NEW YORK-Securities and Exchange Commission Chairman Arthur Levitt accused Corporate America of “manipulation” and “illusion” when accounting for certain costs.
“In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation,” Levitt said in a recent speech at New York University.
“As a result, I fear we are witnessing an erosion in the quality of earnings, and therefore, the quality of reporting. Managing may be giving way to manipulation. Integrity may be losing out to illusion.”
“Merger magic” is how the SEC chairman characterized one practice at which the SEC looks askance-taking acquisition costs as a one-time charge against current earnings by characterizing them as “in-process” research and development expenses. Such write-offs are based on estimates of the future value of research not ready for commercial applications.
As Levitt gave his speech, America Online, which had been negotiating with the SEC about this issue for a few months, slashed to $70.5 million, or 22 percent, the charge it would take for the $316 million it paid to acquire Mirabilis and NetChannel. AOL had said it intended to write off a substantial portion of the purchase costs as R&D-related expenses.
The next day, MCI WorldCom Inc. filed notice with the SEC that it would slash to $3.1 billion from $7 billion its estimated research-related charges for acquiring MCI Communications Corp.
Another practice that has drawn the SEC’s displeasure is inflating costs associated with a one-time event, a work-force reduction, for example. Improper reporting of these “big bath” restructuring charges can permit a company to disguise low earnings.
Also on Levitt’s hit list is the a practice of employing unnecessarily pessimistic assumptions about future liabilities so as to create a “cookie jar” reserve. This cash stash comes in handy to buffer companies’ earnings reports during downturns in their business.
Wildly optimistic revenue recognition practices also have drawn SEC scrutiny, as happens when companies record sales before the transactions are completed and paid for.
Levitt also criticized companies for failing to comply with the “materiality test” by deliberately including many small errors. Individually, these may escape the notice of auditors, who tend to look for variances higher than a certain percentage of revenues or profits. However, collectively, these small errors can add up to the point where they can mislead shareholders.
“This is a financial community problem. It can’t be solved by a government mandate. It demands a financial community response,” Levitt said.
“Therefore, I am calling for immediate and coordinated action: technical rule changes by the regulators and standard setters to improve the transparency of financial statements; enhanced oversight of the financial reporting process by those entrusted as the shareholders’ guardians; nothing less than a wholesale cultural change on the part of corporate management and Wall Street … rewarding those who practice greater transparency and punishing those who don’t.”
The SEC chairman outlined a course of action that involves several SEC departments.
