Tuesday, December 19, 2006

Managing Earnings: Playing the Numbers Game

Did you ever wonder why some companies always consistently beat their earnings targets?

Many accounting professionals have written extensively about how companies “manage earnings.” A company can arbitrarily reduce “excessive profits” in good quarters or fiscal years to “save” such earnings and apply them to future leaner accounting periods in order to avoid earnings disappointments.

Jeff Matthews has an interesting commentary in his recent blog post entitled, “And Beware CEOs Trying to ‘Hit the Numbers?" He wrote in part:

Not only can the focus on hitting a meaningless, and often unsustainable, profit forecast result in stupid, short-term decision making; it can also, as in the case of Tyco, Fannie Mae, Enron, and a list of other companies large and small too lengthy to bother with, result in fraud.
The problem is that management can become so focused and obsessed with hitting earnings targets that certain improper decisions will be made relating to the application of accounting principles to “smooth over” earnings. Ultimately the so called “professional judgment” that management uses in the application of accounting principles can lead to aggressive accounting techniques and even fraud. 

The issue here is known as “managing earnings.” Accounting is more of an art than a science because of certain judgments regarding accounting principles by management with the acceptance of its Audit Committee and external auditors. For example, accounting principles relating to sales, leases, depreciation, accounts payable, and inventory all involve some amount of judgment or leeway.

In the Crazy Eddie fraud, one technique we used to manage earnings was by taking excessive arbitrary reserves against inventories in good years and reducing such reserves against inventory in lean years. In fiscal year 1986, we inflated our earnings by about $16 million due to fraudulent means. When Main Hurdman, Crazy Eddie's external auditors, completed their initial computation of the company's earnings, our gross margins were over 40% in the last quarter. Historically, Crazy Eddie’s gross margins were only about 20%. Our excessive earnings inflation should have been a "red flag" for Main Hurdman to investigate further.

Rather than investigate the red flag, Main Hurdman simply agreed to Crazy Eddie booking extra arbitrary “loss reserves” against our inventory valuations. The auditors thought that Crazy Eddie was being “conservative” but in fact they unwittingly helped us reduce our overly excessive fraudulent earnings inflation.

The use of such arbitrary reserves was known as “accountant’s legal liability insurance,” since the rationale was that no company was ever sued for being too conservative or under-reporting earnings. When I asked the auditors about what Crazy Eddie should do with these “excessive” reserves in future years, they replied to me that such excessive reserves was like “money in the bank.” The auditors explained to me that such excessive reserves can be reduced in future lean years to help Crazy Eddie make its future earnings targets.

In the next fiscal year, when Crazy Eddie started losing money and no amount of fraud could turn such losses into profits, we reduced our excessive arbitrary reserves that we had set up in the prior year, with our auditors’ collusion.

While the external auditors were not involved in falsifying inventory, they were unwitting accomplices to our fraud, since they helped us “manage earnings” through the use of arbitrary inventory reserves.

In many of my conversations with Wall Street analysts, underwriters, and other CFO’s, I found out that the practice of “managing earnings” was prevalent and an accepted business norm. Wall Street does not like surprises and the extra swing that management gets from applying so called judgment to accounting principles allows them to constantly beat their earnings targets. In good years, certain companies will save “unneeded excess earnings” through arbitrary excessive reserves, to save such earnings for the lean quarters or years when they do not make their earnings targets.

Written by,

Sam E. Antar

PS: I am not making this up.

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