of the use of cookie jar reserves is WorldCom Inc. In August 2002, an internal review revealed improperly booked items that totaled roughly $2.5 billion. Some of these related to a series of so-called reserve reversals, which are funds that companies typically set aside to cover the estimated cost of a future event. Once the cost is incurred, any additional funds can be reversed back into earnings. Reserves at WorldCom related to litigation, uncollectible receivables, and taxes.

BIG BATH CHARGES

"Big bath" charges are one-time restructuring charges. Current earnings will be reduced by over estimating these one-time charges. By reversing the excessive reserve, future earnings will increase. For example, the U.S. Generally Accepted Accounting Principles (GAAP) require a company, in year one, to estimate the costs it will eventually incur in the restructuring -- for severance payments, plant closings, and the like -- and charge them off, even though many of the expenses won't actually be paid until year two or three. These charges, which end up in a liability called a reserve, tend to put craters in year one's profits.

Earnings often shine in the wake of a restructuring, but not necessarily because business has improved. The restructuring charge may have been deliberately made larger than the monies to be paid out -- big bath charges -- to allow the excess to be channeled back into earnings in year two or year three. For example, restructuring charges could include a reserve for the estimated cost of anticipated layoffs. A company could take a $1 billion write-off, but in fact lay off 30 percent fewer employees than anticipated.

Rite Aid Corp. took a large restructuring charge in anticipation of closing 379 stores. The U.S. Securities and Exchange Commission (SEC) compelled Rite Aid to reduce the size of its restructuring charge from $290 million to $230 million, add major expenses to its operating costs, and restate its profits.

Big bath charges are not always related to restructuring. In April 2001, Cisco Systems Inc. announced charges against earnings of almost $4 billion. The bulk of the charge, $2.5 billion, consisted of an inventory write-down. Cisco allegedly wrote off an amount that was essentially equal to the cost of the entire inventory that was sold in the previous quarter. Writing off more than a billion dollars from inventory now means more than a billion dollars of less cost in a future period.

At some point, Cisco could, theoretically, announce that business is starting to get better and the company could report results that confirm it, even if sales stay flat. This is an example of what ultra-conservative accounting in one period makes possible in future periods.

CREATIVE ACQUISITION ACCOUNTING

During a merger, purchasers sometimes write-off assets called in-process research and development (IPR&D). As merger accounting works, a purchaser must assign values to all the assets it has bought and, for the most part, capitalize them and write them off in future years. But the values assigned to IPR&D assets must be written off immediately, which means their cost cannot be used to reduce earnings in future years. Typically, acquirers do their utmost to assign maximum amounts of their purchase price to IPR&D so that they can immediately put these costs behind them.

In WorldCom's acquisition of MCI, it reported a $3.2 billion loss on purchased research and development. Presumably, this was the amount that WorldCom paid for MCI's IPR&D. Initially, MCI WorldCom wanted to write-off $7 billion, but relented when the SEC insisted the company reduce the write-off to $3.2 billion.